Losses were driven by a mixture of external risks and internal market factors. External risks included turmoil in Egypt, which potentially threatened the Suez Canal; a higher probability of U.S. intervention in the Syrian civil war; and interest rate volatility caused by the possible Federal Reserve (Fed) "taper" of bond market support. Completion of the corporate earnings season, with a slowing growth rate for both the revenues and earnings of U.S. businesses, also depressed market sentiment.

Besides the fundamental picture, the change in investors' appetite for risk was apparent in the technicals. The S&P 500 dropped through its 50-day moving average mid-month and, after a brief rally, continued to decline. This was not definitive-the S&P 500 also spent time below the 50-day average in late June and early July before recovering-but it was a sign of weakness (see chart). If prices continue to decline, the technical weakness could become more pronounced. Interest rate-sensitive sectors, such as consumer staples, tele-communications, and utilities, were the worst laggards, while the previously embattled materials and technology sectors held up reasonably well. International markets were mixed but generally stronger than U.S. markets. Developed international markets, represented by the MSCI EAFE Index, lost 1.32 percent, while the MSCI Emerging Markets Index also did better than U.S. markets but still gave up 1.90 percent.

Fixed income markets outperformed equity markets, although they could not escape the effects of rising interest rates. The benchmark 10-year Treasury bond yield rose over the month, from 2.58 percent to 2.78 percent, driving losses in the fixed income indices. The Barclays Capital Aggregate Bond Index was down 0.51 percent for the month. Performance was worst for international and, particularly, emerging market bonds, which suffered a 2.89-percent loss, according to the JPMorgan EMBI Global Core Index, as investors repatriated assets into U.S. dollars. Bank loans and short-duration bonds performed relatively well because of their lower correlation to changes in interest rates, but investors still saw a small decline in these asset classes.

At the end of earnings season, according to FactSet, earnings growth came in at 2.1 percent, which was above the 0.6 percent that analysts had predicted. More than half of companies beat revenue estimates, while almost three-quarters beat consensus earnings-per-share estimates. This was good news. Even so, both results were below average compared with the past four years, and overall earnings growth results for the quarter were the third lowest in four years, also according to FactSet.

Much of the earnings results were dependent on the strong performance of the financial sector; excluding financials, aggregate earnings actually declined 3 percent. This broad weakness may continue, given that 85 of the S&P 500 companies have issued negative guidance for the third quarter-only 19 companies have issued positive guidance.

The declining growth rate and discouraging trends in forward guidance combined to make investors more cautious, as demonstrated by the broad-based declines in stock prices. Although equity prices were still at historically high levels, the declines from their peaks suggested that investors were moderating their expectations. Volatility, also an indicator of investor risk appetite, increased in August, with the CBOE Volatility Index(a.k.a., the VIX Index or the "fear index") rising from 13.5 to 17, an increase of more than 25 percent.

Although the slowing growth rate for corporate earnings was certainly a factor in the market declines, political risks dominated the headlines. Investors began to debate in earnest whether the Fed would start to taper or reduce the volume of its bond purchases in September. According to a Bloomberg poll taken in mid-August, 65 percent of the economists surveyed expected at least a small reduction in monthly purchases, with the median respondent predicting that purchases would fall from $85 billion to $75 billion per month. If tapering does occur, this would likely continue to put pressure on certain asset classes, particularly emerging market bonds and equities. If the Fed decides not to taper, these assets could experience a significant rally.

Though the likelihood of tapering on the part of the Fed appeared to increase in August, speculation regarding that possibility was overshadowed by uncertainty over who would succeed Ben Bernanke as Fed chairman. The campaign between supporters of Larry Summers and Janet Yellen brought into relief the potential for unexpected changes in Fed policy.

Another concern is the pending debate in Congress over securing funding for the new fiscal year and raising the debt ceiling. In late August, the U.S. Department of the Treasury announced that it would run out of maneuvering room on the debt before the end of October. Investors remember the 2011 debt ceiling debate, which led to a significant market correction, so they will likely watch events in Washington closely.

Finally, the very real potential for U.S. involvement in Syria also acted to unsettle markets. The use of chemical weapons in Syria sparked heightened rhetoric about the possibility of U.S. and allied military intervention. The price of internationally traded Brent Crude oil spiked from $108 per barrel at the beginning of August to $114 at month-end. U.S. stock markets were also affected. The Dow fell 170 points as Vice President Biden announced he had no doubt that Syria had used chemical weapons, and speculation increased that an intervention would occur.

Despite the political risks, the real economy continued its slow recovery. Housing slowed, driven by an increase in rates. According to the Wall Street Journal, 30-year mortgage rates have risen from 3.7 percent at the beginning of the year to 4.6 percent at the end of July. Though the rise in rates was largely sparked by Fed Chairman Ben Bernanke's comments back in May, the data has only recently suggested that his words have had an appreciable effect on housing demand. Notably, the volume of new home sales fell more than 13 percent in July. At this point, however, the slowdown in housing appears to be a healthy adjustment, as values continue to increase and sales remain strong.

Even with the headwinds in the housing market, however, un-employment claims remain low and consumer confidence is still strong. Leading indicators ticked up during August, and growth for the second quarter was revised upward to 2.5 percent-a result of much stronger-than-expected exports, apparently driven by economic im-provements elsewhere in the world.

The increase in interest rates and declines in stock prices reflect the renewed realization by investors that there are significant political and economic risks going forward. This realization is actually constructive, as it has introduced an element of caution and helped keep valuations real. The ongoing recovery in the real economy, although moderating as housing slows, also seems well supported.

Authored by Brad McMillan, vice president, chief investment officer, and Sean Fullerton, investment research analyst, at Commonwealth Financial Network.