TIAA Global Asset Management

2011 Third Quarter Equity Market Review

William Riegel, Senior Managing Director, Global Equity Investments

Stock prices were volatile during the third quarter of 2011 as investors, beset by anxiety about weakening U.S. economic growth, a slowdown in the global economy, and the European Union’s (EU) sovereign debt crisis, seemed to react—often disproportionately—to every piece of news. Modestly good news could trigger an enormous rally while a mild disappointment might lead to a steep decline. Wild swings in sentiment sometimes occurred on a daily, or even hourly, basis. In August and September, for example, the S&P 500 Index experienced average daily swings of approximately 2% and 1.5%, respectively.

For the third quarter, the S&P 500 Index—a broad measure of the U.S. equities market—fell approximately -14%. Among large capitalization stocks, growth generally beat value. Small and mid-cap value stocks outperformed their growth counterparts. Outside the U.S., stocks suffered even bigger declines. International stocks, as represented by the MSCI EAFE (Europe, Australia, Far East) Index, dropped more than -17%, while the MSCI Emerging Markets Index was down more than -23%.

During the quarter, global equities grew increasingly correlated. That is, they generally moved in lockstep with little consideration for the prospects of individual companies. This suggests that investors were focused more on geopolitical and macroeconomic events than on company fundamentals. Over the long term, company fundamentals and corporate earnings growth tend to drive stock prices. When corporate profits grow strongly, as they did in 2010, investors may find it easier to shrug off bad news. However, during the third quarter a large number of U.S. companies issued profit warnings. Smaller profits were likely to give them less of a cushion to absorb external shocks. As a result, perhaps, investors concentrated their attention on the “big picture,” specifically events in Europe and Washington, D.C.

Optimism Fades in the Face of Persistent Challenges

At the beginning of the quarter, many investors were hoping for a rebound in global economic growth during the second half of the year. However, as the third quarter progressed, economic conditions continued to deteriorate. In September, the International Monetary Fund (IMF) cut its forecast for global growth to 4%. It also warned of “severe repercussions” to the global economy unless European nations strengthened their banking system and the U.S. put its fiscal affairs in order.

In Europe, EU nations failed to reach a consensus during the third quarter on a long-term solution to their debt problems—one that would keep Greece from defaulting on its sovereign debt obligations and would satisfy both the European Central Bank and the interests of stronger EU member nations such as Germany and France. Interestingly, German and French stocks were the largest decliners among European equities during the quarter. Investors also seemed concerned about the stability of European banks, and bank stocks dropped significantly.

Meanwhile, the EU as a whole appeared to be slipping into recession. (The peripheral nations of Greece, Italy, Spain, Portugal and Ireland are already in the midst of painful recessions.) Some observers suggested that an EU recession would be mild if policymakers were successful at restructuring Greek debt and stemming contagion.

In the U.S., the Department of Commerce reported second-quarter GDP growth of just 1.3%, putting the nation on track for less than 2% GDP growth in 2011, largely as a result of sluggish consumer spending, weakness in durable goods orders, and slowing home sales. The Federal Reserve also acknowledged that the American economic slowdown was likely to persist for another year or more. The effects were felt the most during the quarter by stocks in cyclical sectors such as energy, materials and industrials. Financial stocks also declined.

During the quarter, there was also widespread concern about the lack of consensus on how to address the U.S.’s fiscal challenges. Deliberations had been less than constructive, as evidenced by the protracted debate in Congress about the raising of the U.S. debt ceiling. Standard & Poor’s Ratings said as much when it lowered the U.S.’s long-term AAA credit rating to AA+ on August 5th. On the next trading day, U.S. equities sold off as discouraged investors drove the S&P 500 Index down -6.70%.

Emerging Equities Lose Some Luster

Weakness in emerging economies, such as China, was an additional source of unease. Although many emerging nations have reduced their debt levels and have experienced steady growth, they still have a reputation for risk and are often among the first asset classes to sell off during periods of volatility. This was true during the third quarter when emerging markets equities saw substantial investment outflows. Eastern European and Asian stocks suffered the largest declines, perhaps reflecting investors’ concern about the impact on emerging economies of recessions in the developed markets, the possible worsening of the EU debt crisis, and a potential slowdown in China’s economic growth.

Looking ahead, the steep declines of the third quarter may bode well for stocks during the fourth quarter. The U.S. stock market has dropped by more than 10% in 15 calendar quarters since 1964. In 12 of the subsequent 15 quarters, U.S. equities rallied by more than 10%. However, for such a rally to take place, investors are likely to need a steady stream of positive news about the global economy and the EU’s debt problems.