Third Quarter 2007 Market Review

Financial markets were extremely unsettled during the third quarter but nevertheless provided positive returns for the period. The economy continued to grow while a liquidity crisis initiated by spreading weakness in sub-prime mortgage loans increased economic and market uncertainty. Bonds of all credit quality became unusually volatile, and credit spreads widened dramatically, raising the cost of capital for many borrowers. Equity markets reacted and became more volatile as a rising cost of capital pressured corporate profitability, penalized leverage, and hindered merger and acquisition activity. 

Equities Review

Stock markets declined sharply during the liquidity crisis in July and early August but recovered thereafter thanks at least in part to Fed action (see below). There were significant differences experienced between market capitalization and style. Small and mid-cap stocks reacted more during the price declines and significantly underperformed large-cap stocks during the quarter. The S&P 500 Index of large cap stocks rose 2.0% while the Russell 2000 Index of small-cap stocks declined 3.1%. Growth stocks outperformed value stocks, reflecting two main factors, first, a typical reversion to the mean after value indices had outperformed for an extended period, and second, weakness of financial stocks, which are a major part of value investing, as a result of the liquidity crisis. The Morningstar U.S. Growth Index rose 5.0% while the Morningstar U.S. Value Index declined 1.2%. The average diversified U.S. equity fund returned 1.0% for the quarter. From a sector perspective, financials and consumer discretionary stocks fared poorly, dropping more than 4%, while all other sectors appreciated, led by energy and information technology stocks, which rose 9% and 6%, respectively. 

Foreign stock markets exhibited similar volatility, but given different reactions from foreign central banks, did not recover as much. Foreign developed markets were down when measured in local currencies. However, the weakness in the U.S. dollar, down 3.7% during the quarter versus 19 currencies tracked by the J.P. Morgan Dollar Index, boosted returns for U.S.-based investors. The MSCI EAFE Index of foreign developed markets returned 2.2% while the average diversified international equity fund returned 2.9%. Emerging economies continued to drive forward, which, in combination with sharply rising oil and gold prices (many emerging economies are commodities driven) and strong currencies, provided solid returns for U.S. investors. The MSCI Emerging Markets Index returned 14.5% in U.S. dollars for the period. 

Fixed Income Review

A flight from risk created unusual patterns of volatility within the U.S. bond market. Among the most volatile of interest rates were short-term Treasury yields, which vacillated between 2.9% and 4.9% as investors raced to safety. Credit spreads widened significantly throughout July, as Moody’s and S&P downgraded hundreds of securities, and price moves forced leveraged investors to raise cash any way they could. After July, prices for bonds recovered, as investors had time to evaluate underlying fundamentals and adjust their portfolios in a more rational manner. The Fed cut its discount rate by 1% over the quarter and reduced the Fed Funds Target Rate 50 basis points. Broad quality bond indices such as the Lehman U.S. Aggregate Index were marginally profitable during each of the three months and accumulated a return of 2.8% for the quarter. Despite dropping more than 3.5% in July, the Lehman High Yield Index recovered in late August and September to provide a return of 0.3% for the third quarter. The combination of falling yields and rising currencies helped global bonds to a solid return; the Lehman Brothers Global Aggregate Index returned 5.6% in U.S. dollars for the quarter.