Quarterly Newsletter: October 2007

Click here to view the Index Returns for 3rd Quarter 2007
 (PDF,94kb)

Capital Markets Update
The third quarter yielded decent returns amid increased volatility. After a significant drop in July and August, stocks rallied on the news of a Fed rate cut. Emerging Markets was the standout performer (+14.4%) with Real Estate (+2.6%), International (+2.2%) and Large Cap (+2.0%) also providing positive numbers. Only Small Cap had negative returns (-3.1%). In fixed income, the Lehman Aggregate Bond Index (+2.9%) rallied amid a general flight to quality as the 10-year Treasury yield decreased nearly 50 basis points from 5.03% to 4.58%.

"V" as in Volatility
In the third quarter, the S&P 500's path to a 2% total return was not a gentle ride-in fact the track was more like the letter "V." Fortunately, the strength of the recovery matched the abruptness and depth of the plunge. The initial leg of the "V" was a peak to trough 12% drop in the S&P 500 index over a mere 24 trading days. As of this writing, the index has reclaimed its high water mark, completing the second and more enjoyable leg of the "V" in 35 trading days.

How Much Volatility is Normal?
We know that markets don't move in a straight line, but what is a normal amount of volatility? A 100 point move in the Dow Jones Industrial Average tends to dominate the financial headlines, even though this currently represents a change of less than 1%. History provides some helpful perspective. The current equity bull market claims the second longest period since World War II without a 10% decrease in the index. The longest stretch was from October 1990 to October 1997. So, the market pundits say, "we were due."

Measuring Volatility
No one fears upward volatility–that is what investors count on; we fear losing money in a market downturn. A widely used measure of market risk is the VIX, often referred to as the "fear gauge." VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index which measures the market's expectation of volatility over the next 30 days, quoted as a percentage. The index is constructed using the implied volatilities of a wide range of S&P index options.

The graph below charts the daily path of the VIX from 1990 (the earliest data available) through September 30, 2007. During this period, expected volatility averaged 19%. Two thirds of the time, expected volatility ranged between 13% and 25% (the blue shaded area representing one standard deviation above and below the average). We can make several observations.

• The 1997 through 2002 time frame was an extended period of heightened volatility amidst the bubbly run-up and subsequent collapse in large cap growth and technology stocks.
• Extraordinary spikes in the VIX (moves beyond the yellow shading that represents 95% of historical data) tend to occur during significant market disruptions: the near collapse of the Long-Term Capital Management hedge fund during the Russian debt crisis in 1998; the terrorist attacks in September, 2001; and the end of the two and a half year bear market in October, 2002. We may associate heightened fear or peak pessimism with each of these events.
• For recent perspective, the VIX began the third quarter at 16% and ended at 18%, with an interim spike to 31% that coincided with the low point in the S&P on August 16, 2007. Indeed, the surge in expected volatility this August was unusual by historical standards, nearly breaching the two standard deviation boundary.
• Perhaps the most important takeaway is that we have enjoyed an unusually long period of declining and below average volatility over the last five years. If history is a guide, we can expect higher stock market volatility than we have become accustomed to in recent years.

Emotional Response
With greater volatility comes greater emotion–it is human nature and driven by our fear of loss. It is akin to being aboard a smooth, relaxing flight that is abruptly interrupted by a deep air pocket–our instinctive response is to reach for the armrest or the person next to us and to prioritize a safe landing, even if we don't reach our desired destination. After all, there is great interim solace in making the fear go away. Similarly, equity market downdrafts challenge our conviction to stick with the plan and focus on the long-term destination. Alternatively, upward surges may embolden the emotional investor to leverage the tail winds of the current environment and pursue higher returns by increasing portfolio risk.

Time in the Market
History confirms that timing the market is a poor strategy. Few if any investors can consistently pick the right time to enter and exit the market. Though we may feel more confident on the sidelines during heightened volatility, we may compromise our long-term goals by altering the strategic, long-term plan. The reason is that equity markets can deliver sharp upward moves that may account for a large portion of long-term returns. The chart below depicts the penalty for being out of the market for even brief periods of time over the last ten years.

Implications for Investment Strategy
Indeed, periods of high volatility are opportunities to reassess our appetite for risk. Each of us should have an asset allocation that aligns with our financial objectives and risk profile. As personal circumstances change, it is important to revisit the asset allocation and make appropriate adjustments. Over the long haul, rational not emotional decisions underpin a sound and successful investment strategy. Disciplined rebalancing and tax-wise, cost-conscious investing will best enable success in reaching our financial goals.

Welcome Emily!
We are happy to announce a new addition to the Arbor family. Emily Hinton, a 2004 N.C. State grad, joins our operations team with 2½ years of prior experience with an investment advisory firm in Raleigh. Please give Emily a special welcome.

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Arbor Investment Advisors, LLC. Please remember to contact Arbor Investment Advisors, LLC if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. Please also advise us if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. A copy of our current written disclosure statement discussing our advisory services and fees remains available for your review upon request.

Return to Newsletter page