Quarterly Market Updates

MARKET UPDATE AND OUTLOOK : OCTOBER 2007

Current Snapshot:

he leaves are falling and we’ve already had the first significant rain of the season here in Northern California. Summer is definitely over, and many investors are glad of it. It has been nearly two months since the Federal Reserve acted to bolster liquidity in the financial system by lowering the discount rate by 0.5% on August 16.  The next day, the stock and bond markets began to stabilize.  When the Fed followed this cut a month later with another half point cut, this time in the Funds rate, the markets rallied significantly through the end of September.  Since then, they have bounced up to set new highs (Dow, S&P) earlier this month, then dropped back to levels at the beginning of the month as I write this. Oil futures set new highs today, closing over $86/barrel, while the stock market averages all dropped about 0.75%. The mood may best be characterized as facing forward but looking back over the shoulder. While that may lead to a stiff neck, the momentum should be strong enough to advance.

Looking Back: Third quarter of 2007:  

3 started off very strong, with the Dow Jones Industrial average (DJIA) reaching 14,000 for the first time ever on July 17. However, lingering concerns about real estate related sub-prime loans, which had surfaced several months earlier, burst into the headlines when a couple of hedge funds announced they were nearly bankrupt. In a very short time panic spread, first to any non-government guaranteed loan obligations, then to stocks.  It was a classic indiscriminate sell-off, with people madly dumping anything with any degree of risk, seeking the safe haven of U.S. Treasury securities.

From mid-July through mid-August, the DJIA fell approximately 9.5%, its biggest drop since early 2003.  Small company stocks, perceived as riskier than large companies, fell even more, nearly 17% from peak to trough. Corporate bond prices fell too, some as much as 7%, causing their rates to rise as a percentage of their market value.  Foreign stocks dropped in sympathy, though their decline was somewhat mitigated in dollar terms by the continuing decline of the dollar against the currencies of our major trading partners.  But, as has been the case historically, the only safe havens during a panic are Cash and U.S. Treasuries. Hedge funds, which can provide stability during deep bear markets, were mostly ineffective in this case, unless they were net short; that is, betting against the market, or market neutral; meaning fully hedged against market moves.  One of our funds, Hussman Strategic Growth, was fully hedged and actually gained in value during this period.  But others that were long/short, both holding some stocks and shorting others, such as Schwab Hedged Equity, lost more on the stocks they owned (long) than they made on the ones they bet against (short), and ended up declining in value, though not as much as a traditional long-only fund.  Another traditional safe haven, precious metals, didn’t provide any shelter this time, perhaps because prices had been bid up significantly during the previous two years, to the point where they could no longer be considered bargains.  The flood out of stocks and corporate bonds and into Cash and U.S. Treasuries drove their yields down considerably as their prices rose.

Then, as I said earlier, the Fed stepped in, calming the markets.  By the end of the quarter, stocks had rebounded to post slightly positive returns overall, with the Wilshire 5000, the broadest measure of the U.S. Stock market, up 1.4%.  The Nasdaq, with a higher concentration of growth stocks, gained 3.8%.  The DJIA gained 4.2%, while the Russell 2000 index of small stocks dropped 3.1%, reflecting the divergence between large and small stocks referred to earlier.  Commodities ended positive for the quarter with the Dow Jones- AIG index up 5.1%. The trends in U.S. Stocks that began earlier in the year, with large cap out performing mid and small, and growth style out performing core and value, continued during Q3.  Not surprisingly, sectors that favor growth style investments, such as Technology (+6.5%) out performed those with value style (Utilities, +2.1%; Real Estate, +1.3%; Financials, -4.0%).  Natural Resources again was a leading sector (+7.6%). Among world stock funds, emerging markets rebounded from the mid-quarter drop to finish up 11.9%, substantially higher than foreign funds in general (+3.2%). The highest gains were in Gold and Precious Metals stock funds, up 18.3% for the quarter. Long Short category funds, as reported by Morningstar^®, were down -0.2% for the quarter.

Fixed Income funds generally had positive total returns, ranging from 3.8% for World Bond funds and 3.6% for Intermediate Government Bond funds to 1.6% for General U.S. Taxable Bond funds. High Yield Bond funds were unchanged, and Bank Loan funds had a negative return of – 1.6%. Municipal (Tax Free) Bond funds had lower returns, from 1.2% (short term) to 1.8% (intermediate term).  High Yield Munis were negative (-1.6%).  Money Market funds’ yields dropped slightly during Q3, returning approximately 1.12% vs. 1.15% on average over the trailing four quarters.

Looking forward: Q4 2007:

We have seen the U.S. stock market rise during the fourth quarter for the past 6 years (2001-2006). As we always say, past performance is not a guarantee of future returns, so there is less than 100% certainty that Q4 will be positive for stocks. I put the odds at greater than 80% though (stocks historically have risen 73% of the time), slightly better than the historic average, because the economy is likely to weather the subprime storm without falling into recession and investor sentiment trends to build going into an election year. Interest rates are likely to stay down, perhaps drop a bit more, and the weak dollar has a silver lining : U.S. exports are reaching all time highs, as our goods seem cheap to our trading partners, which means higher volumes for U.S. manufacturers. Still, the drama of the past summer serves as a wake up call to investors that it doesn’t take much to switch from hope to fear. For now, there’s more optimism than pessimism and that, more than economic reality, seems most important in determining the direction of the markets.

James P. King, CFP^®
October 15, 2007