Quick Market Update
Now I Remember What a Correction Feels Like
FEBRUARY 4, 2014
Ron Florance, CFA®
Deputy Chief Investment Officer
In this Quick Market Update:
A 10-percent correction has not occurred in U.S. market since 2011, however, markets are trading lower in 2014 and volatility has spiked.
We view corrections as a normal part of the market cycle, and recent action does not change our outlook.
Volatility can present opportunities, and we are evaluating various tactical shifts that may take advantage of the current market environment.
It’s been over two years since the last U.S. stock-market correction. By “correction” we mean a drop of at least 10 percent from the prior high. With domestic equity markets soaring and volatility muted in 2013, memories have faded as to what a correction feels like and why diversification and rebalancing are important. Back in August 2011, the S&P 500 index fell to 1200 from its April high of 1364. That 164-point drop constituted a 12-percent correction. The numbers are bigger now, with the index having topped out at 1848 on January 15. It is down about 100 points (six percent) as of February 3. At the same time, volatility has spiked from record low levels with the Chicago Board of Options Volatility Index (VIX) now trading around 21 (close to the long-term average of 20).
S&P 500 index
Source: Bloomberg Finance, LLP, 1/13/14. 4Q13 Data is a Wells Fargo Securities estimate.
How did we get to this point?
As 2013 began, stock valuations were low as many investors still had the financial crisis in the back of their minds. Earnings had roared back to record levels, but price-to-earnings multiples were suppressed given lack of confidence in the recovery. Several concerns also were weighing on market sentiment, including the fiscal-cliff crisis, higher taxes and continued dysfunction in Washington. As each issue was addressed during the year, investor confidence was restored and prices rose to a point where we would consider stocks to be fairly valued.
Meanwhile, volatility remained low by historical standards (see VIX chart below). And as the markets continued to rise without a pullback, investors became complacent (with some even wondering why all of their money was not invested in equities). As asset allocators we understood this rally would not continue in a straight line and emphasized rebalancing portfolios back to strategic targets throughout the year. We also recognized the diversification doubters would be proven wrong once again and this appears to be the case in the early part of 2014.
CBOE Volatility Index (VIX)
Source: FactSet, 2/4/14
Last year investors’ portfolios likely became overweighted in U.S. stocks, but tax-sensitive investors may have hesitated to rebalance, and thereby realize their gains until the dawn of the new tax year. One could, therefore, anticipate some selling activity by prudent investors rebalancing their portfolios as well as nervous investors exiting the market ahead of an anticipated price drop. Emerging market currency volatility has created a fear of “contagion,” as some investors worry that uncertainty in very small economies like Argentina and Turkey may ignite a global economic crisis. We believe the emerging market issues are local and contained. On Monday, some investors used a relatively weak Institute of Supply Management (ISM) report, which showed manufacturing in the U.S. was still growing but at a slower pace, as an excuse to accelerate selling of their equity holdings. In our view, this report was highly influenced by unique winter weather patterns and does not indicate a reversal in the recovery trend. As asset allocators, we tend to be contrarians, and look for opportunities when others are only focused on fear.
The markets are not yet in official 10-percent correction territory, but are exhibiting volatility and selling trends that investors haven’t experienced in several years. Though nobody likes a correction, it is a normal and healthy part of the market cycle, as it allows investors who may have missed the run-up in prices to enter the markets at discounted levels.
Will current market action change our outlook?
The latest developments in the capital markets do not surprise us. Nor do they change our 2014 forecasts or capital-market assumptions—in fact, we had anticipated an increase in volatility and expected some consolidation of 2013 gains. Instead of running from this latest bout of volatility, we are looking for opportunities as many high-quality stocks just went on sale. Fundamentals have not changed, in our view, and we believe, if anything, our domestic equity forecasts may be on the conservative side. Meanwhile, we see bond prices becoming increasingly unattractive in this environment and will be evaluating possible tactical shifts in the coming weeks.
Despite recent market events, our investment philosophy remains the same—we mitigate risk through portfolio diversification. Investors looking at last year’s straight-line market ascent may have forgotten how important diversification is to reducing risk. In a nice demonstration of the value of diversification, many of the major asset classes we employ offset equity weakness in January, including nearly all the fixed-income classes, U.S. real estate investment trusts (REITs), commodities and hedge funds. Even at today’s low yield levels, we continue to recommend some exposure to bonds to cushion equity declines and provide liquidity for rebalancing. Real assets (commodities and real estate) are driven by forces different from those that drive stocks. Complementary (hedge) strategies are often designed to profit from stock-market declines and volatility.
Because the equity markets tend to make their moves quickly rather than gradually, we do not recommend trying to sidestep a correction by selling and then re-entering the market before it reverses. Market timing is futile as studies suggest a majority of the stock-market returns occur about six percent of the time.1 We believe this is a time when investors will earn their return while traders miss opportunities.
All data for this Quick Market Update was sourced from Bloomberg Finance, LLP, unless otherwise noted.
Wells Fargo Wealth Management provides products and services through Wells Fargo Bank, N.A. and its various affiliates and subsidiaries.
The information and opinions in this report were prepared by the investment management division within Wells Fargo Wealth Management. Information and opinions have been obtained or derived from sources we consider reliable, but we cannot guarantee their accuracy or completeness. Opinions represent Wells Fargo Wealth Management’s opinion as of the date of this report and are for general information purposes only. Wells Fargo Wealth Management does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.
Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses.
Past performance does not indicate future results. The value or income associated with a security may fluctuate. There is always the potential for loss as well as gain. Investments discussed in this presentation are not insured by the Federal Deposit Insurance Corporation and may be unsuitable for some investors depending on their specific investment objectives and financial position.
This report is not an offer to buy or sell, or a solicitation of an offer to buy or sell the securities or strategies mentioned. The investments discussed or recommended in the presentation may be unsuitable for some investors depending on their specific investment objectives and financial position.
Investing in foreign securities presents certain risks that may not be present in domestic securities. For example, investments in foreign and emerging markets present special risks, including currency fluctuation, the potential for diplomatic and potential instability, regulatory and liquidity risks, foreign taxation and differences in auditing and other financial standards.
Fixed income securities are subject to availability and market fluctuation. These securities may be worth less than the original cost upon redemption. Certain high-yield/high-risk bonds carry particular market risks and may experience greater volatility in market value than investment grade corporate bonds. Government bonds and Treasury bills are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and fixed principal value. Interest from certain municipal bonds may be subject to state and/or local taxes and in some instances, the alternative minimum tax.
Indexes represent securities widely held by investors. You cannot invest directly in an index. S&P 500 Index is a capitalization-weighted index calculated on a total-return basis with dividends reinvested. The index includes 500 widely held U.S. market industrial, utility, transportation and financial companies.
The Market Volatility Index (VIX) is an index designed to track market volatility as an independent entity. The index is calculated based on option activity and is used as an indicator of investor sentiment, with high values implying pessimism and low values implying optimism.
The Institute of Supply Management (ISM) Purchasing Manager’s Index gauges internal demand for raw materials/goods that go into end-production. An Index values over 50 indicate expansion; below 50 indicates contraction. The values for the index can be between 0 and 100.
Some complementary strategies and real assets may be available to pre-qualified investors only.
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1 Morningstar Encorr; Roger G. Ibbotson and Rex A. Sinquefield, “Stocks, Bonds, Bills, and Inflation: Year-by-Year Historical Returns,” University of Chicago Press Journal of Business (January 1976); Standard & Poor’s; and Wells Fargo Wealth Management.