Second Quarter 2006 Market Review

After peaking in early May, equity markets in the U.S. and abroad corrected sharply as investors fled from risk and attempted to take profits. As a result, stocks had losses for the quarter. Uncertainty about the Fed’s next moves, increasing inflation, and strong GDP growth were negative for bond prices, producing about breakeven total returns for the quarter. Broadly diversified investors holding alternative strategies funds and a healthy dose of short maturity bonds were able to finish the quarter in the black despite weak stock market conditions.

Equities Review

The average diversified U.S. equity fund lost ground (-3.4%). Large-capitalization stocks fell approximately 6% from their peak on May 10 and returned -1.4% for the quarter. Small-cap stocks dropped almost 11% from their peak, yet recovered somewhat in late June to return -5.0% for the second quarter. Not surprisingly, companies with high expectations and high valuations corrected the most during the period, and, in general, sectors such as information technology, health care, and consumer discretionary were hardest hit across the capitalization spectrum. Utilities, energy, and consumer staples sectors were again at the top of the performance heap for the quarter and other value-oriented sectors also outperformed growth fare

The MSCI EAFE Index indicating returns for foreign blue chips fell 11% from its May 10th peak, yet recovered to return 0.70% in U.S. dollars during the quarter. Most individual markets and the broad index suffered negative local currency returns; however, the dollar lost 2.5% for the quarter against a basket of major foreign currencies, and their strength against the greenback early in the quarter improved the net returns for unhedged U.S. investors. Following the pattern among U.S. stock sectors, those countries which had the most strength in 2005 and the first quarter of 2006 had the farthest to fall and indeed did. For example, the MSCI Emerging Markets Index dropped an eye-popping 20% from its peak to return -5.0% in U.S. dollars for the quarter.

Fixed Income Review

U.S. interest rates moved modestly higher in April, stabilized in May, and then pushed higher again in late June. For the quarter, U.S. Treasury interest rates moved higher by about 30 basis points (0.30%) across all maturities. Thus, all prices moved lower, but longer-term bonds experienced worse results compared with short and intermediate bonds because of their higher interest rate sensitivity. The Lehman Brothers Aggregate Bond Index returned -0.1%. Corporate bonds fared slightly worse than government and agency debt as previously low credit risk premiums expanded much as equity risk premiums were expanding in global stock markets. In the case of high-yield bonds, their higher current income compared with Treasuries did not overcome price declines and management fees such that high yield mutual funds provided modestly negative total returns on average. Unhedged foreign bonds were the best performing major asset category thanks mainly to the strength of foreign currencies; they returned 4.0% as measured by the Citigroup Non-US World Government Bond index notwithstanding rate hikes by several foreign central banks.