Third Quarter Scare

Mid-way through the current year, we observed a noticeable disconnect between the stock market’s above-average performance amidst ongoing gloomy economic news. In fact, for the 12 months ending June 30th, 2011, the S&P 500 earned over 30%.

Then came the third quarter, with each month posting negative returns. At one point the overall market was off about 20% from its recent high in April. Returns on international and small US company stocks have been faring even worse.

What caused the downturn? The markets dislike uncertainty, and there has been plenty of it out there. Scan the headlines for the third quarter, and the word “debt” seems to be everywhere, especially in the form of “sovereign” (government) debt. Debt ceiling negotiations followed by the downgrade of US debt along with the European debt crisis. Each of these events in and of themselves were scary and they all increased speculation of another recession, or double dip. As a result, the word of the day was (or is) … fear.

In August, Standard & Poor’s downgraded US government debt from a top-rated AAA to AA+. Yet, interestingly after the downgrade, US government debt yields fell, as investors around the globe fled — not away from but toward the safe haven of the recently downgraded bonds. In fact, the yield on the US Treasury 10 year note hit an all-time record low, and is currently trading around 2% per year. Apparently investors all over the world still consider US debt to be the closest to a risk-free investment available, even with the downgrade.

In other words stock markets seem riskiest, not necessarily when the news is bad as much as when there’s heightened uncertainty about how bad it may get, and for how long. That’s when investors who lack a long-term plan tend to flee to investments that promise the certainty they’re craving — even if it’s certain low returns such as those currently available from US Treasuries. And when investors flee to safe harbors, it drives down the safe-harbor yields even further. This is what occurred during the height of the panic at the end of 2008. And it’s happening again today.

The antidote to short-term market volatility is to have a long-term plan for your investments.

To that end, even as current market returns seem dismal, there are some reasons for cautious optimism on the economic fronts. Financial author Rick Ferri recently posted an upbeat blog listing ten reasons to be hopeful about the future of our markets. In addition, we recently read a Good News Friday blog that pointed out how even countries with deep debt, such as Iceland and Ireland, often turn around nicely, despite how unlikely it may seem at the time.

Neither we nor anyone else can consistently speculate on or predict any particular market outcomes in any near-term time horizon. But we would suggest that the current downturn will probably prove to be temporary in hindsight, as have so many other downturns in the past. The overall direction of our markets has been upward over the long-term.

Of course, in the larger context of market history, “temporary” can last much longer than any of us would like. If you have near-term spending needs, it’s best to avoid subjecting those necessary assets to market risk. Better to earn paltry returns on dollars allocated for upcoming spending than to watch them dissolve in the face of short-term market volatility.

For your longer-term assets, you can usually afford to let a portion ride out the market stress tests in exchange for expected higher returns. We empathize with those who don’t have a reliable game plan to allocate their assets accordingly, addressing market declines before they happen, so they don’t have to worry as much during them. If you haven’t got a game plan established, now would be an excellent time to start one. If I can help, give me a call.