Fourth Quarter 2001 Market Review

Much of the surrealism of the third quarter continued in the fourth quarter.  Bad news on the economy and corporate earnings was offset by good results for the war on terrorism in Afghanistan and an almost amazing recovery of global stock markets.  The U.S. economy was officially termed as being in a recession, and economic activity was equally bad outside of the U.S., yet U.S. markets rallied sharply in the fourth quarter behind a resurgence of investor optimism.  Developed international stock markets rose during the quarter, though not as sharply as in the U.S.  Finally, U.S. mid- to long-term interest rates rose moderately, and bonds did not offer much return for the quarter.  The table on the other side of this page summarizes data for the quarter (reviewed below) and full year.

 Equities Review

U.S. equities enjoyed their best quarter since the end of the bull market in 1999.  In addition to the broad rise in equity prices, there was a bias to the more aggressive asset classes: growth outperformed value by over 5 percentage points, technology was the best performing sector, the Nasdaq Composite jumped over 30%, and small-cap stocks had their best performance in over 10 years.  Such performance was likely driven by increased investor expectations regarding a potential recovery of stock fundamentals, because the economic backdrop alone would not necessarily have boosted stock markets.  This is a reminder that markets typically look forward 6-12 months and rise well ahead of the actual recovery. 

International equities also offered strong returns, although U.S. investors in those markets again were negatively impacted by the surprising strength of the U.S. dollar.  Against 19 currencies, the dollar appreciated 4.2% for the quarter.  Local currency returns in developed markets were comparable to those of the U.S. and followed the same growth/high tech bias.  The dollar, however, rose over 2% versus the euro and over 9% versus the yen, dampening the returns for domestic investors.  Still, the MSCI EAFE Index provided a quarterly gain in U.S. dollar terms for the first time in two years.  Many of the best performing countries were in the Asia ex-Japan region.  The level of performance was related to the degree of economic recovery investors anticipated.  U.S. investors in Japan, for instance, lost almost 6%.

Emerging markets surged during the fourth quarter, reflecting an increased investor appetite for riskier assets.  Emerging Asian countries appreciated better than 30% due to expectations of increased demand for technology-based parts including semiconductors.  Emerging Latin American countries were also generally up.

Fixed Income Review

The flipside to renewed investor confidence was a belief that the flight to the safety of bonds may have pushed rates below what would be sustainable if the economy does turn around.  Investors’ appetite for bonds waned, and U.S. mid-and long-term rates rose modestly during the quarter.  The lower bond values due to increasing rates largely offset the interest yield so that the total return from taxable bonds was miniscule.  Treasury bill rates fell in reaction to further FOMC rate cuts.  Corporate bonds, particularly high-yield and lower-credit quality bonds, outperformed Treasuries by a fair margin in the quarter.  Many corporate bonds had performed poorly because of the developing economic recession, and thus bounced back during the quarter from extremely wide yield spreads (the difference between the yields on corporate bonds and Treasuries), providing the only bright spot in U.S. bond markets.  Municipal bonds had negative total returns due to higher price sensitivity to increasing rates than taxable bonds.

International interest rates were little changed.  The Salomon Brothers World Government Bond Index was virtually unchanged in local currencies, and declined in dollar terms because of the decline in the yen and the euro versus the U.S. dollar.

 * Mutual fund return data are from Morningstar.

**      Capitalization-weighted index of 500 very large U.S. companies.  The 500 are chosen to achieve a fair cross-section of U.S. industrial and service sectors.  Recent median capitalization of approximately $61 billion.

***     Lehman Brothers index of U.S. Treasury bond total returns (i.e., interest plus or minus change in price).  Bonds in index have intermediate maturity of about 4-7 years.  No mortgage-backed securities included. 

d               Lehman Brothers index of U.S. investment grade corporate bond total returns (i.e., interest plus or minus change in price). Bonds in index have intermediate maturity of about 4-7 years.

#      Index of small U.S. companies.  Recent median capitalization of approximately $930 million. 

##      International stock index indicating return of large foreign companies of 20 major developed countries (Japan, UK, and Germany have the highest weightings).  Returns are converted to U.S. dollars.  No emerging market stocks are included.

###      Salomon Brothers index of total return of foreign government bonds issued by major developed foreign countries (Japan, Germany, France, and UK have the highest weightings).  Returns are converted to U.S. dollars.

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