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COUNTRY Trust Bank Special Report on Recent Market Volatility - Released 10/30/2018

Key Takeaways

  • October has been a rough month for stocks, with many indexes down more than 10%. A fear of rising interest rates and ongoing trade disputes have weighed on investor sentiment.
  • We are seeing somewhat of a disconnect between stock prices and fundamentals. Volatility could very well continue, but we believe that strong fundamentals – namely, robust economic growth and soaring corporate earnings – should ultimately provide support for stock prices.
  • While market volatility can often trigger a desire to “do something”, we believe that investors should generally refrain from making large changes to their portfolio based on market corrections. Investors who make emotional decisions around market volatility run the risk of underperforming over time.

The month of October has a pretty bad reputation when it comes to the stock market. Two of the largest crashes in history occurred in October – 1929 and 1987 – and the market plunged in October 2008 amid the financial crisis. October is, in fact, the most volatile month of the year for stocks, when measured both by standard deviation and daily moves of at least 1%.

Unfortunately, 2018 is not going to improve October’s bad reputation. The S&P 500® index has fallen nearly 10% this month, wiping out all of its gains for the year. Small cap stocks have fared even worse, with the Russell 2000 index down 13% in October. International stocks have not been immune from the selloff either, making an already bad year even worse. (Figure 1)

So why have stocks been beaten up this October?

One reason is a fear of rising interest rates. The Federal Reserve has shown no signs of stopping its policy of raising short-term rates due to a strong job market and rising inflation expectations. As a result, government bond yields jumped earlier in the month, with the 10-year Treasury note reaching its highest level in over seven years. Consequently, the price-to-earnings (P/E) ratio has contracted as the market absorbs higher interest rates (higher interest rates tend to lower the P/E ratio, all other things being equal). The 12-month forward P/E for the S&P 500 is currently around 15X, which is in-line with its long-term average. It started the year around 19X. Somewhat ironically, bond yields have come back a bit as investors have fled to the safety of government bonds amid the stock market volatility.

Figure 1

Secondly, ongoing trade disputes have investors uneasy and have stoked fears of slowing global economic growth. The United States has recently applied tariffs to many goods imported into the country, and some countries, like China, have retaliated with tariffs of their own on U.S. goods. We believe that ongoing trade disputes could slow U.S. economic growth but are unlikely to derail it, as our diverse, largely service-based economy should remain resilient.

Disconnect Between Prices and Fundamentals

As we highlighted in the “Market & Economic Outlook” at the end of September, several signs points to a robust economic expansion. This hasn’t changed, despite the market volatility in October. We note that bear markets, or declines of greater than 20% in the stock market, rarely occur outside of economic recessions. Given the solid economic backdrop, we view recession risks as low.

Additionally, third quarter earnings season has been very solid, with 77% of companies in the S&P 500 beating earnings expectations, according to FactSet. More importantly, earnings estimates for the fourth quarter and full year 2019 have held up well. Nonetheless, many companies who are beating expectations are being punished by the market.

We are seeing somewhat of a disconnect between stock prices and fundamentals. Volatility could very well continue as the market digests higher interest rates and ongoing trade disputes. But we believe that strong fundamentals – namely, robust economic growth and soaring corporate earnings – should ultimately provide support for stock prices.

What Investors Should Do

While market volatility can often trigger a desire to “do something”, we believe that investors should generally refrain from making large changes to their portfolio based on market corrections. Volatility is inevitable for equity investors. Since 1980, the average intra-year decline for the S&P 500 has been 13.8%. Despite this, the market has delivered positive annual returns in 29 of the 38 years.

Investors who make emotional decisions around market volatility run the risk of underperforming over time. (Figure 2) Conversely, investors who take a disciplined, systematic approach to rebalancing their portfolios can often take advantage of periodic market pullbacks by buying more shares at lower prices. Having a plan, and an appropriate investment strategy based on that plan, can help investors weather the ups and downs of the market over time.

Figure 2

COUNTRY Trust Bank Wealth Management Team

  • Troy Frerichs, CFA - Director, Wealth Management & Financial Planning
  • Kent Anderson, CFA - Portfolio Manager
  • Todd Bunton, CFA - Portfolio Manager
  • Weston Chenoweth - Investment Analyst
  • Chelsie Moore, CFA, CFP® - Manager, Wealth Management
  • Jeff Hank, CFA, CFP® - Portfolio Manager
  • Jonathan Strok, CFA - Investment Analyst
  • Austin Burant - Investment Analyst

Definitions

In finance, standard deviation measures the historical price fluctuations of an investment. A security that has a lot of variance around its mean over a certain period has a high standard deviation.

The price-to-earnings ratio is a valuation ratio which compares a company's current share price with its earnings per share (EPS). EPS is usually from the last four quarters (trailing P/E), but sometimes it can be derived from the estimates of earnings expected in the next four quarters (projected or forward P/E). The ratio is also sometimes known as "price multiple" or "earnings multiple."

The S&P 500® Index is an unmanaged index consisting of 500 large-cap stocks. Since it includes a significant portion of the total value of the market, it also considered representative of the market. The index does not reflect investment management fees, brokerage commission and other expenses associated with investing in equity securities. It is not possible to invest directly in an index.

The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small cap opportunity set. The Index does not reflect investment management fees, brokerage commission and other expenses associated with investing in equity securities. It is not possible to invest directly in an index.

The MSCI Emerging Markets Index captures large and mid-cap representation across 23 emerging market countries. The index covers approximately 85% of the free float-adjusted market capitalization in each country.

The MSCI EAFE Index is broadly recognized as the pre-eminent benchmark for U.S. investors to measure international equity performance. It comprises the MSCI country indexes capturing large and mid-cap equities across developed markets in Europe, Australasia and the Far East, excluding the U.S. and Canada.

FactSet’s ‘Earnings Insight’ report provides data on quarterly earnings results for the S&P 500 index.

Chart data comes from Thomson Reuters Datastream, a powerful platform that integrates top-down macroeconomic research and bottom-up fundamental analysis.

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Investment management, retirement, trust and planning services provided by COUNTRY Trust Bank®.

All information is as of the report date unless otherwise noted.

Past performance does not guarantee future results. All investing involves risk, including risk of loss.

This material is provided for informational purposes only and should not be used or construed as investment advice or a recommendation of any security, sector, or investment strategy. All views expressed are based on the information available at the time of writing, do not provide a complete analysis of every material fact, and may change based on market or other conditions. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. Unless otherwise noted, the analysis and opinions provided are those of the COUNTRY Trust Bank investment team identified above and not necessarily those of COUNTRY Trust Bank or its affiliates.

Stocks of small-capitalization companies involve substantial risk. These stocks historically have experienced greater price volatility than stocks of larger companies, and they may be expected to do so in the future.

Stocks of mid-capitalization companies may be slightly less volatile than those of small-capitalization companies but still involve substantial risk and they may be subject to more abrupt or erratic movements than large capitalization companies.

International investing involves risks not typically associated with domestic investing, including risks of adverse currency fluctuations, potential political and economic instability, different accounting standards, limited liquidity and volatile prices.

Fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer-term debt securities. Investments in lower-rated and nonrated securities present a greater risk of loss to principal and interest than higher-rated securities.

Diversification, asset allocation and rebalancing do not assure a profit or guarantee against loss.

All indexes are unmanaged and returns do not include fees and expenses associated with investing insecurities. It is not possible to invest directly in an index.