The Markets Had Been Calm Until Recently
Thursday, October 16, 2014

If the volatility we’ve been experiencing as of late feels like a splash of cold water, it’s likely because it’s been a while since we’ve really experienced it. An extended stretch of calm waters preceded the U.S. market’s recent bout of volatility.

I’m going to share with you some updated numbers from what we crunched for last week’s AAII Dividend Investing update to put things in perspective. We use the iShares Dow Jones U.S. Index ETF (IYY) as the benchmark for both our DI and for our Stock Superstars Report portfolios. This ETF tracks the performance of the largest 1,260 U.S. stocks, giving it exposure to a combination of large-, mid- and small-cap stocks. This ETF incurred daily price changes of 1.5% or more 62 times in 2011 (29 days up by 1.5% or more and 32 days down by 2% or more.) For the entire period following 2011, meaning January 3, 2012, through yesterday, October 15, 2014, the ETF experienced a total of 39 days with a daily price change of 1.5% or more (20 down and 19 up). Again, 62 days in 2011 alone versus just 39 days for the nearly three-year period of 2012 through 2014.

Let’s look at the volatility another way. Wayne Thorp, who maintains a dashboard of market indicators for our Computerized Investing service, has been tracking the number of 1% down days for the Dow Jones U.S. ETF since 1999. Through Wednesday, he counted eight 1% down days over the last six months. This is below the median of 17 days and the average of 19 days with drops of 1% or more since 1999. (Wayne elaborates on this indicator in his Editor's Outlook in the October Computerized Investing email newsletter that is being sent out this weekend.)

We’ve enjoyed the calm and now we’re having to adjust to what is, at least for right now, rougher waters. Whether the current bout of volatility represents a reversion to the mean or something else is open for debate. What I can tell you is that large-cap stocks are now in a pullback (a decline of 5% or more) and small-cap stocks are in a correction (a decline of 10% or more).

Our decision not to extend the current bull market through the end of the third quarter for the purpose of calculating performance for both mutual funds and the AAII Stock Screens reflects the uncertainty caused by the data. As we discuss in the upcoming Quarterly Low-Load Mutual Fund Update newsletter, the average third-quarter returns for funds in the mid-cap category, the small-cap category, all international categories and the majority of sector stock categories were negative. We want to see if the third quarter’s and this month’s returns turn out to be just a temporary dip or the start of a new phase for the stock market.

There’s no denying the worrisome headlines floating about. Ebola is spreading, the Ukrainian crisis has not been resolved, ISIS is organized and is funding itself through black market oil, the European economy remains stagnant with deflation still a threat, earnings estimates for U.S. companies have been falling and economic growth isn’t great here either. On the other hand, prices at the gas pump are falling, the dollar is stronger, the U.S. economy is still expanding, companies are fiscally sound, interest rates remain low and stock valuations, while not cheap, aren’t expensive.

As humans, we tend to project current events as continuing into the future (“recency bias”) and feel the pain of losses more than we derive pleasure from gains (“prospect theory”). Given these emotional tendencies, the hyperbole that gets used by the financial media and the relative calm market conditions we had been enjoying, the recent volatility doesn’t feel good. But stocks are volatile assets. They can fluctuate quite a bit over the short term. Over the long term, however, the higher returns compensate you for putting up with the short-term volatility.

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AAII Model Portfolio Update

A merger prompted the removal of one stock from the Model Shadow Stock portfolio on October 1, 2014. Medical Action Industries (MDCI) was acquired by Owens & Minor Inc. (OMI). Medical Action Industries shareholders received $13.80 per share as a result of the merger. A replacement stock for the portfolio has not been named.

The Model Shadow Stock Portfolio’s -11.6% return for September 2014 trailed its comparison benchmarks: the Vanguard Small Cap Index (NAESX) declined 5.3%, and the DFA Micro Cap Index fund (DFSCX) fell 5.7%. For the year-to-date, the Model Shadow Stock Portfolio has declined 10.3%, trailing the Vanguard Small Cap Index fund (up 0.5%) and the DFA US Micro Cap Index fund (down 5.8%). The Model Shadow Stock Portfolio has a compound annual return of 17.0% since its inception in 1993, while the Vanguard Total Stock Market Index fund (VTSMX) has gained 9.3% annually over the same period.

The Model Fund Portfolio fell 4.1% in September. In comparison, the Vanguard Total Stock Market Index fund was down only 2.1%. For the year-to-date, the Model Fund Portfolio is up 5.1%, while the Vanguard Total Stock Market Index fund gained 6.8%. The Model Fund Portfolio has a compound annual return of 9.4% since inception in June of 2003, and the Vanguard Total Stock Market Index fund has gained 9.2% annually during the same time period. 

The Week Ahead

Third-quarter earnings season will hit full stride next week with more than 125 S&P 500 members reporting. Included in this group are Dow Jones industrial average components International Business Machines (IBM) on Monday; The Coca-Cola Company (KO), McDonald's Corp. (MCD), Travelers Companies (TRV), United Technologies Corp. (UTX) and Verizon Communications (VZ) on Tuesday; AT&T (T) and The Boeing Company (BA) on Wednesday; 3M Co. (MMM), Caterpillar (CAT) and Microsoft Corp. (MSFT) on Thursday; and Procter & Gamble Company (PG) on Friday.

Tuesday will feature the week’s first economic report of note, September existing home sales. The September Consumer Price Index (CPI) will be released on Wednesday. Thursday will feature the October Purchasing Manager’s manufacturing index flash. September new home sales will be released on Friday.

Federal Reserve Governor Daniel Tarullo will speak publicly on Monday.

The Treasury Department will auction $7 billion of 30-year inflation-adjusted Treasuries (TIPS) on Wednesday.

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AAII Sentiment Survey

Optimism among individual investors rose to a six-week high despite the recent downward volatility in stock prices, according to the latest AAII Sentiment Survey. Neutral sentiment fell to its lowest level in 19 months, while pessimism rose to a two-month high.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 2.8 percentage points to 42.7%. This is the highest level of optimism registered by our survey since September 4, 2014 (44.7%). It is also the ninth week out of the past 10 with optimism above its historical average of 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 5.5 percentage points to 23.6%. This is the lowest neutral sentiment has been since March 14, 2013 (22.6%). It is also the third week in the past four with a neutral sentiment reading below the historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 2.7 percentage points to 33.7%. The increase puts pessimism above its historical average of 30.5% for the third consecutive week.

We’re starting to see some signs of polarization in terms of attitudes toward the market. Neutral sentiment has plunged by a cumulative 10.1 percentage points over the past two consecutive weeks. The drop has put neutral sentiment close to the bottom of its historical range. (One standard deviation below average is 22.1%.) At the same time, bullish sentiment has rebounded by a cumulative 7.3 percentage points over the same period. As far as pessimism is concerned, the current three-week streak of above-average bearish sentiment readings is the first such streak since August 22 through September 5, 2013.

Some AAII members have been looking for a dip in stock prices to reduce valuations, and this may be contributing to the increased optimism. Also playing roles are earnings growth, sustained economic expansion and the Federal Reserve’s tapering of bond purchases. Keeping other AAII members cautious are worries about a continued drop in stock prices, a sense that prevailing valuations are still too high, geopolitical events, the pace of economic growth and Washington politics.

This week’s Sentiment Survey special question asked AAII members what industries or sectors they like right now. Nearly one-third (31%) of respondents said they liked health care stocks. Energy ranked second, picked by more than quarter of respondents (26%). Technology ranked third (16%), followed by financial companies in fourth place (14%). When we last asked this question in early June 2014, respondents said they liked energy, followed by technology and health care, and then industrials.

This week’s Sentiment Survey results:

Bullish: 42.7%, up 2.8 points
Neutral: 23.6%, down 5.5 points
Bearish: 33.7%, up 2.7 points

Historical averages:

Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!