As we wrote last month, the most prudent course of action statistically is to assume any particular decline in a bull market is a “correction” and not the start of a new bear market. Bear markets are only revealed over time. As of August 20th, stocks as a whole have recovered the entire -4.1% drop from July 24th to August 7th. The exception would be smaller companies, which have made up only a little over half of the -8% plunge they experienced earlier in the quarter. Through August 20th, the S&P 500 is up 8.8% year to date, while the small cap oriented Russell 2000 is down -2.1%. See Figure 1. Yes, stocks are expensive, but with the economy growing and companies continuing to buy back shares, the path of least resistance is still upward.
Internationally, markets are mixed. Investors are clearly picking winners and losers. Emerging market stocks are up more than 4% on the quarter, while “developed” foreign markets are off 1%. Europe has been the worst performer, as sanctions against Russia have hurt a number of exporting firms. Many emerging markets have been helped by looser monetary policy in China, but that may be a sign of Chinese economic weakness so one should not necessarily see it as a green light. On the other hand, the Persian Gulf region, believe or not, has seen very strong economic performance lately.
Bonds benefitted from the “flight-to-safety” buying in the first five weeks of the quarter, but have cooled off somewhat of late. Of course this applies to high quality government and corporate bonds. Municipal bonds have the best return so far this quarter because they have rebounded with risk appetites this month without having sold off in July. High yield and international bonds dropped considerably in July and their recovery in August has been modest. Gavekal has pointed out the high correlation over the last five years between Federal Reserve policy and junk bond spreads. The more active the Fed is, the narrower the spread gets because financial institutions take the low cost Fed money and buy higher yielding bonds. As the taper winds toward its conclusion, the risky bond “carry” trade becomes less attractive.
One of the worst performing U.S. sectors this quarter has been energy. Energy is almost always volatile, and even with the -2.6% quarterly loss the sector is up 10.3% year-to-date. That said, supplies are quite plentiful these days despite the conflicts in the Middle East. Demand is slipping as Europe-Russian trade dwindles and that is putting downward pressure on prices. With Germany, France, and Italy each failing to grow in the second quarter, I have to wonder how long the Europeans will go along with the Russian sanctions. As long as they remain in place, however, it is hard to be bullish on energy.
One of the most successful funds over the last one, three, and five years from a risk versus return standpoint is the Deutsch Global Infrastructure Fund. It combines electric, gas, and water utilities, energy pipeline companies, and telecommunications. It has more or less matched the S&P 500 with a standard deviation of just 11, giving it a Sharpe Ratio (excess return per unit of volatility) of 1.59.
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