Markets
In the third quarter of 2011, we saw stock markets around the world continue to suffer from a crisis of confidence in policy-makers. In September 2011 alone, Canadian stocks (S&P TSX Composite Index) fell -8.66% to bring its return to -12.02% for the quarter. U.S. stocks (S&P 500 Index) fell -0.93% for the month of September and -7.00% for the three months ended September 30, 2011. International stocks, as reflected by the MSCI EAFE Index, dropped -3.55% for the month and -12.49% for the quarter. The bond market fared better, with the DEX Universe Bond Index up +1.81% for the month and +5.12% for the quarter. (All figures in Canadian dollar terms.)
Market Index Returns
| Index | Sep2011 | 2011Q3 | 2011YTD |
|---|---|---|---|
| S&P TSX Composite | -8.66% | -12.02% | -11.88% |
| S&P 500 | -0.93% | -7.00% | -4.23% |
| Russell 1000 (Value) | -1.49% | -9.52% | -6.92% |
| MSCI EAFE | -3.55% | -12.49% | -10.46% |
| MSCI World | -2.60% | -9.86% | -7.53% |
| DEX Universe | +1.81% | +5.12% | +7.43% |
| Source: StateStreet All returns in CAD to September 30, 2011 |
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Uncertainty
Even though portfolios structured for longer-term time horizons will be well-positioned to benefit from expected future growth in equity markets, the short-term volatility we have seen in September is unsettling to some. Market declines can be a powerful emotional driver, as we saw in 2008-2009, creating an impulse to change investment strategy. Typically, these periods of extreme volatility signal a high degree of uncertainty among active market participants and today’s short-term uncertainty is driving market decisions to excessive daily proportions.
The primary source of uncertainty is doubt about the willingness of global-policy makers to do the right things. Policy-makers, for the most part, know the nature of the problems they face, whether it is sovereign debt in Europe, inflation in emerging markets, or U.S. unemployment and deficit issues. These are not easy issues to resolve and will likely take years to work through, but they are known.
Solutions for these issues are available. Whether it is through the monetary policies of central banks including interest rate management and the purchase of government securities, or through the multitude of fiscal policies available to governments, the capability to work toward the resolution of fiscal problems exists. It is the doubt in the willingness of policy-makers to take on some risk — primarily political risk — that incites the uncertainty reflected in market volatility.
Risk-on; Risk-off
Take the "risk-on; risk-off trade" concept as an example. When news reports cause market participants to perceive greater risk that policy-makers will not act appropriately ("risk-off"), those investors will move assets to locations that provide the most liquidity, primarily the United States Treasury bond market. To finance this, investors move assets out of the "riskier" stock markets causing significant price changes, or volatility.
When the converse occurs, and news reports indicate a greater likelihood that policy-makers will take appropriate action ("risk-on"), those same market participants will again seek "riskier" assets for their higher return potential. They move from liquidity (Treasury bonds) to stocks, sometimes with overwhelming conviction. Market volatility is amplified by the active nature of participants who follow this trading strategy, and the fact that they follow a trend in a herd-like fashion.
Keep in mind though, that the evidence of global economic growth, although slower than usual, is clear. However, recovery from this balance sheet recession is not the same as a recovery from a typical recession. Policy-makers play a much larger role and market participants must have confidence in their actions. Otherwise, markets experience a crisis in confidence.
Investor Response
The signals of a normal business cycle are muted by the heavy policy actions necessary to stimulate an economy recovering from a balance sheet recession. Without the traditional financial and economic signals, market participants trading for the short term look to other signals and become less nuanced in their interpretation. They are left with an almost binary decision: risk-on or risk-off, leading to volatility.
For longer-term investors, a proven methodology is one that continues to follow the indicators that will guide prudent decisions about long-term investment outcomes. This methodology begins with building the right portfolio structure, and then following economic indicators that will help understand the strengths, and weaknesses, of that structure, with a look to adjust it if necessary.
Today, many long-term investors are at the mercy of the emotional roller-coaster of a daily news cycle that is built to alarm and entertain. The best antidote is to understand the presentation of the news for what it is — an attempt to stimulate emotion — and to keep the investment decisions about your financial future well-grounded in thoughtful analysis.
William R. Horton, Jr., CFA
Chief Investment Officer
October 14, 2011
