Economically, not all that much happened in October. On September 30th the Economic Cycle Research Institute (ECRI) said that we were headed for recession based on their leading indicators.[i] Those indicators barely changed at all over the next four weeks, thus the ECRI still forecasts recession. Consumer confidence and employment also remained at or near recessionary territory. One might, on the basis of that information, surmise that nothing much happened in the stock market in October. If so, one would be very, very wrong. We all know that stocks have had a tremendous month (up 14% with one day to go)[ii]. I presented the facts this way to illustrate that markets are capable of massive movements — in both directions – despite little in the way of real economic change.
We are in an era of greatly increased volatility. The Securities and Exchange Commission saw fit a couple of years ago to abolish the uptick rule, a Depression-era rule that banned short selling of declining stocks, which helped discourage waterfall-type declines[iii]. Moreover, the SEC has done nothing to rein in high frequency trading, a high volume, computer-driven strategy that tries to destabilize markets and then profit from the inefficiencies that are created from that instability. Investors and investment professionals need to recognize this and plan accordingly. Corporate earnings growth rates are probably not going to change all that much in the future (since they have been fairly consistent over the intermediate and long term), but stock prices will probably continue to fluctuate wildly. If one can remember that stocks represent ownership in real companies (most of which increase their sales and earnings in any given year), than they have a good chance of making money over time as a stock investor. If you can’t grasp this both intellectually and at the “gut” level, then you should probably use this 14% rally to get out of stocks and stay out. As I stated in the September 30, 2011 Quarterly Commentary, I believe stocks will easily be the best performing asset class over the next 10 years. But not for those who cannot stomach volatility. A market that rose 14% on basically two flimsy pieces of news – 1) the U.S. economy grew 2.5% in the third quarter[iv] (slightly more than expected), and 2) Europe came up with a vague plan to avoid collapse for another several weeks – can easily give back that much and more in November.[v]
Bottom line – Stocks were oversold at the end of September. They were due for at least a modest bounce and wound up getting an impressive one. That said, at today’s level of 1285 on the Standard & Poors 500 we are much closer to the top end of the post QE1 trading range than the bottom, so risk probably exceeds opportunity. The best that can be said for stocks is that we are in a favorable seasonal pattern (stocks have a strong historical tendency to outperform between Halloween and MLK Day). The worst is that the twin issues that produced the 20% decline from the end of April[vi] – the U.S. economy and European sovereign debt – have not gone away.
Emerging market stocks had a very strong October (+20%)[vii] as tough credit conditions in China and Latin America began to ease due to the global slowdown. That unfolded pretty much as we expected (see our September Update). While I believe there is a day of reckoning in China’s future, it is not too late to buy emerging markets funds, both stock and bond.
High yield bonds have also responded to the perceived better outlook for global economies in October. The average high yield fund rose almost 6%. I think the rally will continue. At this point I like high yield bonds, but you have to think of them as a lower risk equity alternative rather than a higher risk bond alternative.
-Mark Carlton, CFA
[ii] As measured by the S&P 500 10/1/11 – 10/28/11
[iii] It did not eliminate them, as all of us who were in the business on October 19, 1987 can attest.
[v] That said, I do not believe that it will.
[vi] As measured by the S&P 500
[vii] As measured by the S&P 500 10/1/11 – 10/28/11