• A market rout on Thursday ended an unusually quiet period for stocks.
  • Stocks can still move higher, but further gains are likely to be accompanied by more volatility.
  • Potential triggers for more turbulence include rising geopolitical risk and a less accommodative Fed
  • We would continue to emphasize large caps, particularly in energy and “old tech,” as well as taking a look at emerging markets.

Geopolitical Tensions a Prelude to Volatility?

A market rout on Thursday brought to an end an unusually quiet period for financial markets. Early last week, U.S. equities hit new highs, supported by solid U.S. corporate earnings, particularly from financials, and more mergers and acquisitions activity. But on Thursday, rising geopolitical tensions — including the tragic downing of a Malaysian civilian airliner over Ukraine — finally derailed the rally.

By week’s end, large caps had recovered their losses while small caps continued to slip. For the week, the Dow Jones Industrial Average rose 1.09% to 17,100, the S&P 500 Index was up 0.69% to 1,978 and the tech-heavy Nasdaq Composite Index climbed 0.82% to 4,432. The small-cap Russell 2000 Index lost 0.88% for the week. Meanwhile, the yield on the 10-year Treasury dropped from 2.52% to 2.48%, as its price correspondingly rose.

Despite the market swings last week, volatility is still very low by historic standards. This suggests to us that while stocks can move higher, further gains are likely to be accompanied by more volatility.

The Consequences of Complacency

Thursday’s sell-off was significant in at least one way: It was the first time since April 16 that the S&P 500 moved more than 1% in a day. The three-month streak had not been equaled since 1995.

While the spike in volatility was short lived, it was the first time investors have been shaken out of their complacency since April. And as the uptick is coming from historically low levels — the bottom 1% of historical observations — it may have much further to go. Even at its peak on Thursday, equity market volatility, as measured by the VIX Index, only reached 15, roughly 25% below the long-term average.

Low volatility suggests investors are complacent and not taking into account the prospect for bad news. Indeed, there is no shortage of potential triggers for more turbulence ahead.

To begin, geopolitical risk is clearly rising. If nothing else, last week’s tragedy in Ukraine demonstrated that the unrest in the eastern part of the country is far from over. Meanwhile, we are witnessing the continued fragmentation of Iraq and now a ground war between Israel and Hamas in Gaza.

In addition, investors should be mindful of conditions in credit markets. One of the major reasons volatility has been suppressed is linked to the unusually accommodative monetary policy of the Federal Reserve and a very benign credit cycle. Should the Fed raise interest rates sooner than expected and foster a less accommodative regime, that would likely be associated with a further rise in volatility.

"Even a modest pickup in volatility will feel different compared to the placid environment of the past several months."

So What Do I Do With My Money?

Even a modest pickup in volatility will feel different compared to the placid environment of the past several months. We would continue to suggest investors emphasize asset classes that provide some cushion, primarily vis-à-vis less challenging valuations. In particular, we would favor an equity mix geared toward U.S. large caps, particularly in energy and “old tech,” and would avoid the momentum names in social media.

Last week was a good reminder of why we advocate this approach. Large caps managed to recoup their losses, while small caps — where the price-to-earnings ratio is nearly twice that of large caps — ended the week modestly lower. And more speculative sectors that look even more expensive, such as biotech, suffered the most. Last week’s action also confirms our recommendation for smaller exposure to retailers and consumer discretionary companies, which are also expensive, trading at nearly a 25% premium to the broader market. Retail sales disappointed again in June; year-to-date sales are averaging just 3.5% year-over-year growth versus 4.2% in 2013 and over 5% in 2012.

In addition, we’d still advocate bringing up international exposure, particularly in Asia. The recent improvement in Chinese economic data has provoked the beginning of a rotation back into emerging markets (EMs). Last week was the sixth consecutive week of inflows into EMs, which suggests sentiment toward the asset class is starting to turn.

It is difficult to predict what could trigger another sell-off. But as the old saying goes, “Hope for the best, prepare for the worst.” For investors, that means emphasizing asset classes and regions that offer some relative value, and that can help mitigate the impact of a market correction.

The Case for Dividend-Paying Equities

The question of whether dividend-paying equities make sense today has a fairly simple answer, but there is a caveat. Russ Koesterich discusses dividend-paying stocks’ long-term performance and reveals how investors can benefit while avoiding high costs in the U.S.

2014 Outlook

The List: What to Know, and Do, in the Second Half of 2014

The first half of 2014 was not without a few surprises. What’s in store for the remainder of the year? Find out what every investor needs to know.

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