Following the tremendous gains in the global stock markets in 2013, many feared that the market had become overvalued and was due for a correction in prices. In fact, January began with market losses, seeming to confirm those concerns. The US markets were off by 3.5% and the International markets were down more than 4%. But the markets rallied in February. In most markets, gaining back all of the January losses, and then some. Markets were mixed in March, finishing the quarter to close with a modest gain in most major equity asset classes.
The best performing group of stocks was International Small Cap, which had a first quarter return of 3.36% based on the MSCI EAFE Small Cap index. The bottom group was Emerging Markets, which rallied to finish the quarter nearly even at -0.43% for the MSCI Emerging Markets index. The widely followed S&P 500 finished right in the middle with a first quarter return of 1.81%.
The Return of Volatility
With markets finishing the quarter with small gains, the surprising story of the first quarter was the return of market volatility. Here’s a sampling of the headlines:
Of course, in every story there’s someone ready to tell you how to profit or invest:
February 3: Forbes, Market Volatility is Another Reason to Play Investment Defense
February 25: The Street, How to Profit on Stock Market Volatility
Here’s the back story: 2013 was not only a very good year for stocks, it was a year of surprisingly low volatility. In fact, we noted this in our 2013 Market Summary:
What’s remarkable about the 2013 stock market is not the 30 plus percent returns, although it’s certainly remarkable. In fact, 2013 delivered the highest returns for the S&P 500 since 1997, and the 13th highest calendar year going back to 1926. What was truly notable is how steady the ascent was.
So, were the first three months of 2014 a return of volatility as the financial media and investment pundits suggest? In our analysis, put simply, no. The media is reacting to an increase in daily volatility compared to the unusually low volatility of 2013. However, when the same comparison is made with a longer term perspective, it becomes clear that the daily volatility experienced in the first quarter of 2014 is still low by historical standards.
The chart below shows the number of days that the S&P 500 gained or lost more than 3%, 2% and 1% for each year since 2009 as well as the full period of 1970-2013. The complete data is on the attached table. (Click to enlarge)
But if the volatility is still low by historical standards, why has the media made this the story?
We can only assume, but “volatility ticks up, still low historically” doesn’t make for great headlines. “Watch out, rough waters ahead” is much more eye catching.
For most investors, increased volatility reminds them of the inherent risk of investing in stocks. Volatility becomes equated with a higher likelihood of losing money. And while it’s true that major market losses tend to happen during periods of increased volatility, the opposite is not true. Periods of high volatility do not necessarily equate to market losses, just as we saw in 2009.
Equity markets continued to deliver gains in the first quarter in nearly all major asset classes, albeit more tempered than last year. Investors in international small cap were rewarded, as were value investors globally.
In the U.S. markets, the popular S&P 500 index closed the quarter with a gain of 1.81%. Small cap stocks delivered a similar, but slightly lower gain of 1.21%. Value stocks outperformed growth as the Russell 2000 Value index of small cap value stocks grew 1.78%, separating itself from the Russell 2000 Growth index return of 0.48%. Large value stocks were the top performers in the U.S. as demonstrated by the Russell 1000 Value index return of 3.02%.
Among international markets, small cap led all groups with the EAFE Small Cap index gain of 3.36%. International small value did even better with a return of 3.59%. The large cap international EAFE Index gained a modest 0.66%, while the large value EAFE Value index grew 1.17%.
The range of returns across developed countries was broad. Italy led with a return of 15.03% and Japan lagged all developed countries, losing 5.10%.
Emerging markets began the year with significant losses in January. They rallied through February, and especially the closing weeks of March, but it just missed closing in the black. The MSCI Emerging Markets index lost 0.43% for the quarter.
The range of returns for Emerging Market countries was even more broad with Indonesia gaining 22.44% and Russia losing 14.69%.
Whether volatility will continue to increase or a return to calm seas is in store, we don’t know. But we do know that reports of volatility in the media should not be cause for concern. What is causing the increase in volatility? Speculation. That is all. There is a great deal of uncertainty in world affairs and in the US with a new Fed chair and a few years of really strong stock market returns along with less than stellar economic numbers. In periods of uncertainty, market volatility generally increases.
Our investment strategies are built around the philosophy that risk and return are related. As volatility increases, so does the perception of risk. The good news is that our client portfolios are properly positioned to ride through the process, whatever it may bring.
All the Best!
Scott A. Leonard, CFP®
Eric S. Toya, CFP®