After being fairly contained for the past few quarters, the start of the fourth quarter has proven to be extremely volatile. In just the first week of the new quarter, the S&P 500 has either risen or fallen by more than 1% on five of the first six days, or 83% of the time. For reference, in the first three quarters combined, the S&P 500 rose or fell by more than 1% on only 22 days, or 9.3% of the time. As we have often noted in our market outlook and commentaries, we believe 2014 will be a year of elevated volatility levels.

We have identified a number of market tailwinds which may benefit equity investors, but we have also identified a number of market headwinds which may counteract and keep equity returns in check. The constant stream of conflicting news is likely to result in an increase in market swings, both in frequency and magnitude, such as we have seen over the past few days. In periods of increased volatility, it is prudent to maintain a disciplined investment strategy that focuses on diversification and overallocates to strategies that benefit from market fluctuations. Before the recent jump in market volatility, equity investors were enjoying another solid year of returns. However, over the past few weeks, markets have taken a decidedly negative tone, reflecting increased uncertainty, for the following reasons:

• A flurry of mixed reports on the U.S. economy — While improvement in the labor market continues to make headlines, recent readings on consumers (both spending and credit), factory orders, manufacturing and services have all disappointed economists and investors.
• Concerns about the global economy — Recent weak data on the European economy, along with comments from the International Money Fund (IMF) and the World Bank, suggest that the global economy is not chugging along as many had expected. In particular, the IMF lowered growth forecasts for 2014 and 2015 and estimated that Europe has a 40% chance of slipping back into recession. On the other hand, while European Central Bank (ECB) President Mario Draghi, acknowledged that the Euro Zone is slowing, he pledged to boost the size of the ECB’s balance sheet (i.e. increase stimulus).
• Weakness in small cap equities — Given the greater economic sensitivity of smaller companies, experts believe weakness of small cap stocks relative to large cap stocks may be a sign of a potential market correction. Year-to-date through October 9th, small cap stocks (as represented by the Russell 2000 Index) have lost 7.31%, while large cap stocks (as represented by the Russell 1000 Index) have risen 5.48%. This wide divergence in performance between the two asset classes has investors worried.
• Uncertainty about the direction of interest rates — With Fed tapering likely ending this month, there has been much debate about the Fed’s next action (whether it will raise interest rates or keep them steady). Both “doves” (who would prefer to not to raise rates) and “hawks” (who would prefer to raise rates) at the Fed have voiced their differing opinions. This polarity, along with minutes from the most recent Fed meeting that highlight growing concerns over a strengthening dollar, have helped to drive uncertainty about the future of interest rates. Uncertainty equals more volatility.
• Other factors — Increasing geo-political risks in the Middle East and Asia, along with the Ebola scare, have also weighed on investor sentiment.

All of these factors have contributed to the recent negative tone and choppiness in the financial markets. Though volatility is on an upswing, we do not believe the negative market tone is warranted. Yes, the aforementioned concerns exist; however, strong corporate earnings, a lack of inflation, and historically low interest rates are just a few bullish indicators. As it has been for the past several quarters, our investment stance is founded on a base-case scenario that allows for cautious optimism. The U.S. economy seems to be on a path of modest, non-inflationary growth. Economic performance in Europe and Japan has disappointed, but massive monetary stimulus and weakening currencies point to a pickup in activity within a few quarters. Interest rates appear to be poised to rise gradually in the United States, but not abroad. Stock markets around the world have managed to do well in worse circumstances than these over the past few years, and there appears no reason to expect otherwise in the near future. While we still believe the financial markets are on a solid foundation, as we have noted many times, volatility is likely to remain elevated and portfolios should be positioned accordingly. Beyond favoring developed markets that stand to benefit from global stimuli, a slight overweight in growth over value in stocks, and less interest rate sensitivity in fixed income, we continue to urge greater portfolio diversification that includes an allocation to investments such as alternative strategies, commodities, and REITs, which have demonstrated low correlation to traditional investments like stocks and bonds.