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Market Commentary

August, 2011

SPM's response to recent market volatility

As we’re sure you are acutely aware, financial markets have experienced higher-than-typical volatility as of lately, with Thursday, August 4, experiencing a significant sell off in equities.  In just one day, the Dow Jones Industrial Average (DJIA) dropped by 3.12%; the S&P 500 dropped by 4.76%.

With financial markets as complicated as they are these days, it can be difficult to pinpoint the exact triggers for such a sell off. Our hypothesis is that several key elements converged at just the right moment, causing day traders and active institutional investors to “head for the hills”. These factors include:

• Remerging rumors that Standard & Poor's (S&P) was going to downgrade the U.S.'s credit rating after most economists believed this risk had been alleviated by the recent raising of the U.S. debt ceiling.  Note: Late Friday night, S&P did downgrade U.S. credit from AAA to AA+.
• New reports that Italy and Spain were in far greater troubles than previously thought.
• Anticipation that unemployment numbers (reported on August 5) were going to be significantly worse. Note: actual numbers came out mildly better than expected.
• Robo-traders (i.e., computers that trade automatically) hit their sell stop limits, amplifying equity sells.

While steep, single day declines, such as what we saw on August 4, can be disconcerting, to say the least, it’s important to maintain some perspective with respect to market declines and their impact to your investments.  We recommend that you:

• Don’t panic. While it is easy to feel like the current challenges in financial markets are entirely unique, periods of significant market volatility are actually quite common. In fact, since the early 1930’s, every decade has had at least one major decline of about 15% or more in the S&P 500. 
• Remember what you have. Your money is diversified across multiple asset classes and is being managed by “best in class” money managers. While nearly all portfolios are affected by short-term downside volatility, properly managed portfolios are more likely to recover quickly. Moreover, many of you have positions in contracts (e.g., Equity Index Annuities, Variable Annuities, Universal Life Policies, etc.), which may provide certain guarantees on your principal and/or future income payout. When you consider all of your investments as a whole, you’ll find that your downside exposure may be less than a comparable market index.
• Maintain discipline. Your financial advisor created a total investment strategy that is custom tailored to your situation, goals, and needs. It considers how much downside volatility is acceptable, given your risk tolerance and other personal financial requirements.  Making any drastic changes to your investment strategy based solely on recently market volatility may jeopardize your ability to achieve your long-term financial goals.
• Keep perspective. While past performance is no guarantee of future results, taking a historical look at past market corrections may provide some confidence that markets have the tendency to recover well following a period of decline. The following table highlights key periods of decline in the S&P 500 and the 12-month returns immediately following two years each decline⁽¹⁾:

While we encourage clients to not succumb to any knee-jerk reactions, we are not suggesting that you do nothing right now. Our advice is to:

• Assess your short-term capital reserves. Most investors like to keep some amount of capital in cash or cash equivalents for “rainy days” or, perhaps investment opportunities. While the amount of capital in reserves may vary greatly from investor to investor, it is considered wise to have enough to cover at least six months of living expenses. If you feel that you do not have enough in your cash reserves, please contact your advisor for a consultation.
• Evaluate your current income sources. For those primarily living off of passive income (i.e., retired), you may have too much of your retirement income exposed to significant downside risk.  If you are retired and feel that your current income sources might be exposed to an excessive amount of risk, please contact your advisor for a consultation.
• Have non-managed investments evaluated. Your assets under Select Portfolio Management’s care are under the watchful eye of our investment committee. However, you may have other assets, such as 401(k) accounts, individual IRA accounts, etc., that may not be aligned to handle interim periods of volatility well. If you are concerned about held away investments, please contact your advisor for a complimentary review.
• Revisit your long-term goals.  Lastly, in times like these, it never hurts to revisit your long-term goals to make sure that you’re still on track. If you’re approximately 10 years or less from retirement, you may want to consider purchasing one of Select Portfolio Management’s fee-based financial plans, which will provide an in-depth assessment of your financial situation and a detailed analysis of what it’s going to take to achieve your financial goals.

What is Select Portfolio Management doing?

Our investment committee has been carefully watching events unfold. We have been meeting daily to discuss what, if any, changes should be made to clients’ investment portfolios. For those clients participating in our tactical asset management program through Select Money Management, we are in the process of making the following changes to our asset allocations:

• Approximately three months ago, as a defensive move, our investment committee decided to increase our tactical cash position up to 5% to 10% of the total portfolio (depending on which model). Now, we are increasing our cash position up to 20% to 30%, which should help provide a buffer against potential future declines and provide “dry powder” if and when we see buying opportunities.
• Approximately four months ago, when news regarding U.S. Treasuries came to light, we eliminated all long-duration government securities from our portfolios. Now we are expanding our selection by eliminating intermediate-duration government securities as well.  In fact, the only government-affiliated securities we are holding right now are Treasury Inflation-Protected Securities (TIPS) and Government National Mortgage Association (GNMA) funds.
• Across all of our core asset allocation models, we have reduced our exposure to equities by approximately 5% to 10%. Within equities, we are favoring blended all-caps over strictly growth- or value-oriented funds.

No doubt, the financial markets will have a significant reaction to the downgrading of U.S. credit by S&P. Just how long this reaction lasts is the six-million dollar question. In any case, we will be diligently keeping an eye on the situation and any new developments.

And finally, in spite of all this recent doom and gloom, we’d like to remind you that there may be a silver lining - and an important one. America’s downgrade may serve as a sobering wakeup call. Economists have dubbed the phrase “Sputnik Moment” - a visible shock to our national consciousness that can unify Americans around a common goal - that of halting gradual U.S. economic decline and put the country back on the path of high growth, job creation and financial soundness. For the sake of the country and the wider global economy, let’s hope that policymakers resist the urge to bicker and start working together to enable this country and economy to thrive once again.

Sincerely,

The Select Portfolio Management Team

Disclosures

⁽¹⁾ The percentage decline is based on the index value of the unmanaged S&P 500 excluding dividends and/or distributions. Each market decline reflects a period of more than 80 days and a decline of about 15% or more in the S&P 500’s index value.  The average annual total returns and hypothetical investment results do not include any sales charges, management fees, or other expenses. 

All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. Past performance is no guarantee of future results.

The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely-traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The Nasdaq Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighted index composed of 2000 U.S. small-cap common stocks. The Global Dow is an equally weighted index of 150 widely traded blue-chip common stocks worldwide. Market indexes listed are unmanaged and are not available for direct investment.