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Volatility Spikes as Stocks Drop and Treasuries Gain

Well that was quick. It was just three weeks ago that the S&P 500 was making new all-time highs and now instead of being up above 2,000, the index closed on Friday at 1,906. That caps a 5.2% decline in price since its recent peak on September 18. YTD the index is still holding on to gains, and remains up 4.8% on a total return basis. The financial news media was quick to point out that as of Friday’s close the Dow Jones Industrial Average is now negative for 2014. However, that is on price change only. When dividends are taken into account the Dow is still up 1.6% since the start of this year.

After a few roller coaster days on Wall Street, almost every single equity index around the world was lower for the week. In the U.S, the S&P 500 was down 3.1% while mid and small caps lost over 4%. Asian shares fared a bit better as Japan was down only about 1.5% in USD thanks to a strengthening Yen and Chinese equities actually managed some modest gains. European shares were generally hit the hardest as many markets across the continent saw declines of 5% or more.

The normal inverse relationship between bond and equity prices was in effect this week, as the selloff in stocks spurred a flight to quality in U.S. Treasuries. Treasury yields were down 10 basis points or more for maturities greater than two years. The yield on the 10 year was down 15 basis points for the week to close at 2.28%, a level not seen since the “tapper tantrum” of June 2013.

The strong moves in the market came about even though it was a relatively light week for economic data. The equity selloff began in earnest on Tuesday as the IMF released a lower forecast for its expectations of global growth. The IMF now expects world GDP to grow by 3.3% in 2014, down 0.1% from its projection in July. The Washington D.C. based agency is also increasingly worried that fewer and fewer countries seem to be able to keep pace with the relatively modest recovery that has been taking place in the U.S.

The release of the Fed minutes on Wednesday sent markets sharply higher and provided a brief respite from recent declines. The minutes seemed to stress what the Fed has been saying for quite some time; rate increases will be dependent upon good economic data and will not be conducted on a predetermined schedule. Nevertheless the calm did not last as comments on Thursday from ECB President Mario Draghi reinforced concerns over economic growth in Europe. While Draghi stands firm in his commitment to ease conditions further if necessary, the German finance minister expressed concerns this week over conducting outright purchases of government bonds. This difference of opinion is important as U.S. style QE is slowly becoming the only monetary tool Europe has left.

The market decline has brought with it a sharp increase in the general level of volatility. Of the eight trading days in October so far, six of those days have seen a move of more than 1% (up or down) in the S&P 500. If you recall back to the summer, the S&P went 62 days starting in May without a single gain or decline of more than 1%. That streak of low volatility was the longest since 1995.

Another measure of volatility is the VIX, commonly known as the market’s “fear gauge”, which jumped over 38% this week to close at 21. While that increase is a bit startling, the index is now within one point of its long term average. That tends to suggest that this week’s moves were not completely out of the ordinary and that up until recently markets had been unusually calm and perhaps even a bit complacent.

The pro-democracy protests in Hong Kong picked up steam again on Thursday after the local government backed out of planned talks with the “Occupy” movement organizers. The protests had waned dramatically in the past few days in anticipation of the planned talks, but by Friday people were returning to the streets to make their voices heard. The protests over the past couple weeks stem from an August 31st ruling issued by the mainland government that outlined the nominating criteria for electing the city’s leader in 2017. Among other requirements, all candidates must “love China, love Hong Kong” and while that may seem reasonable initially, the ruling ultimately means that voters will only get to choose from a short list of Communist Party approved officials.

A man walks to work as pro-democracy demonstrators sleep on the road in the occupied areas surrounding the government complex in Hong Kong on October 6.
A man walks to work as pro-democracy demonstrators sleep on the road in the occupied areas surrounding the government complex in Hong Kong on October 6.

Such a screening process undermines the universal suffrage which is declared in Hong Kong Basic Law, the governing document of the city that has been in place since the British returned its former colony to Chinese control. And that is the crux of the issue here. Western media has been quick to jump on the term “Umbrella Revolution” to describe the events that have unfolded, but the protesters are also quick to dismiss the term. From their perspective they are not revolting and trying to overthrow their existing government structure, they are simply demanding that the already agreed upon form of government be carried out.

Earnings season for the third quarter kicked off after the close on Wednesday with a good report from aluminum manufacturer Alcoa. A total of six companies in the S&P 500 released earnings this week. Things pick up next week with 53 companies in the index scheduled to report, including J.P. Morgan, Citigroup, BlackRock and Google. According to data compiled by Bloomberg, analysts are expecting company profits for the S&P 500 to gain 4.8% and sales to increase 4.2% compared to last quarter.

Sears Holdings, the parent company of both Sears and Kmart, had a bit of a rough week. The iconic albeit struggling retailer was down over 15% as news came first on Wednesday that vendors have begun to halt shipments to the company. It is certainly hard to sell stuff if you have no inventory, and it is hard to get inventory if people don’t think you are going to pay for it. More bad news came on Friday when it was announced that Kmart was the latest retailer to have the security of its payment system compromised. No word yet on how many customers are affected, but it is believed the breach has been going on for about a month.

Economic data out next week will include PPI, retail sales, and the Fed’s Beige Book on Wednesday. Industrial production will be out on Thursday, and Friday will close out the week with a reading on consumer sentiment. Earnings reports will also be in full focus as the stock market looks to regain its footing. Monday is Columbus Day, which means that the bond market, banks, and APCM will all be closed. Equity and option markets are open for normal trading. Have a good week everyone!

 

Nicholas Case
Senior Investment Analyst

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