After an unusually quiet summer, volatility is back in the market. The Dow lost almost 400 points last Friday, and has moved significantly in both directions all week. The change marks an abrupt end to a long, tranquil summer.

In the equity market, the S&P 500 Index went through 44 consecutive trading sessions without moving more than 1% in either direction leading up to the selloff last Friday. Trading volume spiked in late June following the Brexit vote but then settled down for the rest of the summer.

After Brexit, a Tranquil Summer

NYSE Daily Trading Volume, in $Billions (June through August 2016)
 
Monetary policy was also quiet. The Fed was on hold, central banks remained accommodative and rates were anchored near historic lows. But while the markets took a vacation this summer, the investment landscape was being re-shaped by three developments that were quietly gaining momentum. 
 

Price-to-Earnings Multiples Expanded

One of the trends we were following this summer was the continued expansion of P/E multiples, despite the lull in trading activity and the absence of proportionate earnings growth. Multiple expansion is concerning because it is often driven by investor sentiment rather than corporate fundamentals (such as earnings). In other words, we do not believe multiple expansion is a durable source of investment returns over the long term.

It is impossible to know where the ceiling is for P/E multiples in any given sector, but history shows that natural limits do exist. Stock prices do not climb indefinitely and multiples cannot expand forever.

Market Participation Broadened

After an unusually quiet summer, volatility is back in the market. The Dow lost almost 400 points last Friday, and has moved significantly in both directions all week. The change marks an abrupt end to a long, tranquil summer.

On the other hand, an encouraging pattern that emerged this summer was the expansion of investor participation in asset classes and market sectors beyond the "safe haven" income-focused trades that performed particularly well in the first half of the year (such as the S&P, fixed income investments or income-oriented equity sectors like Utilities and Telecommunications). 

As the summer progressed, investors rotated away from income-oriented sectors and migrated toward growth-oriented sectors—a direction that is generally favorable for our portfolio positioning. Risk assets were also supported by the actions of central banks, including corporate bond purchases by the ECB, negative policy rates around the world and dovish central bank comments in the wake of Brexit.

The Economy Strengthened

The summer's market tranquility was supported by modest improvements in the US economy:

• The employment picture improved. Although the US jobs report fell short of expectations in August, the economy added roughly 151,000 jobs. That brings the six-month average to 175,000 jobs per month.
• Key markets showed signs of stabilization. Areas that investors have been watching closely also improved this summer, including China’s economy and the energy market, where oil traded in a comfortable range of roughly $40 to $50 a barrel. Stable energy prices are generally supportive of financial conditions and they have recently lent support to credit spreads, especially in the high yield market.
• Support for stimulus spending gained traction. The idea of using fiscal stimulus to supplement monetary policy is gaining momentum around the world. Rhetoric from both leading presidential candidates in the US indicates government stimulus spending could be in the offing.

Ahead: Modest Expectations

While the US economy showed modest improvement this summer, we expect financial markets to provide muted returns, punctuated by episodes of volatility.

Risks include uncertainty about the direction of Fed policy, hyperactive global central banks overseas, a growing list of questions about Brexit, the US presidential elections and geopolitical tensions. These risks have resulted in an asymmetrical risk/reward profile in the equity market.

But judging by the valuations we see in various segments of the market, investors have high expectations for earnings in the fourth quarter of 2016. The economy will have to continue improving steadily if corporate America is to meet those expectations.

Portfolio Manager Paul Johnson contributed to this report.

This communication is intended solely to provide general information. The information and opinions stated are as of September 16, 2016, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

CFA® and Chartered Financial Analyst® are trademarks owned by CFA institute.