Markets post record gains

October saw most global markets bounce sharply off their annual lows, and although domestic equities traded dramatically lower on the first trading day of the month, they ultimately rallied to close in positive territory year-to-date.

The Dow Jones Industrial Average experienced its best month since October 2002, gaining more than 1,000 points or 9.72 percent; year-to-date the Dow is now up 5.45 percent. The S&P 500 Index gained 10.93 percent in October, its best monthly performance in almost 20 years, leaving it 1.3 percent higher for the year.

Markets pushed higher despite initial uncertainty surrounding the European debt situation. Investors finally received much needed clarity when European leaders announced details of a comprehensive plan to help relieve debt pressures and protect Europe’s banking system. Gains in domestic economic output also helped drive markets up.

From a technical standpoint, it seems that markets rallied off an oversold situation at the end of September and were able to break above key technical resistance levels during October. But now that markets have gained momentum, some traders are speculating that they may be overbought, which could cause some pressure to sell. The wide range of opinions expressed by commentators and analysts makes reading the tea leaves extremely difficult. One thing is clear: market volatility remains elevated.

International markets up sharply

Despite turmoil in Europe, international markets posted robust gains during October. The MSCI EAFE Index climbed 9.64 percent, although it is still down 6.78 percent year-to-date. The riskier MSCI Emerging Markets Index gained 13.08 percent, but it too is down, 13.53 percent, for the year.

Gains in the emerging markets index were particularly indicative of what has continued to be a risk-on/risk-off period for markets (see chart). October’s risk-on trade was also evident in most other risk asset classes. Still, despite the strong rebound in October, investors may be anticipating additional downside risk.

 

 

Source: Bloomberg

Fixed income continues to anchor portfolios

Core fixed income investments held onto gains in October, while riskier fixed income assets posted strong returns. Both the high-yield and bank loan sectors had traded sharply lower in August and September, as the risk-off trade prevailed. These asset classes have tended to be fairly sensitive to the business cycle and were negatively impacted in the face of recessionary fears. As recessionary concerns subsided during October, investors took advantage of attractive price levels and bought back in. Consequently, the Barclays Capital High Yield Bond Index gained 5.35 percent for the month, though it is still down 2.99 percent for the year. Core fixed income, as measured by the Barclays Capital Aggregate Bond Index, gained a modest 0.11 percent for the month. With the index up 6.76 percent year-to-date, the asset class has continued to provide diversification benefits for portfolios and has helped reduce portfolio volatility.

Better economic news

 

Equity market volatility over the past few months caused many investors, pundits, and even economists to worry that recession was imminent. Consumer confidence plummeted, and doom-and-gloom headlines dominated newspapers. Given this backdrop, it may have come as a surprise to some that the U.S. economy grew at a faster clip in the third quarter of 2011 than it had in either the second or the first. Personal consumption, business investment, and exports all helped gross domestic product (GDP) grow at a 2.5-percent annualized rate during the three-month period ending September 30.

Consumer spending has proven surprisingly resilient, as demand for automobiles seems to have rebounded after slowing in the wake of the Japan earthquake last March. In addition, retail sales have proven fairly robust. Unfortunately, this spending has come at the cost of a declining savings rate, which has fallen to an average 3.6 percent of disposable income.

With the unemployment rate remaining stubbornly high at 9.1 percent and with little in the way of wage inflation, additional spending must come at the cost of saving. Spending helps short-term growth, but a declining savings rate would be a worrisome trend over the medium to long term. Let’s hope that businesses eventually decide to add to the workforce, which would allow spending to grow without a proportionate drop in savings.

Manufacturing has seen a small rebound, with ISM manufacturing indicating slow expansion and industrial production continuing to grow. Housing, on the other hand, is still lagging. A few months ago, it had appeared that home prices might be rising, but additional data revisions have shown that prices continue to fall nationwide, albeit at a slow pace.

Greece, austerity, debt, and yet another plan

 

The European debt situation continues to cause market volatility. Early in the month, stories were leaked that the European Central Bank (ECB), with the tacit approval of Germany and France, was looking at a long-term solution to the Greek debt situation. A proposed resolution was announced at month-end, causing global markets to rally sharply. The plan called for banks to write down Greek debt by 50 percent, a measure that banks had initially resisted. In return, the ECB pledged €1 trillion ($1.4 trillion) to the European Financial Stability Fund to help stabilize European financial institutions.

Investors initially reacted very positively, seeing this as a workable long-term solution. But skepticism quickly returned, as Greece’s prime minister proposed a referendum on the bailout plan. The vote may occur in December or January and could cause market jitters in the interim.

Expect volatility to persist

Markets have been unpredictable, and there is little to suggest that volatility will subside anytime soon. This is especially the case given the political landscape in both Europe and the United States. Until we see less dramatic headline risk and more evidence that the economy can stand on its own two feet, markets could continue to fluctuate. As a result, investors would do well to focus their attention on their long-term goals rather than on the daily newsbeat.

 

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Free Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities.

Authored by Simon Heslop, CFA^®, director of asset management, at Commonwealth Financial Network.

© 2011 Commonwealth Financial Network^®