Q1 2014 Market Commentary

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Market Commentary
By The Deighan Team

Volatility is back. You may have missed it since the MSCI All Country World Index actually eked out 1.2% for the first quarter of 2014 and the US S&P 500 delivered 1.8%. However, both stock indices were down a worrisome 5% mid-quarter, raising concerns that we may be in for a market correction. US bonds as measured by the Barclays Capital Aggregate Index marched pretty steadily upward cushioning the volatility of the stock side of the portfolios and delivering 1.8% for the quarter. If you never looked at your portfolio mid-quarter, the suggestion that we live in volatile times may seem like much ado about nothing, but if you were heavy in stocks, and needed to draw on your portfolio on February 2, 2014 you would certainly have noticed. Upside volatility is fun, but as we learned in 2008, downside volatility can be a real sticking point.

So, if volatility is back, then what can we expect in the months ahead? We have had a strong 2013 comeback in the equity markets of developed nations worldwide, but the emerging markets that were so hot just a few years ago lost almost 13% for the year. Everything is connected and concerns over the emerging market slowdown have now spilled over into the economies of developed nations still finding their way out of the woods following the 2008 worldwide meltdown. The specific trigger for the mid-quarter pullback in worldwide equity markets may have been the early year Eurozone inflation reports suggesting continued price weakness, coupled with reports out of China showing further economic contraction. The stress in the emerging markets was evident worldwide. Argentina devalued its currency, and Turkey was forced to raise its interest rates sharply to halt a currency decline. Brazil ended the quarter with a debt downgrade when S&P cut their sovereign debt rating to BBB minus. Fortunately, encouraging news that Japan is making headway against years of deflation and stagflation, coupled with signs of economic resiliency in the US and parts of Europe, helped buoy most equity markets back into positive territory. News that China plans to address its downturn with infrastructure initiatives was additional welcome news at the end of the quarter.

Certainly there are challenges everywhere, but in the US, five years of corporate deleveraging, low interest rates, low inflation (especially low wage inflation), and increased energy independence, have put us in a reasonable place to bring back jobs from overseas. Many analysts, including Liz Ann Sonders, Chief Investment Strategist at Schwab, are calling for cautious optimism, pointing to a shrinking US deficit that may even disappear for awhile in 2016. Still, we have many structural issues. Low wages and low inflation may be good for consumers who have decent jobs, but it is tough on the many workers and their families who live near or below the poverty line including many of our youngest workers with heavy college debt. Large financial institutions still have far from transparent financials, and the regulations in place to prevent further abuses are weak and clumsy. Finally, although the Fed’s balance sheet is huge, Sonders points out that on the plus side, velocity of money remains low. In other words, the Fed is slowing its support of the economy. Europe and Japan have made economic improvements as well, but they lag the US in recovery. Europe struggles with drag caused by the weaker economies in the EU and Japan struggles with its energy challenges. On balance, the developed nations are making progress, but we live in a very connected world, and the problems of emerging market nations including China, India, Brazil and Russia will continue to weigh on us along with problems of our own making. As these issues rise to the top, they often trigger sharp market responses.

Speaking of Russia, it looms as a large dark cloud over Eastern Europe and Asia. Political tensions are high given Russia’s intervention in Crimea, and pressure on the Ukraine. It is pretty clear that Vladimir Putin would love to restore Russia to its territorial greatness. As a result, Russia is forcing its ardor on neighboring countries much to the displeasure of the West which has imposed economic sanctions. Europe is heavily dependent on Russia for oil and natural gas, but spring is in the air and current reserves may get Europe through long enough to allow the economic sanctions to have their intended effect. Recent events have taken a harsh toll on the Russian equity markets resulting in a 14% downturn for the quarter.

So, what is to be done to reduce risk of downside volatility in a troubled world? Twenty years ago when Jenifer Wilson and I founded Deighan Wealth Advisors we knew we were stepping into a volatile business. We had already experienced Black Monday on October 19, 1987 when the S&P 500 dropped 25% in the space of a week, but as uncomfortable as that event was, the stock market recovered relatively quickly showing a positive year-end for 1987 and an even better one for 1988. We took heart and over the ensuing twenty years we have helped clients through many volatile market environments. In 1994, just as we started, we looked back to a bad year for bonds, when the Fed tightened five times over the course of the year to battle rising inflation numbers. Each time the Fed hiked interest rates, bond values plummeted, and stocks barely stayed positive. It was a tough year. However, the Fed’s strategy worked. The jobless rate and inflation dropped, and most importantly, compensation growth slowed. As a result, both bonds and stocks bounced out of the 1994 slump laying the foundation for a five year stock market climb to the 1999 tech stock bubble. Of course, that bubble burst miserably in March 2000 and the S&P 500 melted down 30% to its trough in September 2001. During this period, bonds rallied and cash held true, holding up the portfolios for diversified investors. We survived the 2000-2001 stock slump only to plow right in to another irrationally exuberant bull market that ended with the 2008 market crash when the S&P 500 dropped 36%, while the 10-year US bond soared 20% as investors fled to perceived safety. Then, 2009 brought an about face with the S&P 500 seesawing up almost 26% while the 10 year US bond delivered -11%.

We can tell you from personal experience that market volatility is not only back, it has always been with us. There is no silver bullet to avoid it. Market timing attempts do not work. Countless studies have affirmed this. As Northern Trust Company advised in their 2014 Q1 Review: Volatility Happens, “We encourage investors to reduce their sensitivity to volatility. Through proper allocation between risk control assets and risk assets investors can position themselves to ride out the volatility inherent in risk assets.” In short, while we are cautiously optimistic that the growth side of client portfolios can grow further in 2014; pullbacks along the way are normal and should be expected. Following a strong year for stocks, the chances for pullbacks are higher, which is why respecting the role of the risk control side of the portfolio is so important. While the “risk control” side of the portfolio may seem boring and uninspired, we have only to look back to the painful years 2000, 2001, and 2008 to see the value of a diversified portfolio. So, while we hope for political stability and economic growth in 2014, we will also help clients be prepared to ride out the inevitable downside dips. We will do this by paying special attention to cash levels in the case of retired and nearly retired clients to avoid selling growth securities in a down market. This is why we continually ask clients if there are upcoming cash needs or capital expenditures on the horizon. We will continue to diversify client portfolios across asset classes, and perhaps most important of all, we will prepare clients to endure market volatility. From everyone here at Deighan Wealth Advisors, we wish you a happy, healthy Spring!