A Mixed Bag Keeps Investors on their Toes
The final week of the third quarter saw volatility rise somewhat as investors reacted to a series of developments—some positive, some negative.
U.S. Gross Domestic Product growth for the second quarter was revised higher, to 1.4% from 1.1% (better than the 1.2% revision that investors expected). Business investment during the second quarter was stronger than initially reported, while consumer spending remained healthy.
That said, economic growth for the first half of 2016 was just 1.1%—data that concerns investors who believe the economy should be growing faster at this point in the economic cycle, and that reassures some investors that the Fed was justified in holding rates steady earlier in the month.
Consumer confidence in September also was better than expected, hitting its highest level since 2007, while new home prices in July (as measured by the S&P CoreLogic Case-Shiller 20-city home price index) rose 5% on a year-over-year basis. Corporate America’s confidence also improved, with higher-than-expected durable goods and capital goods orders in August.
Overseas events impacted the markets significantly. A major surprise came from OPEC, which agreed to limit its oil production to between 32.5 million and 33 million barrels per day. Oil prices rose 4% and energy company stocks rallied, as investors hoped the agreement would help reduce the current oversupply of oil. Some skeptical investors were cautious, however, pointing out that many details (such as which OPEC countries will be allowed to cut production) still need to be worked out.
Investors expressed concerns about the regulatory capital levels at Deutsche Bank and Commerzbank, two of Germany’s largest financial institutions, and whether any problems there could spread to other banks and create a credit crunch. Stocks fell sharply and volatility spiked on the news.
More positively, measurements of eurozone economic confidence and business confidence both rose to higher-than-expected levels.
GAIN: Active Asset Allocation
Global stocks ended the third quarter near their all-time highs. The Fed’s decision to keep interest rates low earlier in September helped maintain liquidity and helped markets drift higher.
We continue to overweight small-cap stocks and emerging markets, which have benefited from the ongoing stock market rally. Volatility in the stock market remains at or below its historical average, despite a spike late last week on financial concerns about two major German banks. It is possible that volatility could rise as we get closer to the Presidential election in November.
In contrast, commodities experienced volatility. In particular, oil prices are swinging to the upside and downside on announcements of changes to production targets and changes to supply and demand expectations.
In fixed-income markets, rates remained low. As long as equity markets remain stable, we expect to continue to favor corporate bonds due to their attractive yields.
PROTECT: Risk Assist
Volatility, as measured by the CBOE Volatility Index (VIX), was subdued for much of the week, although it surged higher on Thursday in the wake of concerns over the financial health of two major German banks.
It is possible that the VIX will rise going forward, as October has historically been the most volatile month of the year. For example, the average October VIX level over the past decade is 23, versus an average of 19.5 for all the other months combined. Accordingly, we have updated our volatility forecasts and hedge/unhedge trigger points for all Risk Assist models. Our volatility forecast for the S&P 500 in October fell to 9.2%, historically very low, which is one reason why protection is so cheap today.
SPEND: Real Spend
Stocks outpaced fixed-income markets for the third quarter. All Real Spend models were already at their maximum spending reserve allocations, and the quarterly rebalancing in these portfolios will reset them back to their optimal allocations for each spending rate.
Given the equity market’s performance—and given Real Spend’s overweight allocation to equities relative to many traditional target-date funds—now is a good time to remind ourselves of some facts about the historical returns of equities versus fixed-income*:
- Percentage of rolling 5-year periods since 1926 in which bonds beat stocks: 24%
- Percentage of rolling 10-year periods since 1926 in which bonds beat stocks: 15%
- Percentage of rolling 15-year periods since 1926 in which bonds beat stocks: 5%
- Percentage of rolling 20-year periods since 1926 in which bonds beat stocks: 0%
Past performance doesn’t guarantee future results, of course. But as almost 90 years of history shows, stocks have won out over bonds the vast majority of the time. Real Spend’s systematic portfolio management was designed with the goal of taking advantage of this long-term trend, while still keeping a careful eye on downside risk management.
*S&P 500 Total Return and Intermediate-Term Government Bonds using Quarterly Data from Ibbotson.