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Dowling & Yahnke’s Perspective on Recent Stock Market Volatility

By on August 10, 2011
Categories: MARKET NEWS

A week ago, we wrote about tracking the House of Representatives’ passage of a compromise bill increasing the federal debt ceiling and decreasing spending, a bill that was eventually signed into law by President Obama.  The ensuing six trading days saw extreme volatility in various markets, with equities worldwide trending lower.  In just the eleven trading sessions following July 22nd, the S&P 500 lost 17% of its value, wiping out all of its gains since last September.  (Yesterday’s market action provided some significant relief, as the S&P 500 rose 4.7% on news that the Federal Reserve intends to keep short-term interest rates low for the next two years.)  Volatility was highest on August 8, 2011, in part due to Standard & Poor’s downgrade of long-term U.S. debt to AA+ (with a negative outlook), suggesting that U.S. Treasury bonds are no longer “risk-free.”  We take this opportunity to write again, sharing our perspectives on recent events and how they relate to our clients’ investment strategy.

Markets can be volatile.  In recent memory, we have seen many periods of similar volatility: Black Monday in 1987 (a 22.6% drop in the Dow Jones Industrial Average in one day), the tech wreck of the early 2000s, the 9/11 terrorist attacks, and the global financial crisis of 2008-2009.  Short-term fluctuations are often driven by behavioral tendencies:  selling risky assets when bad news or uncertainty prevails and buying risky assets when confidence abounds.  This maxim has rung true in each of these historical periods, as well as, we believe, over the last week.  It is in these periods, however, that investors benefit most from a long-term perspective, resisting the urge to react emotionally, and instead focusing on the four pillars of successful investing:  diversification, low costs, tax efficiency, and discipline.  We encourage our clients to continue to embrace this long-term perspective during these periods of volatility.

An allocation to bonds proved beneficial over the trading week following the debt ceiling deal, from August 2nd through August 8th, with all major segments of the bond market (municipals, U.S. Treasuries, and global bonds) exhibiting positive returns.  Many of our clients have balanced portfolios with significant exposure to high-quality bonds.  The bond component of these portfolios functioned as designed in an adverse stock market.

We believe that stocks remain a compelling investment for those with a reasonably long time horizon.  The current consensus earnings estimate for the S&P 500 Index in 2011 is approximately $96. The S&P 500 Index closed on August 8, 2011, at 1119, equating to a price/earnings (P/E) multiple of 11.7, well below the historical average of 16.4.  This low valuation exists despite healthy corporate profits, buoyed by strong international sales, trimmed payrolls with little wage pressure, and cost efficiencies.  Corporate balance sheets contain over $1 trillion in cash reserves.  Companies can potentially use this trove of cash to repurchase stock, raise dividends, make acquisitions, and/or expand operations, all of which have the potential to increase shareholder value.  From an income standpoint, the S&P 500 dividend yield stands at 2.3%, compared to the 10 year U.S. Treasury yield of 2.3%, based on data at the close of trading on August 8, 2011.  On a fundamental and relative basis, stocks remain attractive and will likely reward investors who hold them at current levels.

A natural inclination at this moment might be to sell stocks and buy bonds, gold, or hold cash.  Unless short-term liquidity is needed, maintaining an allocation to stocks and resisting the desire to sell shares remains, in our opinion, the prudent thing to do.

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