Overview

  • Last week stocks suffered their worst pullback since the summer.
  • We do not believe the sell-off reflects a fundamental shift in market conditions, but it does point to three important lessons to be mindful of going forward. Those are:
    • Volatility is starting to rise.
    • Not all market segments are responding similarly.
    • Valuations are likely to matter more as markets rely less on momentum.

A Challenging Week

Last week stocks suffered their worst pullback since the summer. The Dow Jones Industrial Average fell 0.96% to close the week at 17,113, the S&P 500 Index lost 1.4% to 1,982 and the Nasdaq Composite Index declined 1.46% to 4,512. Meanwhile, the yield on the 10-year Treasury slipped from 2.58% to 2.53%, as its price correspondingly rose.

While it was a challenging week for investors, we do not believe the sell-off reflects a fundamental shift in market conditions. However, it does point to three important lessons to be mindful of going forward: 1) Volatility is starting to rise; 2) not all market segments are responding similarly; and 3) valuations are likely to matter more as markets rely less on momentum.

A Number of Candidates, But No Obvious Catalyst

September is living up to its reputation for weakness, evidenced in part last week when stocks suffered their worst one-day decline since the summer. There was no significant or obvious catalyst for the sell-off, contrary to the headlines that attributed the decline to everything from Apple’s supply chain problems to a weak durable goods report to the potential for a Russian retaliation to Europe’s sanctions. Bond prices also were not immune, with high yield once again demonstrating weakness. And while Treasury prices generally held up last week, even that portion of the market experienced volatility on Friday, which may have stemmed in part from Bill Gross's resignation from Pimco.

In our view, Thursday's weakness appears to be a case of lingering global threats (add a new one in the form of a potentially worsening Ebola outbreak) colliding with investor complacency and some stretched valuations. That said, while there was no single, identifiable catalyst for last week's sell-off, a few themes have emerged over the past month.

"Last week may have left investors feeling as if markets have become much more turbulent, but it’s important to put things in perspective."

A Tale of Volatility and Valuations

First, volatility is starting to rise, but from very low levels. Last week may have left investors feeling as if markets have become much more turbulent, but it’s important to put things in perspective. Volatility is still low by historic standards. During Thursday’s sell-off, the VIX Index, a key measure of equity market volatility, peaked at around 16, still 20% below the long-term average. But an impending rate hike from the Federal Reserve and slightly less benign credit conditions are having the predictable impact of nudging volatility higher. As investors begin to prepare for a first rate hike, volatility should continue to normalize.

Second, not all market segments are the same. Equities were generally off last week, although they recovered somewhat on Friday. Indeed, stocks have been struggling since the S&P 500 first crossed the 2,000 threshold in late August, but individual market segments are behaving differently. For example, while U.S. large caps are down barely 2% from their peak, small-cap stocks have never managed to eclipse their February top and are now down roughly 8% from their summer highs.

This leads to the third lesson: Focus on relative value. In many cases, the parts of the market that have been performing better of late are some of the relative bargains.

One of the reasons small-cap names have been struggling is that their valuations are considerably more stretched than those of their large-cap cousins. Based on current earnings, U.S. small-cap stocks trade at around a 60% premium to large caps. That large premium — the result of multi-year momentum-driven gains — appears to be hurting the sector.

On the other hand, one of the interesting aspects of last week’s sell-off was that two of Asia’s largest markets — China and Japan — managed to buck the trend and finish higher. Chinese equities benefited from a better-than-expected manufacturing release while Japanese stocks seem to be responding to share buybacks, which have now reached a six-year high. All that helped, but stocks in Japan and China are also benefiting from modest valuations, at least compared to equity markets in the U.S. and Europe.

The Outlook for High-Yield Munis


Peter Hayes offers his outlook for high-yield municipal bonds, considering implications both for new and current high-yield investors.

Investment Directions

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