“Headlines Causing Fear” 4th Quarter 2014 Market Commentary

3rd Qtr Review

Market volatility increased significantly in the 3^rd quarter as the news came out about Ebola, European markets slowing, and ISIS becoming a threat in the Middle East.  Most major indices were down during the quarter led lower by small caps and international stocks, while large US companies and bonds held on to small gains.  In this issue of Allgen’s quarterly market commentary we will discuss how recent fear could create a good buying opportunity in stocks, positives and negatives entering the holiday season and we will give you an update on interest rate trends and how that effects various securities.

Recent Fears and the Market

Fear has increased significantly as we have entered into the 4^th quarter.  Three headlines have caused the most fear; 1) Threat of ISIS in the Middle East, 2) Slower economic growth and 3) The spread of the Ebola virus.  The Ebola virus threat has seemed to cause the most fear.  While we believe Ebola to be a serious worldwide health concern, most experts agree that there is not a high probability of it spreading in developed countries. Here are a few excerpts from a recent article on WebMD.com: “Ebola is much less contagious than many other more common diseases. The virus, much like HIV or hepatitis, is spread through blood or bodily fluids and is not airborne.” “I would anticipate the reproductive rate for Ebola in the U.S. to be zero,” Adalja says. Compared to the airborne organisms spread by casual contact, “it takes effort to get infected with both of these viruses [HIV and Ebola],” Adalja says. (Source: http://www.webmd.com/news/20140806/ebola-virus-how-contagious)

While these recent concerns have caused fear to rise, historically a spike in fear has been a good buying opportunity. The chart on the left compares the S&P 500 (top part of the chart) with the VIX (aka fear indicator – on the bottom part of the chart).  When the VIX has spiked over a level of 20 during the last 2 years (indicated by yellow vertical line) it has been a great buying opportunity.

Recent spikes in fear combined with a positive seasonal tendency for the market to do well going into the holiday season leads us to believe this is a good buying opportunity.

Positives and Negatives Entering the Holiday Season

While the list of positive and negatives doesn’t cover everything, we believe it touches on some of the most important issues. On the positive side, gas prices at the pump are near the lowest prices they’ve been for the last two years (see chart on next page).  The less people spend on gas the more they have to spend on other things.  Secondly, job conditions are improving.  Unemployment recently broke below 6% for the first time since 2008.  The long-term unemployment rate, while still high, has come down significantly from a high near 4.5% to under 2%.  Also, the number of people who voluntarily quit (usually to look for another job) has increased which is usually a positive sign of confidence that one can find a better job.  And Job Openings have increased to nearly the highs prior to 2008. Lastly, it is seasonally a good market environment for stocks.  The chart on the right shows how the market has performed during the 4^th quarter in the S&P 500 since 1928.  The gray shaded areas indicate years like this year – when the market has been going up between 0-10% (S&P 500 is up 8.34%) going through the first 3 quarters, the 4^th quarter was positive 87% of the time. During mid-term election years the 4^th quarter was up 85.7% of the time and during mid-term lame duck years the 4^th quarter was up 100% of the time.  While history is not guaranteed to repeat itself, “We like our odds for a positive 4^th quarter!”

Looking at the negatives we must point out that most likely the Fed will end its quantitative easing at the next Fed meeting at the end of October.  The last two times the Fed ended quantitative easing the S&P 500 pulled back 16% and 19%, respectively.  At the time we wrote this the S&P 500 had pulled back about 7% from its high.   Although experts believe Ebola has a low probability to spread in developed countries a lot of times perception and fear can be a stronger motivator over reality.  A high level of fear of Ebola could cause people to travel less and go out and consume less which could cause some industries (tourism, retail and entertainment) to struggle.  But, it should not prevent people from buying gifts via online retailers.

 Bond Update

Bonds have done their job this year in our client’s portfolios.  Bonds have 3 main uses in a portfolio: increasing stability (lowering volatility), providing a stream of income, and increasing liquidity.  Of those three, the most important thing they have done this year is to provide security when markets have pulled back.  Bonds, in general are doing better than stocks this year and have typically gone up when markets have gone down.  This has allowed us to rebalance portfolios and sell some bonds as they have gone up and buy some stocks as they have come down. Long-term, Allgen is in the camp that believes we are coming out of a balance sheet recession (too much debt followed by deleveraging) which is historically associated with gradually increasing rates.  At this point we don’t see a major threat to bonds sharply decreasing in price.  Consensus points to the Fed starting to gradually increase rates in June of 2015.

 Going Forward

While recent fears have caused the market to drop, we view this as a buying opportunity for stocks.  History shows that times of heightened fear have been good times to buy.  While we believe there are multiple positives like low gas prices, improving jobs outlook and positive seasonal trends that favor a strong 4^th quarter, we also see short-term risks with the Fed ending Quantitative Easing and the perceived fear of Ebola spreading.  While stocks provide long-term growth potential, bonds have served their role in protecting capital, reducing volatility and providing income.  While we do believe interest rates will start to increase next year we think that the increase will be gradual.  We continue to manage risk first in all of our investments, while seeking to outpace our clients’ appropriate benchmark over the long-term net of our fees.

Written by:
Jason Martin, CFP®, CMT, Chief Investment Officer Allgen Financial Services, Inc.; 
Paul Roldan, Chief Executive Officer; Chris Damiano, Operation Specialist

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