Volatility has been crazy! The S&P 500 third quarter total return was -13.9% followed by +10.9% for October and now back to declines in November. The Russell 2000 index of smaller stocks returned -21.9% and +15.1% for Oct-Nov. Volatility also reigned in the fundamental world during Q3, as economists cut their +2.5% 2011 U.S. GDP estimates to +1.0% with higher odds of a double-dip recession before reversing to 2H 2011 growth of 2% and higher odds of sustained economic expansion through 2012. One factor in the volatility was the debt ceiling crisis, which was wholly unnecessary but extremely alarming as an indicator of governmental dysfunction. The global outlook was likewise far from stable, as the sovereign debt/banking system crisis in Europe added to the craziness in the financial markets.
I wish I could say this had no impact on the Market Meter, but that was not the case. The volatility of the markets, the economy and politicians translated into numerous changes in our Market Meter inputs. By early October as the volatility was nearing its apex, the Meter had plunged to -2 from +5 in May! This was by far the steepest dive in the history of the Market Meter, but with two points regained this month, it popped back up to 0. Looking into the history books again, we see the quickest roundtrip from bearish to bullish took place in the spring/summer of 2009, which by coincidence was the last time the world didn’t quite come to an end.
In early May, all Market Meter inputs were rated +1 (except the Major Trend which was neutral). The S&P had just reached a new high for the 2009-11 rally at 1370. We were projecting +3.0% to +3.5% 2011 GDP, but were concerned about the negative impact of the severe winter weather, Arab Spring-related oil price spike, and the Japanese earthquake shock to the manufacturing supply chain. We proved to be overly optimistic in our expectation that these were transitory and would reverse by late summer. As we awaited signs of improved growth, the issues discussed above combined to instead cause a manic-depression that captured consumers, businesses and investors alike.
Only two Market Meter inputs were unchanged over the May-November period. The good news is that the Federal Reserve remains totally committed to averting recession/deflation so it is unchanged at +1. The not-so-good news is that the Major Trend (secular trends lasting years or even decades) held at a weak 0 rating. As we have stated many times, the bursting of the credit bubble engendered deleveraging headwinds that may keep risk aversion at the forefront of our investment strategies for years to come.
We’ve been bullish for two years which helped us to earn positive results for our clients, but with the Major Trend and inputs from external research sources flashing longer term caution signals, we viewed the remaining Market Meter inputs with a wary eye. Consequently, as economic forecast and earnings estimate revisions gave warnings of turning negative, we downgraded Economy from +1 to -1 and Valuation from +1 to 0. No such bias was required for the Technical inputs as the selloff quickly cut them to -1. The net result was the +5 to -2 overall drop and we followed the Meter by reducing our exposure to more-cyclical (risk-on) equities and raising cash reserves in client accounts.
Our Autumn Market Message was titled “Whistling Past the Graveyard” and investors suddenly decided to do just that in October. Recession fears were mollified by the surprising +2.5% Q3 GDP report and progress was made on the European debt crisis. The early-October “test” of the August lows was successful, so Short Term Technical flipped from -1 to +1 and that two point swing returned the Market Meter to 0. Thus, for the first time in nearly a year, we increased our equity market exposure by redeploying a portion of the cash reserves raised this spring/summer. Volatility needs to subside for us to see further improvement in the Market Meter, but the European crisis and Congress’s Super Committee failure have kept volatility high.
All of these factors must be taken into account as we develop our economic outlook and investment strategies for 2012. Potential shifts toward more defensive or more aggressive tactics will be determined by the outcomes of that effort. For now, we are maintaining a relatively neutral stance toward the markets.
The opinions and information contained in this message have been derived from sources believed to be accurate and reliable, but FirstMerit Bank, N.A. makes no representation as to their timeliness or completeness. This message does not constitute individual investment, legal or tax advice. All opinions are reflective of judgments made on the original date of publication and do not constitute a guarantee of present or future financial market conditions.
Have a question about investments or investment services? Contact Bob Leggett, Chief Investment Officer, FirstMerit Wealth Management Services, at [email protected].
