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Market Commentary 09/30/2014


This quarter we saw markets, economies and central bank behavior move in distinctly diverging directions. While the average stock fund posted a negative return for the first time in nine quarters, there were a few sectors that defied the average, showing positive returns. Generally, we have seen an increase in volatility across the sectors, with levels reaching their highest since a spike earlier this year. After enjoying several years of muted volatility in investments around the globe and having many stock markets near their record highs, the increased volatility shouldn’t come as a tremendous surprise. For the last year we’ve been talking about, and preparing portfolios for, a period when markets aren’t uniformly moving up.

At Legacy, one of our core principles is diversification. It is one of the best ways to reduce the risks that come from any one investment, whether it is an individual stock, bond, sector, region or fund. However, diversification is less appreciated and more difficult to achieve when asset classes move together. As we look at the performance of individual portfolio holdings since the beginning of the year, we examine the movement of the different investments that are moving out of step with one another. After a considerable period where economies and markets tended to be highly correlated, we are now seeing strong divergence that is also filtering down to regions and sectors.

While it may not feel robust, the US economy has been showing signs of improvement at the same time that much of the rest of the developed world has been struggling. This is causing the Federal Reserve to consider raising rates as the US economy is arguably reaching an “escape velocity,” at which point it will no longer need the extra boost from Fed policy. The healthy growth path of the US economy, however, is starkly different from the outlooks in Europe and Asia. Europe has experienced two recessions over the last decade and now their biggest economies look to be sliding toward a new phase of stagnation. Japan is showing some modest signs of life after aggressive stimulus programs but took a step backward after the country’s April tax hike. When we look at China, we see their role as a global growth engine threatened by rapidly decelerating growth. In August the country recorded the worst industrial production growth in over five years.

Among US companies, there has also been a considerable divergence in performance. Since reaching their highs in recent months, US large caps have maintained modest growth while US small caps have entered correction territory. This difference is evident in the quarter’s returns as large companies (represented by the S&P 500) returned a modest but positive 1.1% contrasted with a loss of 7.4% for small cap stocks measured by the Russell 2000 index. The difference is even larger on a year-to-date basis with the large company stocks up 8.3% and small company stocks down 4.4%. Generally, the large cap US equities were driven by strong gains in Health Care, Technology and Utilities which posted 16.6%, 14.1% and 13.9% respective returns through the first three quarters.

Similarly we are seeing emerging market economies and their returns moving in completely different directions. Countries such as India have had a resurgence as a wave of investor and business optimism has swept through following the election of Narendra Modi. Brazil in contrast has seen its economy dip into recession. Even after a national spending spree for this summer’s World Cup and in preparation for the 2016 Olympics, the situation is dire. The rating agency Standard and Poor’s recently downgraded the country’s credit rating from BBB to BBB-, the lowest investment grade rung.

Much of the strong performance in large US stocks can be attributed to the accommodative stance of our Federal Reserve. In a developed world saddled by debt and emerging markets beset by decelerating growth, investors have increasingly come to view the US economy as a refuge, which explains a large share of the money that has flowed here.

Does this recent outperformance of S&P 500 stocks suggest that investors should give up on diversification? Some investors might be asking that question, but there remains a strong case for not putting all of your investment eggs in one basket. Prominent investment strategists such as Liz Ann Sonders from Charles Schwab and Dr. David Kelly of JP Morgan would say that in the near term the US should continue to show strength based on our economy but that the level of volatility in stocks will also continue to increase. Uncertainty around the globe has become the norm not the exception of late. Global conflicts, geopolitical concerns, and the end of the Fed’s QE program all increase the level of market volatility.

As volatility increases and concerns shift, the sector leaders will ultimately rotate making diversification the key to long term success. Looking at historical performance shows us that past winners rarely stay on top for long. US stocks have been on top recently, but there’s no guarantee that they will stay there over longer stretches. These switchbacks, which have been a hallmark of markets through time, are one of the key reasons we diversify across multiple asset classes in the first place.

Volatility can also work in the investor’s favor. Many portfolio managers have been increasing cash over the last year by selling some of their winning stocks. The above-average levels of cash are available for opportunities they find for new investments both here and abroad. In the accumulation phase of life, market volatility provides opportunities to invest at lower prices.

Legacy views this current market volatility as an opportunity. We have implemented a tactical strategy over the past 12 months of taking profits and building up fixed allocations in order to create a buffer to some of the downside. This benefits investors that are currently drawing from their portfolio or have a risk averse outlook. Long-term investors make money over time, not over night. As investors, we never like to see the negative aspect of investing in our own portfolios, but the use of diversification, taking profits when they exist, and understanding the investment cycles that come in the form of volatility is what ultimately adds value to all of our portfolios. Legendary investor, and founder of Davis Investment Discipline, Shelby Cullom Davis said it best:

“There is always something to worry about and a hundred reasons not to invest. Those who abandon stocks because of fear or uncertainty may pay a tremendous price. History has shown that a diversified portfolio of equities held for the long term has been the best way to build real wealth.”

There have been a lot of events around the world creating uncertainty. The next few months may be a test for the markets, but we believe that with patience, opportunities will be created to buy great companies at discounted prices.

As always, we appreciate the trust you have in us and welcome any thoughts or questions.

Thomas L. Menzel, CFP®                                             Shawn J. Jacobson, CFP®, ChFC, MBA
Asset Manager                                                            Asset Manager
JP Morgan 4Q 2014 Guide to the Markets; Is Volatility Ushering in a New Market Phase?, Chuck Royce on 3Q14: The Fed in the (Market) Driver’s Seat?, BlackRock Weekly Investment Commentary , October 6, 2014; Clear Sailing…or Choppy Seas?, Schwab Market Perspective; Talking Point 10 2014, Morningstar; Quarterly Monitor, WSJ October 6, 2014; Stocks Could Use Some Separation Anxiety. WSJ September 30, 2014; Growth Fear Sink Markets, WSJ October 8, 2014; Investors See Reasons to Jump In, WSJ October 1, 2014; Stock Valuations Go Under the Lens, WSJ September 29, 2014

IMPORTANT DISCLOSURES: The opinions presented in this communication are subject to change without notice and no representation is made concerning actual future performance of the markets or economy. Information obtained from sources is considered reliable but is not verified. The research and other information provided herein speak only as of it date. We have not undertaken, and will not undertake any duty to update the research or information or otherwise advise you of changes in the research or information. Performance information presented is not an indication of future results and index data is provided for market reference purposes only. This is not an offer to buy or sell or the solicitation of an offer to buy or sell any security/instrument or to participate in any particular trading strategy. This document is the property of Legacy Financial Advisors and is intended solely for the use of the Legacy client, individual, or entity to which is addressed. This document may not be reproduced in any manner or re-distributed by any means to any person without the express consent of Legacy. This material is for educational purposes only. Mis-transmission is not intended to waive confidentiality or privilege.