After one of the best weeks in years, we endured one of the worst, with volatility persisting. The absolute returns were sharply lower, though Top 20 and CG/B tracked the market relatively closely:
Before I discuss each of the models, I want to briefly share my perspective on what happened this week. We had moved to the top of the range since the market broke down in early August on Tuesday, but reversed sharply to end the day down. On Wednesday, the FOMC concluded its two-day meeting and announced, as widely expected, its plan to extend the maturities of its Treasury holdings as well as to begin reinvesting principal and interest payments back into the mortgage market again. The trouble with the market really began when the statement was released. Already the FOMC had telegraphed its concerns about economic deterioration at the last meeting, in August, when it shared for the first time that rates would likely remain low until 2013. Perhaps to justify its policy action, but also to encourage Europe to act quickly to fix its financial mess, the FOMC cited a "significant downside risk" to the economy. The market sank 3%, but the trouble really kicked in on Thursday, with emerging markets breaking their old lows substantially for the most part (particularly China) and precious metals breaking down as well. By the end of the week, the U.S. market was one of the few that hadn't taken out its August lows, though many key stocks surely did.
Top 20 declined by 7.3%, which was about 0.76% worse than the S&P 500. Given how much more dramatically smaller stocks fell, it might have been worse. Performance was quite varied, with a few stocks actually rising. On the other hand, we had a few stocks that were slammed to 52-week lows, including our Energy stock, our Financial stock and our Emerging Markets ETF.
Conservative Growth/Balanced declined by 4.45%, which was .87% worse than the blend of stocks and bonds. We retain a slight advantage relative to the benchmark so far in 2011. Here, we were hurt by the same Financial stock that impacted Top 20 and our overweight relative to the benchmark (we had about 13% more stocks than the 60% in the hybrid index). One stock managed a gain. I have identified a new opportunity and expect to rebalance a bit and to use our excess cash potentially.
Sector Selector ETF fell 8.25%, which was 1.7% worse than the S&P 500. I continue to be set up entirely incorrectly for the environment that has persisted over the past two months, with recent trades exacerbating the situation. During the week, Financials, Small-Caps and Emerging Markets were all sharply lower than the the overall market. While we have reduced our exposure to Mega-Caps and to Technology, our remaining holdings fell substantially less than the S&P 500. While I may be forced to change my outlook in coming days, I continue to believe that our positioning will prove to be advantageous.
Outlook
I have been discussing three scenarios over the past couple of months. The least likely scenario in my view, which is that the the lows of early August are taken out significantly, certainly feels more likely after a week like this. After all, most other markets have done so already and are officially in bear markets. My optimistic scenario (that this was all a big mistake) is looking less likely, but I wouldn't rule it out. The world is fixated on European banking issues related to the debt of Greece and other weak EMU member countries (Italy, Spain, Portugal primarily). For us to rocket out of here requires a credible fix, which is complicated but possible, but it needs to happen very soon.
I continue to think that the most likely scenario is that we come out of the range we have been in positively, but that it takes a while. This is not fun, because the environment stays risky and volatility remains heightened. Hence, a week like last week followed by one like this week. Did this week's action kill this scenario? I don't think so, but I have to admit that my own fear level escalated sharply on Wednesday after hearing the Fed's statement (significant risks). The cynic in me believes that the Fed is trying to push Europe to step up and implement a unified solution (just as they appear to be shaking their finger at Congress and the President). It's true though, and we knew it before, in this interconnected world, we all suffer when leading global banks are losing confidence.
We saw a lot of capitulation this week, including the emerging markets breaking down. This cascaded into US Industrials breaking down (DD, MMM, CAT) as well as commodity prices plunging. There aren't too many areas of the market left to capitulate - maybe it has to happen. After AAPL, there aren't too many. Still, veteran market watchers know that the end of a correction or bear market usually takes place when investors throw in the towel on their favorite investments. Gold's plunge certainly smells of this type of capitulation.
Finally, as ugly as the two-day move proved to be, U.S. stocks, as measured by the S&P 500, held the lows of August. Now, we can ill afford to stay down here long, so even those of us who remain hopeful may have to hide under the desk in coming days, but the market has proven to be resilient in the face of lots of challenges.
So, wrapping it up, the risk case certainly is gaining momentum, but it's too early to call it. I have given some thought, for what it's worth, to what the downside might be. I am coming up with about 1000 on the S&P 500, which is 12% below our close today. That's not my expectation at all, but that's an area that we should expect if the market gets closer to the 1100 area. On the other hand, I think a test of 1250 in the near-term is likely on a move just a little higher from here.
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Final Thoughts
It's very easy to let one's emotions take over during periods of extreme volatility such as we have experienced over the past two months. It's important to keep perspective. Seeing a 7 or 8 percent decline in a week can lead to a fear that in another 12 or 13 weeks, it will all be gone, but that certainly isn't the case. Just as the market rallied sharply five consecutive days last week when hopes had been dashed on the prior Friday (9/9), we never know exactly what lies ahead. The best opportunities are typically when things feel horrible, while the worst ones are following extended periods of success. Anyone remember early 2000?
Stocks are roughly unchanged over the past year and even the past 10+ years. There are no guarantees, but stocks look to be a great bargain. I don't always say that because that's not always the case. I don't know if things start to get fun again Monday, October, January or 2013, but I remain optimistic that long-term investors will be rewarded over the next decade.
Regards,
Alan Brochstein, CFA
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