Why Investors Must Brace For Volatility In September

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Mutual fund investors regained much if not all of their losses from the July sell-off as the S&P 500 broke the psychologically significant 2000 level in August.

The stock market powered higher despite fears of Europe falling back into recession, geopolitical conflict, high valuations and uncertainty over the Federal Reserve's interest rates policies. Mutual fund managers are optimistic that the forward-looking stock market is pricing in strong economic growth. In addition, the U.S. remains the best bet given the wild cards in the rest of the world.

SPDR S&P 500 ( SPY ) jumped 4.0% for the month, lifting its year to date return to 9.9%. The average domestic stock fund rose 3.84%, after slipping 2.72% in July, and ended August up 5.95% for the year, according to Lipper Inc. Midcap growth funds were tops among nonleveraged diversified funds, gaining 4.99% in August.

S&P 500 index funds, up 3.96% in the month, held their year-to-date lead with a 9.45% return. Small-cap growth funds' 4.64% gain trimmed their year-to-date loss to 1.02%.

"The market correctly anticipated better economic activity and earnings and jacked the multiple up ahead of time," said Mark Spellman, a portfolio manager with Alpine Woods Capital Management in Purchase, N.Y., overseeing $4.5 billion in assets. He also co-manages Alpine Equity Income Fund with $81 million in assets. "And now what you're seeing is companies growing into those multiples."

Storm Clouds On Horizon?

However, breadth indicators suggest the stocks are overbought, while value metrics scream excessive valuations. At month's end, the S&P price-to-sales ratio regained its dot-com bubble high of 1.77 -- its highest level in at least 60 years. At the same time, the real earnings growth rate at 13.4% is deep below the average growth rate of nearly 28%, indicating lackluster earnings growth. The stock market capitalization-to-GDP ratio, which Warren Buffett considers the "best single measure" of valuations, hovers at nearly 124%. Although it's still a far cry from its Internet bubble high of 148% from 2000, it's significantly overvalued compared with a fair valuation of 75% to 90%, according to GuruFocus.com.

"Stocks are now more than double their pre-bubble historical norms, and presently suggest that the S&P 500 will be no higher a decade from now than it is today," John Hussman of Hussman Funds, wrote in a commentary Aug. 25 titled "Broken Links: Fed Policy and the Growing Gap Between Wall Street and Main Street."

"We expect the current QE (quantitative easing) bubble to unwind no more kindly than the prior bubbles in 2000 and 2007," he added.

Market sentiment shows investors remain too optimistic and complacent, says Brad Lamensdorf of The Lamensdorf Market Timing Report and manager ofAdvisorShares Ranger Equity Bear ETF ( HDGE ). HDGE is down nearly 11% this year and an average annual 24.10% the past three years.

"I find this akin to 2007 and 2000 when the next big move that occurs is down," Lamensdorf said in an email. "Even the most recent run (up) is on extremely low volume."

In the meantime, the stock market remains in an uptrend with the economy growing and the Fed, while moderating its policy, continues to be accommodative.

Sector Fund Performance

Health care funds outpaced all sector funds, surging 6.77% in August and 17.29% year to date. Precious metals and natural resources funds lagged, losing about 1% each in August. WTI crude oil prices slipped 2.4%, while gold bullion prices ended the month nearly flat.

Anticipated Federal Reserve interest rate hikes and stronger economic data lifted the dollar's value, 1.6%, to its highest level in nearly a year, thereby depressing dollar-traded commodities.

At the same time, the U.S. had 4 million more barrels of oil on hand midmonth than it did in the year-ago period, according to the U.S. Energy Information Agency. Domestic production has increased by 1.1 million barrels a day over the same period last year, thanks to the U.S. fracking boom.

The upshot of falling oil prices is that lower gas prices goes hand in hand with higher consumer spending, which accounts for 70% of the U.S. economy, supporting the consumer discretionary and consumer staples sectors.

Internationally, traded Brent crude oil fell 5.0% as supply disruption fears from the Middle East abated. Europe's high sales taxes, persistently high unemployment rates of 11.5% and antibusiness rules and regulations are fanning deflation. That's bleeding through to the global economy given that Europe is the biggest importer of Chinese goods, says Frank Holmes, CEO of U.S. Global Advisors with about $1 billion in assets in San Antonio.

Equity precious metals funds remained the leading sector year to date with a 26.48% return. It's natural for investors to book some profits on fears the price of gold will go down, said Dan Neiman, portfolio manager of Neiman Funds with $400 million in assets under management in San Diego.

Foreign Fund Performance

Latin America led global funds, rising 6.23% in the month, and 12.86% year to date. It was among the worst-performing regions last year.

Europe funds limped in with a 0.12% gain that left them down 0.54% for the year. Fallout from the Russia-Ukraine conflict, an overvalued euro currency and weather were blamed for the region's economy stagnating in the first half of 2014. IHS expects Europe GDP to grow just 0.9% this year.

"At present, the economy isn't strong enough for markets to re-evaluate growth prospects," research analysts at Credit Suisse wrote in a report released Aug. 22. "Nor is it weak enough to prompt a policy response sufficient to challenge markets to re-evaluate growth prospects."

A rise in Japan's sales tax in the second quarter led to a steep drop in domestic demand that rippled to Europe, impacting export growth more so than the Russia-Ukraine crisis, they added.

China funds ticked up 1.43% and lifted their year-to-date gain to 4.45%. The government stimulated the economy by boosting infrastructure spending, especially on housing, encouraging banks to lend to small and midsize businesses and relaxing restrictions on home purchases.

On top of that, China's stock market regulators merged trading of A and B shares, allowing mainland and Hong Kong investors to invest in each other's markets, said Tracy Chen, senior research analyst at Brandywine Global, which oversees about $52 billion in assets.

"So people are betting on the price convergence of those two markets. B shares are trading cheaper than A shares," Chen said. "This could be the inflection point in the Chinese equity market. I don't think this is a temporary phenomenon."



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Mutual Funds

Referenced Stocks: SPY , HDGE

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