August is often a quiet month for markets, but this year volatility spiked as uncertainty spurred the fourth straight monthly loss for U.S. stocks.  Grabbing the most headlines in early August was Standard & Poor’s decision to downgrade U.S. long-term debt, but the real detriment to confidence was a string of soft economic data in the U.S. and the ongoing debt crisis in Europe.

In just an 11 day period the S&P 500 tumbled 16.77%.  The selloff started when revised U.S. GDP showed barely any economic growth and was exasperated by a series of disappointing readings for manufacturing, labor, and confidence gauges. Historically-telling indicators such as the yield curve continue to point to the U.S. avoiding a new recession and the stock market has historically performed better when consumer confidence is low (it’s currently at the lowest since April 2009).  Still the recovery appears unstable, much like trying ride a bike and pedaling very slowly – it’s difficult to stay upright without support and it doesn’t take much of a shock to get knocked over.

Adding to the panic was fear of a Lehman-like scenario where Europe’s banking problems bleed through to the global financial system.  European policymakers seem to be in denial of long-term solvency issues, opting for temporary fixes that have done little to shore up confidence.  Given the weak backdrop for growth in the Eurozone, the need for steep near-term fiscal spending cuts to reduce deficits, and the increasing threat of a liquidity crisis among the region’s banks, a regional recession in Europe seems increasingly likely.

At its worst, the S&P 500 fell 17.90% from its April 29 high. Volatility, as measured by the VIX Index, surged to the highest level since the depths of the financial crisis.  In response to the market turbulence and wavering economic outlook, Federal Reserve policymakers agreed (in a 7-3 vote) to keep interest rates at record lows until at least mid-2013.  Minutes from their August meeting show that additional stimulus items were discussed including buying more government bonds (QE3), lengthening the average maturity of its portfolio, lowering the interest they pay on reserves, or pledging to keep its balance sheet near a record $2.86 trillion for a specific time.

With the potential for future Fed action and some modest improvement in economic sentiment, the S&P 500 closed out August with the best eight-day rally since 2009, reducing the correction that began April 29 to 10.61%.

Large cap stocks outperformed their mid and small cap counterparts, while value continued to trail growth.  Utilities and Consumer Staples were the only two S&P 500 sectors managed to squeak out monthly gains.  These two sectors are generally viewed as an area of safety within equities due to their less economically sensitive earnings and high dividend yields.

Domestic stocks easily outperformed international and emerging market stocks.  The MSCI EAFE Index of developed international stocks was weighed down by poor European market returns – no surprise there.  The MSCI Emerging Market Index also had a nasty month.  Slowing growth and increasing inflation were already a concern for emerging economies, but the threat of a slowdown in the U.S. and Europe could deal an additional blow to many of these nations that rely on exports.

Treasurys posted their biggest monthly gain since December 2008 despite the first ever credit rating downgrade of U.S. debt, a sign that investors still view Treasurys as a safe haven.  The bond rally comes as investors have reduced their expectations for inflation as breakeven rates on Treasury Inflation Protected Securities (TIPS) fell to 2%, much lower than the 2011 high of 2.65% in April. 

Not all bonds were in favor in August.  High-yield (junk) bonds lost roughly 9% during the month, wiping out the 6.1% gain for 2011 through the end of July, as investors demanded sought in light of economic uncertainty.

Peter Lazaroff

St. Louis, MO

Acropolis Investment Management