Following years of relative calm, volatility in the stock market returned with a vengeance during the third quarter. Sudden losses wiped away all of the modest gains the market had managed in the first half of the year. The S&P 500 declined -6.4% representing the worst quarterly showing for the index since the 2011 third quarter decline of -13.9%. The S&P 500 is now down -4.5% for the year.
At its worst, the S&P 500 was down -12.4% from its high in May. The falloff marks the first official “correction” in four years. (A correction is defined as a market decline that is greater than 10% from its previous peak.) As unsteadying as this seems, the recent drop falls short of the average intra-year decline of -14.2% over the past 35 years. This means that this year’s pullback is actually somewhat routine and has been milder than average, but most would agree that the declines have not felt “routine” or “mild.” After years of steady advances, the swift market decline and the volatility that has followed, have certainly caught investors off-guard.
In contrast to previous market declines, the recent drop has lacked a clear catalyst. Market commentators have pointed to the slumping economy in China and uncertainty in the Federal Reserve’s interest rate policy as primary culprits. However, both of these stories have developed slowly and lack the “punch” to adequately explain the sudden and dramatic decline that began this episode in late August. The absence of an obvious catalyst strongly suggests that the market’s slide has been principally driven by technical (and not fundamental) factors such as program trading and computer algorithms.
With the more than 50% slump in the price of oil over the past year, energy related stocks have been among the market’s worst performers. The S&P Energy Sector Index declined -17.4% in the third quarter and –29.7% over the past 12 months. Along with the general declines in energy companies, Master Limited Partnerships (or MLPs) have suffered especially severe declines. For the quarter the Alerian MLP Index fell –22.1% and has declined –39.2% over the past year. MLPs are energy pipeline and infrastructure companies that typically pay a high dividend yield and are popular among yield oriented investors.
As rough as the third quarter was for the U.S. stock market, international stocks performed even worse. The MSCI EAFE, which measures international stocks, declined –10.2% for the quarter, bringing the return for the year to –4.9%. As worries about Greece and the Euro-zone have begun to recede, renewed concern about the pace of growth in China has surfaced leading to increased nervousness about growth in the global economy.
The wild market gyrations have affected the bond market as well. Although the Barclay’s Aggregate Bond Index has risen 1.1% this year, most of the strength has been concentrated in the safest sectors of the bond market, namely U.S. Treasury bonds and high quality municipal bonds. Meanwhile, riskier segments of the bond market have been battered. High yield corporate bonds, for example, declined -4.9% in the third quarter. Floating rate, convertible, and emerging market bonds also saw significant losses. These declines were primarily the result of a widespread “flight to quality.” Lingering uncertainty, however, about the Federal Reserve’s intentions for its interest rate policy has also added to the market confusion.
In contrast to the disquieting volatility in the financial markets, there have been encouraging signs of strength in the U.S. economy. In the most recent reading, real GDP growth registered an impressive 3.9% annual rate versus the long-term average of 2.9%. The labor market has continued to recover and unemployment has fallen to 5.1%, its lowest rate in seven years. Other indicators, such as housing starts and auto sales, have also shown signs of improvement.
Following such a difficult period in the market, it is understandable for investors to feel somewhat unnerved and frustrated. The sharp declines in the third quarter punctuate what has been a rather dreary 12 months for investors. Stocks have swung violently back and forth over the past year only to end lower than where they began. But these types of disruptions are normal, and, at times, necessary to keep the stock market from running too far ahead of its fundamental underpinnings. We believe that the recent volatility has primarily been a natural consequence of a long and mostly uninterrupted bull market. We have confidence that once the market finds its footing, the underlying strength in the economy will allow the current long-term bull market to resume its upward climb. It also is worth noting that the market has rallied quite a bit in recent sessions, following the end of the quarter.
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Horizon Wealth Advisors is a Houston based fee-only wealth management firm. Horizon is a fiduciary advisor. We specialize in helping successful individuals and families understand, organize, and manage their often complex financial situations. Horizon offers integrated financial planning and investment management services.