As discussed previously, September and October have reputations as volatile and down months.  This year certainly proved the assertion true.

The bears had plenty of ammunition to sell stocks.  There was continued geopolitical turmoil, weak economic numbers out of Europe, and a Federal Reserve that discontinued quantitative easing.

Lower Oil Prices

In addition to these concerns, there was a surprise move by Saudi Arabia to lower oil prices.  That’s right – lower prices.  There may be several motives for the Saudi strategy -an attempt to gain market share or to put economic pressure on its enemy, Iran.  We may never really know.

The most obvious impact was that oil stocks fell sharply, especially small-cap energy producers that are more sensitive to changes in oil prices than large, integrated companies.  Energy companies comprise about 11% of the S&P 500, so the impact was felt beyond the energy sector to the broader indices.

To further the October stock market woe, Mr. Market interpreted the Saudi price cut as a signal that the global economy is weakening, adding fuel to the bearish mood and put more downward pressure on stocks.

The downdraft in stock prices was very uncomfortable.

It was quick and deep.  I think the exchange-traded funds and the algorithmic trading strategies assisted in creating the volatility.  The current structure of the markets with the proliferation of index funds and electronic trading is going to make steep, fast drops and congruently quick recoveries, part of the normal life of the markets. We need to accept that and plan accordingly.

As I write this column we are in the midst of a recovery from the September/October correction.  Throughout 2014, smaller companies’ shares have performed poorly compared to large companies.  Consistent with this, shares in small companies fell further in September and October than large companies and in the recovery that began at the end of October, small stocks have not risen as much as the large ones.

I think the relative under-performance of small-caps is due to the concern that the global economy is slowing and that small companies will have less wherewithal to maintain profits.  The question of global growth or lack thereof will be front and center as we move from 2014 to 2015.

The US economy has been doing relatively well vis-a-vis other high-income countries.  As the third-quarter earnings reports for the S&P 500 are almost all in, we see that 77% of the companies reported earnings that were higher than estimates and 60% had revenues that exceeded estimates.  This is good news for the bulls.

If earnings continue to rise then the bull market should continue.  It is unclear whether small-caps will catch up to larger firms.  Small-caps need confidence and that may come back only if investors see better growth in Europe and Japan and whether China can maintain its growth.

— Ian Green, Pendragon Capital Management

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Note: This blog article is intended for general informational purposes only. Nothing in it should be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product.