During the third quarter U.S. stock prices were highly volatile -- rising in July, showing
some signs
of uncertainty in August, and declining precipitously in September. Nearly all of the
sectors declined
during the quarter. The S&P 500, a measure of large company performance, fell by 6%,
while small
company stocks, measured by the Russell 2000, decreased by 8%. Both value and growth
stocks
declined. Bonds were flat during the quarter. The benefits of international
diversification were in
evidence, as broad-based international stocks rose by 4%, although emerging market stocks
fell by
8%.
There were three main reasons for the fluctuations. First, economic data show that there
are signs of
increasing inflation, and previous attempts by the Federal Reserve Board to slow economic
growth
have not proven successful. This has led to fears of higher inflation and interest rates.
Second, there
is concern about the continued growth of corporate profits. The relatively high corporate
valuations
in July were based on the continued healthy profits reported during that month, but many
analysts
doubt whether continued excellent performance can continue. Third, there is anxiety over
the
valuations of particular sectors in the market, particularly high technology stocks.
These three factors will likely continue to cause stocks to oscillate during the final
quarter. Of the
three, I am most concerned about the potential for sector overvaluation. The risk
exhibited by the
two others, inflation and earnings uncertainty, appears to be mainly based on short-term
factors, and
has already manifested itself in a 10% decline in values. Although these factors could
cause minor
dips, it is unlikely that they will cause a major shift in values in the future. However,
a severe decline
in a sector could harm investors who have over-allocated their money into industries that
they felt
would outperform the market. During chaotic periods it is most important to practice broad
diversification. It is important for you to research your investment funds to detect
potential
under-diversification, and adjust your portfolio to avoid any extreme risks.
In my July commentary, I stated two reasons why that the market might not perform well in
the third
quarter:
"If the Fed senses the potential for an increase in inflation, it may very well
increase interest rates
again before autumn, which will dampen stock prices. A second and more serious concern is
about
corporate earnings. The relatively high stock valuations in today's market reflect
optimism about
continued growth in profits. If many companies announce earnings below expectations, we
will see a
potentially severe decline in stock prices."
I point this out merely to illustrate that the volatility displayed over the past month is
not surprising,
and should not affect your long-term investing strategy. While there is always a tendency
for
investors to want to react during turbulent times, the proven best approach is to maintain
the policies
that were followed during more stable periods. Now is not the time to change your
strategic
allocations. Long-term stability in allocations is the method that repeatedly has produced
successful
portfolio results. 
Lummer's Logic Archives
Scott L. Lummer, Ph.D., CFA, 401k Forum's Chief Investment
Officer, is a recognized expert in the investment field. He has conducted extensive
research on asset allocation, international investing, risk management, mutual fund
analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook.
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