Following a relatively soft first quarter of 2004, the capital markets finished the latest three months with even smaller gains.  The 2003 resurgence of equity prices continued to abate as investors shifted their attention from improving balance sheets and profits statements to macroeconomic factors, interest rates, and share valuations. The U.S. Federal Open Market Committee began to move away from the accommodative stance it had maintained for several years.  The related rise in interest rates pushed down bond prices and produced negative total returns; these events probably signaled the end of the bull market for bonds. The table on the other side of this page summarizes data for the second quarter (reviewed below) and past six months.

Equities Review

Equity market gains in the second quarter were lackluster and in fact negative for a number of asset categories. The S&P 500 was up 1.7% for the period while the average domestic stock fund posted a total return of .9% in the second quarter, according to Morningstar statistics. Small-capitalization stocks trailed large caps (the Russell 2000 Index rose just .5%), due in part to valuation concerns and in part to concerns about tighter monetary policy restraining economic growth. Despite overall improvement in the economy, it appears that stocks had risen so sharply from March 2003 that investors concluded that most of the good news was already in the prices. Further, the expectation of higher interest rates raised questions about future economic and profit growth. So the market bifurcated: those segments where valuations were a concern (telecom, technology and materials) and those expected to be hurt by a rise in rates (utilities and some financial industries, especially REIT’s) had mixed to negative returns, while those expected to benefit from higher prices (energy) and those with more positive outlooks thanks to the ramp up in capital spending (industrials) posted solid gains. Natural resources funds led the overall market with a 3.3% gain for the quarter.

The U.S. dollar gained value against other developed country currencies, ending the quarter up about 2.2% versus 19 currencies tracked by the J.P.Morgan Dollar Index.  This hurt American investors in many foreign markets.  While the MSCI EAFE Index, which covers most non-U.S. industrialized nations, returned 2.4% in local currencies, it gained only 0.2% in U.S. dollars because of currency losses.  Similar to the U.S. , energy was the best performing sector, while information technology and telecom services were the worst. Emerging markets were battered in the second quarter due to rising valuations over the last twelve months, the impact of a rising interest rate environment and a number of country specific issues that impacted share prices. Asian developed markets also performed poorly as the growth outlook took a hit when China announced actions to slow down its overheated economy.

Fixed Income Review

Unfortunately for investors, bonds did not offer much of an alternative in this choppy quarter due to the rise in interest rates, the more credible threat of inflation, and expectations for tighter monetary policy.  In the U.S. , the Lehman Aggregate Bond Index declined 2.4%, its worst showing since the first quarter of 1994. Within the bond market, the spread sectors (corporates, mortgages, and asset-backed) performed as poorly as Treasuries. The key differentiating factor in bond market performance was average maturity. Longer-maturity bonds fell very hard in response to the rise in rates. For instance, the Lehman Long Treasury Bond Index fell over 5%.

Foreign bonds also performed poorly, with the additional factor of the rising dollar further diminishing performance. There was little difference in the declines from corporate and government bonds. Most of the discrepancies in returns by country were driven by currency changes rather than yield curve adjustments.  The Salomon Brothers World Government Bond Index lost 3.4% in dollar terms.