Third Quarter 2009 Market Review

Financial markets extended the second quarter rally with equities and fixed income securities posting strong returns as investors’ appetite for riskier assets remained strong amid growing expectations that the recession was ending. The S&P 500 Index rose 15.6% and the Barclays’ Capital U.S. Aggregate Bond Index returned 3.7% for the quarter. Fixed income performance was strong during the third quarter as spreads continued to tighten. International securities also had a very good quarter reflecting the global nature of increasing investor confidence as well as currency gains for unhedged U.S. dollar investors.

Equity Review

The rebound in equities that began on March 10th continued during the third quarter as corporate earnings, albeit not particularly robust, generally appear to have exceeded expectations. Specifically, 74% of companies reporting earnings in the months of July and August reported a positive earnings surprise while only 24% reported a negative earnings surprise. The average diversified U.S. equity fund returned 16.8% for the quarter. While all equity styles posted strong gains for the quarter, value significantly outperformed growth, as investors became increasingly more comfortable with the risk associated with owning more distressed companies. Small-cap stocks outperformed large-cap stocks, also consistent with increased risk appetites. Performance varied notably by sector. Financials, as well as economically sensitive sectors such as materials and industrials, were among the best performers, gaining 24.2%, 23.1%, and 21.3%, respectively. In contrast, the more defensive sectors such as utilities, health care and consumer staples were among the worst performers, gaining 6.7%, 10.0%, and 11.4%, respectively.

International stocks also posted strong gains as economic conditions and investor confidence improved overseas. The average diversified international equity fund returned 19.1% for the quarter, just less than the MSCI EAFE Index, which returned 19.5%. Emerging markets modestly outperformed developed markets and, as in the U.S., value stocks outperformed growth stocks and foreign small-cap stocks bested their large-cap brethren. The return of 14.8% for EAFE in local currencies was boosted by currency gains for the U.S. dollar investor as the dollar declined 4.0% versus 19 currencies tracked by the J.P. Morgan Dollar Index.

Fixed Income Review

Quality (or the lack thereof) continued to drive performance within the fixed income markets. Investor demand for higher risk securities persisted, and spreads between the highest and lowest quality bonds continued to tighten during the quarter. High-yield bonds, investment-grade corporate bonds, high-yield municipal bonds and non-agency asset backed securities tied to real estate substantially outperformed U.S. Treasuries and agency mortgage-backed securities. To illustrate the divergence, the Barclays Capital Aggregate U.S. Treasury Index and the Barclays Capital U.S. Corporate High Yield Index returned 2.1% and 14.2% for the quarter, respectively. In addition, the U.S. yield curve remained relatively steep, with short-, intermediate-, and long-term rates trending modestly lower during the period. Higher quality foreign bonds outperformed their domestic counterparts, aided by currency profits on U.S. dollar weakening. The Barclays Capital Global Aggregate ex-U.S. Bond Index gained 7.9% for the quarter.