So much for a slow month to end the summer, August was the most volatile month in equity markets since the financial crisis in 2008. The month started off with the US Congress waiting until the very last minute to agree upon terms to raise the federal debt ceiling in a compromise that leaves most of the future budget cuts still to be determined between now and January 2012. The lack of significant budget cuts, along with the ineptitude of Congress to come to decisions, led S&P to follow through on their warning and cut the US federal debt credit rating to AA+. Concerns over the European sovereign debt crisis contagion spreading to Italy continued, buoying the European Central Bank to commence buying Spanish and Italian government bonds to stem the sharp selloffs in those markets. The focus in Europe also turned towards French bank exposure to European sovereign debt resulting in sharp equity market drops throughout Europe in mid-month. Economic data showing a slowdown in German GDP, mixed data on the US economy including a sharp drop in the Philadelphia Fed index of current business activity to -30.7 in August (from +3.2 in July), and signs of a slowdown in China, resulted in most economists lowering their forecast for US GDP growth significantly to levels of around 1% to 2% for the remainder of 2011 and all of 2012. The Federal Reserve promised to keep short-term interest rates low for the next two years at least, but Bernanke was non-committal about any further quantitative easing at the central bank symposium held annually at Jackson Hole.
Markets went wild as a result of all of the uncertainty and consumer confidence in the US took a sharp downturn to 44.5 for August from 59.7 in July. Consumer confidence and its effects on consumption will be a key determinant of whether the US heads back into a double dip recession or not. The S&P 500 index finished the month down -5.4%, after being down as much as -13.4% on 8-August, and small cap stocks were hit even harder with the Russell 2000 index down -8.7% for the month. Volatility spiked as there were four straight days of returns greater than +/- 4% with the VIX volatility index hitting levels of 48% prior to coming back down at month end to 32%. Program trading levels were more than three times normal levels exacerbating the market volatility beyond the rational fundamentals. The Dow Jones Industrial Average reached a low of 10,588 before bouncing back and closing out the month at 11,613 (see graph below of Open-High-Low-Close daily ranges for the Dow). The financial sector equities were hit the hardest (-8.5%) while the defensive utility and healthcare sectors fared much more favorably (+0.9% and -1.4%, respectively – see table below).
Open-High-Low-Close Daily Bar Graph of DJIA in August 2011
US Equity Sector Performance in August 2011
In credit markets, credit spreads widened with high yield bond markets getting hit the hardest with most high yield bond funds down over -3% for the month. Amidst the panicked market, US Treasury bond markets, particularly in the intermediate-term and long-term sectors had their best performance month in recent history with 10 year US Treasury yields dropping from 2.80% at the beginning of the month to 2.21% at month end, getting to below 2% intermonth. With the 2 year US Treasury yield pinned around 0.2% yield after the FOMC meeting, the 10 year US Treasury yield steadily dropped to narrow the spread from 246 bps to 203 bps as the yield curve flattened substantially. The Barclays Aggregate Bond Index closed up +1.46% for the month, driven by the long-term Treasury sector performance. Performance in the intermediate corporate sector was also up but much more muted than US Treasuries at +0.27%. Performance in the short-term corporate sector was surprisingly down -0.41% as credit spread widening dominated the drop in short-term treasury yields.
The Limited Risk Portfolio performed well relative to other risk assets but was down -2.82% for the month, relative to the S&P 500 index drop of –5.4%. Equity risk was nearly fully hedged heading into the US debt ceiling final negotiations, but after a compromise had been settled upon, hedges were removed and equity risk was slowly added back to the portfolio on price dips through the course of the month to get the overall Limited Risk Portfolio back up to roughly 60% equity risk by month end. Market timing asset allocation decisions helped avoid some losses in equities, but positions taking the view that long-term Treasury yields had dropped too far to be justified hurt the portfolio and were removed mid-month when it was deemed that the momentum for downward long-term Treasury interest rates was just too strong in the current market and defied economic fundamentals. Towards month-end a position in a high dividend yielding REIT with a high balance sheet leverage ratio (ticker: NLY) was sold with the view that either future equity issuance or future dividend cuts will be necessary. The portfolio finished the month with a high cash balance of 21% which will likely be opportunistically deployed in coming weeks.
The Bond Portfolio was up +0.45% for the month with most of the performance coming from the short-term Treasury sector (VFIRX up +0.5%) and the government guaranteed mortgage sector (VFIJX up +1.7%). Exposures to credit markets lagged other sectors due to credit spread widening and the lack of significant exposure to the long-term US Treasury sector led to underperformance to aggregate market benchmarks for the month, though with considerably less market risk. Exposure to short-term corporate exposure will be analyzed for possible changes as recent performance has been negative over two of the past three months.
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