Market Bulletin October 16, 2014 U.S.: Fear, Fever and Fundamentals James C. Liu Vice President Global Market Strategist J.P. Morgan Funds David M. Lebovitz Associate Global Market Strategist J.P. Morgan Funds Ainsley E. Woolridge Market Analyst J.P. Morgan Funds Tai Hui Managing Director Chief Market Strategist Asia J.P. Morgan Funds The volatility of U.S. equities and interest rates continues this week. The S&P 500 has now pulled back over -7% from the all-time highs reached one month ago, resulting in the largest drawdown this year. Meanwhile, the 10-year Treasury yield has fallen to around 2.1% (it fell below 1.9% at one point), the lowest levels since the taper tantrum last year. Other global markets are in similar situations. For instance, the STOXX 600 index in Europe is down over 5% year-to-date. We believe that this reaction is primarily driven by fear and not fundamentals. In this note, following the storyline of the one we published two weeks ago (A herd migration to safety), we examine two sources of fear for U.S. investors and important market dynamics around volatility. The message is still the same: long-term investors should continue to look through recent volatility, especially as the earnings season continues. The wall of worry The Ebola outbreak in West Africa has led to a visceral response in the U.S., especially with 24 hour news coverage. News that a second health care worker in Dallas has tested positive for Ebola caused the 10-year Treasury yield to begin its descent alongside S&P 500 futures. While this is a serious public health concern, the market’s recent moves are likely to be an overreaction to the limited number of cases so far. Prior pandemics, including H1N1 in 2009 and SARS in 2003 were similar to the current Ebola outbreak because of the high concentration of cases in a particular region of the world. The fear of rapid contagion due to international travel was also clearly present. While the market impact of H1N1 is difficult to assess since it was deemed a pandemic by the World Health Organization in April 2009, it did not derail the subsequent market recovery. In addition, the WHO raised a global alert about the outbreak of SARS in Asia in March of 2003. For U.S. markets, March 2003 turned out to be the bottom before a long bull rally that was also not derailed by these concerns. Market Bulletin According to Gallup Polls conducted at the time of each outbreak, 37% of Americans feared contracting SARS, compared to 22% of Americans who report that they are worried about contracting Ebola. While spread of a disease is worrisome, in reality, there were 75 cases of SARS reported in the United States from November 2002 to July 2003. But the fear of contracting a contagious disease at supermarkets, in malls or on public transportation and its effects on businesses can be enough to cause short-term market volatility. On top of these concerns, there have been some hiccups in the U.S. economic data. This morning’s retail sales and PPI data came in weaker than expected, adding fuel to the fire of a weak market, but these numbers can fluctuate significantly on a monthly basis. Retail sales did disappoint by falling -0.3% from August compared to expectations of a -0.1% decline. However, this is only the second month of negative retail sales growth in 2014, and sales have in fact increased 4.3% year-over-year. Producer prices were also lower than the market expected, declining -0.1% over the August reading compared to expectations of a 0.1% increase. Decreasing gasoline prices led the weakness in this month’s producer price index, and have fallen $0.30 since July. Excluding volatile categories like food and energy, final demand prices for goods actually increased 0.2% since August. What else has the market been worried about this year? The polar vortex, Ukraine and Russia, Iraq, Israel and Palestine, the Hong Kong protests, the conclusion of Fed tapering, and most recently European growth – the list goes on and on. While many of these are still ongoing, these events feel more concerning when they first arise, leading to volatility (we discuss market skepticism in our paper The Sentimental Investor). Ultimately, the pattern this year has been one of a market that takes it on the chin by rebounding strongly after pullbacks. While there is always the risk that this time is different, we discuss in the final section reasons for optimism in the U.S. trends. CHART 1: S&P 500 PERFORMANCE AND WORLD EVENTS IN 2014 Index level 2,100 2,050 U.S. employment miss and continued geopolitical tensions spark unease in the market 2,000 -3.5% Alibaba IPO Market nervousness over conflict between Ukraine and Russia 1,950 -4.0% 1,900 Militants seize Iraqi cities 1,850 Malaysian Air flight shot down over Ukraine Russian troops enter Crimea 1,800 -7.4% Weaker U.S. economic data, protests in Hong Kong, and threat of Ebola in the U.S. contribute to sell-off -5.8% 1,750 1,700 Jan '14 Polar Vortex causes economic weakness Feb '14 Mar '14 Apr '14 May '14 Jun '14 Jul '14 Aug '14 Sep '14 Source: Standard & Poor’s, Strategas Research Partners, LLC., J.P. Morgan Asset Management. For illustrative purposes only. Data are as of 10/15/14. 2 Oct '14 Market Bulletin Volatility All defense, no offense Long-term investors should not panic due to volatility alone. In fact, volatility at these levels is not any more unusual than the extremely low volatility experienced earlier this year. The VIX index, at 27, achieved similar levels in 2012, and was almost double that in 2011. A VIX index closer to the average of 20 should still be expected for the long run. Stock market sectors have not all reacted equally. Despite a bounce-back in cyclical stocks during the summer due to improved economic numbers, they have underperformed defensive sectors in recent weeks. Case in point: the best performing sector in 2014 is still utilities (14% total return year-to-date), whereas it was the worst performer in 2013 when investors were optimistic and yields were rising. The difference between cyclical and defensive performance is measure of fear and skepticism that is also strongly correlated to the 10-year Treasury yield. EXHIBIT 2: S&P 500 VOLATILITY SINCE 2011 VIX Index 50 45 40 EXHIBIT 3: CYCLICAL VS. DEFENSIVE SPREAD AND 10-YEAR TREASURY YIELD Returns of Cyclical less Defensive Sectors and the 10-year Treasury Yield 2.0% 35 30 25 2.90 0.0% Cyclical vs. Defensive Spread (LHS) 2.70 -2.0% 20 15 10 Jan '11 Jul '11 Jan '12 Jul '12 Jan '13 Jul '13 Jan '14 Jul '14 Source: Chicago Board Options Exchange, Bloomberg, J.P. Morgan Asset Management. For illustrative purposes only. Data are as of 10/15/14. The main point for investors is to keep volatility in perspective (we discuss volatility and client recommendations in more detail in our recent white paper titled Investing with Composure). From April to July, there wasn’t a single day with a +1% or -1% return on the S&P 500. Relative to those low levels, today’s market moves appear staggering. Relative to a longer history though, such moves can be common over short periods. Pullbacks over many days of 1% to 2% historically occur multiple times a month, even in good times. Pullbacks of 5% to 10%, where we are today, occur between once per quarter to once per year. The current market pullback is not, in and of itself, a reason to overreact. 3 2.50 -4.0% 2.30 10-Year Treasury Yield (RHS) -6.0% 2.10 -8.0% 1.90 -10.0% Jan '14 Feb Mar '14 '14 Apr May '14 '14 Jun '14 Jul '14 Aug '14 Sep '14 Oct '14 Source: Standard & Poor’s, Bloomberg, J.P. Morgan Asset Management. For illustrative purposes only. Data are as of 10/15/14. We believe that hiding in defensive sectors is a mistake. Although long-term interest rates have fallen this year, they should still rise going into 2015, especially as the Fed begins the tightening cycle. In addition, an improving labor market, reduced government spending drag, and other factors should improve quarterly GDP growth rates to close to 3%. Improving fundamentals should benefit cyclical sectors like technology and consumer discretionary which are sensitive to stronger economic fundamentals. Market Bulletin A Glass Half Full In the end, there are still significant reasons to be positive on U.S. markets and to continue to believe in rising rates, especially in the context of the broader economic cycle. Most economic indicators continue to signal that the U.S. economy is expanding. A strong labor market, coupled with a decline in gasoline prices, should provide a boost to consumer income and spending. The surge in electricity production, coupled with an increase in manufacturing employment and hours worked suggests that the manufacturing sector continues to recover. Despite some headwinds, especially from Europe, this does not appear to be the beginning of a broader decline in the U.S. economy. It is important that investors shift their focus to the earnings season. By all estimates, the current earnings season should produce another quarter of record corporate profitability, for a variety of reasons. A stronger dollar may hurt exporters, but domestically focused companies should benefit from reduced input costs, including lower energy prices. Margins are still at record highs, and may continue to increase due to globalization and technology. Additionally, revenues may increase over the next several quarters as the consumer balance sheet strengthens. Focusing on fundamentals is the best way for investors to avoid fear and to stay positioned for long-run growth. 4 Market Bulletin The Market Insights program provides comprehensive data and commentary on global markets without reference to products. Designed as a tool to help clients understand the markets and support investment decision-making, the program explores the implications of current economic data and changing market conditions. The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment in any jurisdiction, nor is it commitment from J.P. 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