Quarterly Market Updates

MARKET UPDATE AND OUTLOOK : JULY 2007

Current Snapshot

As I write this, the U.S stock market has just closed its best day since March, 2003, when the current bull market began.  Such exuberance relatively late in a market cycle is somewhat unnerving.  Are we approaching a blow-off top akin to 1999-early 2000, the last time we saw this kind of market action?  While fundamentals aren’t as extreme as they were then, it’s still difficult to find justification for this level of enthusiasm in current and prospective economic conditions.  It’s been said that the stock market “climbs a wall of worry everyday.”  There’s certainly cause for worry: rising interest rates, rising energy costs, and gasoline prices in particular, a record trade deficit announced yesterday, potential inflationary pressure from a tight labor market, slowing corporate earnings growth, ongoing political tension and instability in the Middle East, and slowing economic growth.  In spite of all that, the market set new records today.  A colleague thinks we have one more big upward move this cycle before a severe correction.  The problem is that no one rings a bell when a market reaches a top.  The recent reversal of the strong upward trend in residential real estate prices in most regions should serve as a reminder of just how quickly a market can turn.  The past 4+ years have been the second longest period in history without a correction of at least 10% in the U.S. stock market.  While this doesn’t bother some, it gives me pause.  As tempting as it may be to jump in with both feet, I continue to recommend a broadly diversified portfolio strategy that includes some defensive elements.  While I’m enjoying the above-average results we are getting so far in 2007, I have not forgotten what bear markets feel like. 

Looking Back: Second Quarter and First Half of 2007

For a summary of the first quarter of 2007 (Q1, ’07) as well as other prior newsletters, please refer to our website, www.jpkingassociates.com.

After a shaky Q1, ’07, stock markets, both U.S. and Foreign, enjoyed a very strong surge during April and May before tailing off in June.  For the full quarter, stock indexes were up strongly, with the broadest of these, the Wilshire 5000, up 6.0% and the S&P 500 Index up 6.3%.  The average U.S. stock fund was up 6.4%.  In general, large stocks did somewhat better than core, with value lagging slightly, but the differentials were modest.  Looking at sectors, we see more significant differences.  Among mutual funds, Natural Resources (+14.8%) and Telecom (+11.2%) led the way, followed by Technology (+9.1%).  Laggards were some of the first quarter’s leaders: Utilities (+3.5%), Health Care (+4.0%) and Real Estate (-8.0%).  Specialty Diversified Equity also lagged (+2.6%), which is to be expected when the overall market moves up strongly.

Foreign stocks also enjoyed a strong quarter.  The EAFE (Europe, Australia, Far East) index of developed markets was up 5.3%, and the Dow Jones World (ex. U.S.) index, which includes emerging markets as well as developed markets, was up 7.9%.  Among mutual funds, Emerging Markets (+14.3%), led by Latin America (+20.2%), had the largest gains.  Pacific region (+8.1%) and Europe (+7.4%) showed impressive results as well.  We continue to recommend an overweight to International Stocks in our portfolios.

Turning to fixed income, it was another tough quarter.  There was some excitement in June as intermediate and long term U.S. rates spiked up by as much as 0.6%, from 4.65% to 5.25%.  While that may not sound like a lot, in the bond market where moves of 0.05% are considered significant, this was huge.  The result was that almost all categories had negative returns for the quarter, though less than 1.0% except for long term U.S. Governments (-1.1%).  Short Term (+0.4%) Emerging Markets (+0.2%) and High Yield (+0.3%) mutual funds managed to show slightly positive returns, as did floating rate/bank loan funds (+1.3%).  Municipal bonds followed the same pattern as Taxable bonds, declining between 0.5% (High Yield Munis) and 0.9% (Insured Munis), except for Short Term (+0.2%).

Commodity indexes were generally down slightly for the quarter, with the Dow Jones –AIG Commodity Index returning -0.13%.  Gold and precious metals were up slightly, though stocks of gold mining companies were essentially flat.  This was after a relative strong Q1 increase of 4.6%, bringing the year-to-date gain to about 4.5%.  While lagging stocks, this is still a decent return.  The other low-correlation asset class we use in client portfolios is Hedge Funds, which also experienced a moderate quarter and year-to- date.  The Morningstar Long-Short category average return was 2.6% for Q2 and 4.4% year-to-date.  These asset classes are fulfilling their objectives of providing competitive risk-adjusted returns over the long term with low or negative short-term correlation with equities.  Finally, returns on Taxable Money Market Funds (+1.2%) and Tax-Free (Muni) Money Funds (+0.8%) were better than most fixed income categories, but substantially less than equities. 

Looking Forward: Q3 2007 and Beyond:

As I said at the beginning of this letter, I’m nervous about the current stock market run up.  But we have defensive elements in every portfolio, so no change in strategy is recommended.  We will be reducing the allocation to U.S REIT (Real Estate Investment Trust) funds, shifting to International.  The U.S. REIT fund category has enjoyed a great run from 2000 through Q1 2007, but valuations have deteriorated to the point where further gains will be difficult to achieve.  The Q2 correction is a signal to rebalance the allocation back to original target.  Other than this, we believe stocks likely have favorable prospects for further gains through the rest of 2007. 

James P. King, CFP^®
July 12, 2007