2011 – Third Quarter Review

In this blog post we offer you an overview of the third quarter of 2011. We realize that this is a longer post with a lot of content, so we suggest reading the first two sections to gain a broad overview, and to continue from there for further details and insight. For a better view of the graphs included, click on the image and the enlarged image will open in a new window. We welcome all questions and comments!

 Markets Update: Third Quarter in Review

  • Equity markets around the world had their worst quarter since the end of 2008, as investors reacted negatively to the sovereign debt problems in Europe, the budget stalemate in the US, and poor economic data in most developed countries and in some large emerging countries such as China. The broad US market lost over 15%.
  • In US dollar terms, the overall performance in other developed markets was even worse, but that performance differential with the US was entirely due to currency fluctuations. In local currency, developed markets as a whole performed on par with the US. As in most of the past few quarters, there was much dispersion in performance at the individual country level. Greece, which remains at the center of Europe’s sovereign-debt woes, was by far the worst performer. At the other end of the spectrum, Japan, whose dollar-denominated returns greatly benefited from the strength of the yen, and New Zealand were the top performers. The US dollar gained ground against most major currencies except the yen, which hurt the dollar-denominated returns of developed market equities.
  • In US dollar terms, emerging markets had sharply negative returns and trailed developed markets. In local currency, however, emerging markets as a whole had similar performance to developed markets. As in developed markets, there was much dispersion in the performance of different emerging markets. Peru and some of the smaller emerging markets in Asia did relatively well. On the other hand, Russia and other European markets were among the worst performers. The US dollar also gained ground against the main emerging market currencies, which contributed negatively to the dollar-denominated returns of emerging market equities.
  • Value stocks had mixed performance relative to growth stocks. In the US, small value outperformed small growth, but large value greatly underperformed large growth. In other developed markets, value stocks trailed growth stocks across all market capitalization segments. In emerging markets, value outperformed growth across all market capitalization segments.  Along the market capitalization dimension, small caps greatly underperformed large caps in the US and in emerging markets, but not in developed markets outside the US.
  • Most fixed income securities benefited had excellent returns, especially short-term US government securities, which greatly benefited from the flight to quality, and inflation-protected securities.
  • Real estate securities had poor returns but good performance relative to other equity asset classes.

Beyond the Quarter: A Survey of Long-Term Performance

Change in Value of $10,000 Invested in Various Markets

Change in Value of $10,000 Invested in Various Markets

(October 1, 2010-September 30, 2011)

Value of Stock Markets Around the World (January 1990-September 2011)

Returns of Balanced Portfolios (as of September 30, 2011)

US Stock Returns (as of September 30, 2011)

International Stock Returns (as of September 30, 2011)

Country Returns in US Dollars and Local Currency (as of September 30, 2011)

Real Estate Investment Trusts (REIT) Stocks (as of September 30, 2011)

Bond Returns (as of September 30, 2011)

Living With Volatility

The current renewed volatility in financial markets is reviving unwelcome feelings among many investors—feelings of anxiety, fear, and a sense of powerlessness. These are completely natural responses. Acting on those emotions, though, can end up doing us more harm than good.

At base, the increase in market volatility is an expression of uncertainty. The sovereign debt strains in the US and Europe, together with renewed worries over financial institutions and fears of another recession, are leading market participants to apply a higher discount to risky assets. It is all reminiscent of the events of 2008, when the collapse of Lehman Brothers and the sub-prime mortgage crisis triggered a global market correction. This time, however, the focus of concern has turned from private-sector to public-sector balance sheets.

As for what happens next, no one knows for sure. That is the nature of risk. But there are a few points individual investors can keep in mind to make living with this volatility more bearable.

  • Markets are unpredictable and do not always react the way the experts predict they will. The recent downgrade by Standard & Poor’s of the US government’s credit rating, following protracted and painful negotiations on extending its debt ceiling, actually led to a strengthening in Treasury bonds.
  • Quitting the equity market at a time like this is like running away from a sale. While prices have been discounted to reflect higher risk, that’s another way of saying expected returns are higher. And while the media headlines proclaim that “investors are dumping stocks,” remember someone is buying them. Those people are often the long-term investors.
  • Market recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was last this bad—the S&P 500 turned and put in seven consecutive months of gains totaling almost 80%. This is not to predict that a similarly vertically shaped recovery is in the cards this time, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.
  • Never forget the power of diversification. While equity markets have had a rocky time in 2011, fixed income markets have flourished—making the overall losses to balanced fund investors a little more bearable. Diversification spreads risk and can lessen the bumps in the road.
  • Markets and economies are different things. The world economy is forever changing, and new forces are replacing old ones. For example, the IMF noted in its April 2011 World Economic Outlook that while advanced economies seek to repair public and financial balance sheets, emerging market economies are thriving. A globally diversified portfolio takes account of these shifts.
  • Nothing lasts forever. Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.

The market volatility is worrisome, no doubt. The feelings being generated are completely understandable. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value will re-emerge, risk appetites will re-awaken, and for those who acknowledged their emotions without acting on them, relief will replace anxiety.