2015 Third Quarter Report: That Whooshing Sound

Many investors were glad to finally see the end of the third quarter, and most will feel like their portfolios are worse off than they actually are. That whooshing sound you hear is not just air being let out of the markets; it’s also an end to that optimistic feeling that many people had been cautiously building during the long six-year bull market that followed the Great Recession.

The past three months turned yearly gains into yearly losses almost completely across the board. The widely-quoted S&P 500 index posted a loss of 6.9 percent in the third quarter, and is now down 6.7 percent for the year. The Russell Midcap Index has lost 8.5 percent and the Russell 2000 Small-Cap Index is down 7.7 percent in the first three-quarters of the year.

Meanwhile, in the global markets, the broad-based EAFE (Europe, Asia and Far East) index of companies in developed foreign economies lost 10.7 percent in dollar terms in the third quarter, for a negative 7.3 percent return so far this year. Emerging markets stocks of less developed countries, as represented by the EAFE EM index, were down a whopping 18.5 percent for the quarter, and they are down 17.1 percent for the year.

There were many contributors to the loss of confidence in the stock market, and they appear to have been mainly psychological. Analysts blame the Federal Reserve Board for not having raised rates as the so-called “smart money” seems to have expected in September. Why are low rates perceived to be a bad thing? Fed economists seem to believe that the economy has not recovered sufficiently to warrant stopping the central bank’s long-running stimulus program. Who are we investors to argue with the Fed economists?

Except…the explanation for not raising rates had little to do with actual economic activity, which is finally moving ahead, as of the second quarter, at an annualized 3.9 percent growth rate for U.S. GDP. This rate is higher than the 3.7 percent estimate from the Bureau of Economic Analysis, and much higher than the 2 percent rate that the U.S. economy has experienced since 2009. At the same time, consumer income, wages and salaries and spending are all increasing modestly, existing home sales are growing at a 6.2 percent rate over last year, and the unemployment rate, once higher than 10 percent, has finally dropped down to the 5 percent range.

When you look at your portfolio’s decline year-to-date, you see relatively small losses. However, many investors are remembering that they were wealthier just a couple of months ago. It’s tough to watch your portfolio go down, but it’s also worth remembering that people have been predicting a significant downturn—erroneously—for the better part of 6 years.

The third quarter could be a temporary drawdown that sets the market up for a push back into positive territory by the end of the year, which would give us a record 7 years of positive market performance. The alternative is that we could see the year end in negative territory, perhaps even giving us the first true bear market (defined as a drop of 20 percent from the peak) since the Great Recession. We don’t know how the psychology of millions of investors will turn in the next few months, and neither do the smart money analysts.

We do, however, have confidence that the existing bearish volatility will be followed by yet another bullish period that will eventually take us back to higher prices, and we’re pretty sure that the markets will punish anyone who tries to outguess their unpredictable behavior in the short term. Meanwhile, perhaps we should look at the fact that we can buy many kinds of investments at cheaper prices than we could just three short months ago.

In times like these diversification is essential. “Don’t put all your eggs in one basket” is the most simple way to diversify. The goal is to improve your returns for your level of risk, not only to boost performance. By owning various uncorrelated assets – assets that do not move in the same direction at the same time – you have a smoother ride and increase your chance of staying invested for the next positive move in the markets. Diversification also helps to minimize your losses.

Viewed another way, on a day stocks sell off, CNBC would have you believe a horrific bear market is on the horizon. However, when stocks are down bonds tend to stay steady and even advance, mitigating some of the rollercoaster move of your stocks. In addition, alternative assets help to also counterbalance those difficult periods. During the Great Recession (2007 – 2009), equities were down 56.3 percent, but Treasury Bonds were up 15.1 percent.

There is no generic diversification model that will meet the needs of every investor. Your time horizon, risk tolerance, investment goals, financial means and level of investment experience will play a large role in determining your investment mix. This can be an overwhelming task. You can rest assured that Waverly Advisor’s Investment Committee is focused on creating and maintaining well-diversified portfolios for your chosen level of risk.