Third Quarter 2003 Market Review

U.S. stock prices gained for the second consecutive quarter, extending their rally and lifting major indexes to levels not seen in over a year. Conversely, relatively low starting yields, signs of an improving economy, and a general lack of demand resulted in the first quarterly decline for the U.S. bond market in almost four years.  Outside the U.S., stocks and interest rates also rose. In addition, most major currencies, particularly the yen, appreciated versus the U.S. dollar (“USD”). The table below summarizes data for the quarter (reviewed below) and past nine months year to date. 

Equities Review

Stocks rallied, and economic improvements led to a bias favoring small caps over large caps and growth styles over value styles.  The Russell 2000 Index, which tracks small cap stocks, returned 9.1% versus 2.7% for the S&P 500 Index.  The average diversified U.S. equity mutual fund rose over 4% in the third quarter, which leaves funds poised to post their first calendar year gain since 1999. Technology stocks were the best performers, while telecom stocks were the worst. It was significant that many of the best performing securities, at least among the large-cap universe, were companies that announced an improvement of fundamentals. As in the second quarter, there was some speculation in the small-cap market as improvement in business conditions and earnings was not enough to explain the heady gain. Indeed, the rally appeared to run out of steam late in the third quarter; small-cap stocks fell 6% over the final weeks of the quarter. Performance of real estate mutual funds was strong, a 9.1% return for the quarter, while the natural resource sector posted a 3.2% gain for the period.

The U.S. dollar lost value against other developed country currencies, ending the quarter down by about 1.3% versus 19 currencies tracked by the J.P. Morgan Dollar Index.  Outside of the U.S., the MSCI EAFE Index, which covers most non-U.S. industrialized nations, returned 8.1% in USD, aided by the dollar’s decline. As in the U.S., smaller capitalization stocks outperformed their large cap counterparts. Pacific region markets did exceptionally well because of some renewed confidence about Japan coupled with the dollar’s 6.9% loss versus the yen. The relationship between many Asian economies and the technology sector also boosted the region’s stock markets as did abatement of SARS. Europe’s markets rose just 3.9% in USD due to continued economic sluggishness and only a modest boost from the euro, which gained just 1.3% versus the dollar. Emerging markets outperformed developed markets for the fifth consecutive quarter, gaining about 12% in local currencies and 14% in USD.

Fixed Income Review

The corollary of all the good news for stocks was that bonds held less appeal for investors as they began to anticipate stronger U.S. and global economic growth in the second half of the year. The combination of attractive returns from equities, concerns about the impact of economic improvement on interest rates, and the lack of demand for relatively low yielding Treasuries resulted in a sharp rise in rates early in the quarter. Within the bond market, there were relatively few opportunities to earn a return. While investment grade corporate bonds outperformed Treasuries on a relative basis, only financials had a positive return. High yield bonds continued to benefit from the same corporate optimism that supported equity prices.

Foreign yield curves also steepened.  Medium- to long-term rates rose between 50-75 basis points (bps) in Japan, 20 bps in the U.K., and 10-20 bps for the euro benchmark curve. Fortunately for unhedged U.S. investors, the fall of the USD offered the opportunity for attractive currency gains from non-U.S.bonds to supplement modest local currency returns. The Salomon Brothers Non-U.S. World Government Bond Index rose 2.7% during the quarter when translated to dollars.

9 Months
Ending
9/30/03