Third Quarter 2006 Market Review

Financial markets recovered during the third quarter as evidence of a slowing U.S. economy gave investors confidence that the Fed would end its long campaign of interest rate increases. Since the Fed refrained from hiking rates at its August meeting, U.S. stocks have moved broadly higher, foreign developed and emerging stock markets have also moved higher, and medium and long-term interest rates have moved significantly lower in the U.S., sending bond prices higher. The U.S. dollar was mixed versus major foreign currencies.

Stocks

TThe U.S. stock market rose 4.6% for the third quarter, as measured by the Russell 3000 Index, which is a broad market measure comprised of both large and small capitalization stocks. Value stocks again outperformed growth stocks, and large cap stocks bested small cap stocks by a significant margin during the quarter. For instance, the Russell 2000 Index of small company stocks returned only 0.4% for the quarter. Across all cap ranges, stocks with higher earnings growth and higher earnings expectations significantly underperformed low growth and low expectations companies. The return of the average diversified U.S. equity mutual fund of 2.1% lagged the broad market (Russell 3000 at 4.6% and Wilshire 5000 at 4.3%) because of a higher weighting in small cap stocks and the drag of management fees. As usual, there were large deviations across sectors. The sharp pullback in commodities and energy prices produced weakness in the energy, materials, and industrials sectors. Conversely, telecommunications, information technology, and financials sectors performed well. And despite the recent declines in existing home sales median prices, real estate mutual funds rose strongly due to their exposure to mainly industrial and commercial properties.

Foreign developed and emerging markets stocks rose solidly for the period. The main exception was the Japanese market, which was up 2.1% in local currency terms but declined .7% for an unhedged U.S. investor after currency losses. The MSCI EAFE Index returned 3.9% for the period, and the average diversified international stock fund earned a similar 3.5%. Overall, overseas market returns were only mildly affected by foreign currency fluctuations because the U.S. dollar rose during the period by a mere 0.2% versus 19 currencies tracked by the J.P. Morgan Dollar Index.

Bonds

The slowing economy, the Fed’s actions, the declining housing market, and a reversal in commodities prices sent medium and long-term interest rates lower and bond prices higher. The yield on the ten-year U.S. Treasury note dropped 52 basis points from 5.15% on June 30 to 4.63% at quarter end. Intermediate U.S. government bonds returned 2.9% as government bond mutual funds posted their best quarterly returns in four years. The broad Lehman Brothers Aggregate Index returned 3.8% for the period, and corporate bond funds posted their best returns in three years. As indicated, the U.S. dollar appreciated slightly, putting a small dent in third quarter returns for foreign bonds, which nonetheless were positive for the period.