The stock market indices continued their calendar year progress until the month of September, when small cap stocks began what has become a correction now amounting to approximately 12%. Since the end of the quarter, market weakness has spread to a larger range of stocks and the broad averages have corrected approximately 6% from their all-time highs just six weeks ago. The media has covered in depth the significant increase of market volatility in the past few days. What it has been lacking is the solid explanation for the change, or a valid context for what has transpired.
In each of the five years following the financial crisis in 2009, we have had somewhat annoying or even disturbing “corrections.” Usually, they have come in the summer months. In each case there was a headline news trigger which set off selling and by year end investment fundamentals trumped near term concerns. We believe that 2014 will follow the script from previous years.
The U.S. economy is in very good shape and an extended economic recovery continues. In fact, one worry has been that recovery will prompt the Federal Reserve to raise interest rates by the summer of 2015. We consider this prospect to be a positive, not a negative. Another concern has been the deteriorating outlook in Europe, somewhat tied in with the U.S. trade embargo on Russia. While the U.S. dollar has strengthened and U.S. multinational companies are going to be negatively impacted, the opportunity has been created for foreign investors to look more favorably on U.S. stocks, particularly small cap stocks which derive less than 17% of their earnings from foreign sources (in contrast to larger U.S. companies that have 40% of earnings outside of U.S.).
Another influence on markets recently has been a dramatic plunge in the price of energy which negatively impacts energy stocks. Again, this factor is to us more positive than negative as it amounts to a tax cut for U.S. consumers and a clear benefit to airline and travel companies (and we are underweighted in energy). A final possible explanation for market volatility is the recent Ebola pandemic. We now know that U.S. citizens are not entirely protected from the risk of this tragic outbreak. But, we have the best medical research, professionals and facilities in the world.
A theme we have mentioned on more than one occasion, is the under investment in U.S. equities by endowments, foundations and corporate pension funds. These entities have witnessed the “train pulling out of the station.” Now that the correction is occurring, they have another attractive entry point to add to their U.S. equity positions and exit some of the disappointing hedge funds and global equity investment exposures.