Second Quarter Market Review

"You make most of your money during a bear market; you just don’t realize it at the time." Shelby Cullom Davis

The first half of the year had all the thrills and chills of a bad horror flick. There were nauseating triple digit declines in the U.S. market, warnings of collapse among players in the global financial system and the subprime-mortgage-housing foreclosure crisis debacle. Then we had a rally in early spring and investors breathed a sigh of relief as many believed that the subprime monster had been tamed and the worst was behind us.

Ah, but never underestimate a bad horror movie. There was more than just one monster in this picture. The oil monster was on the rise and he scared consumers out of their SUVs. His pal, the inflation monster, also caused fear as he caused food prices and healthcare costs to rise. In response, the markets ran scared and fell hard again. These last two monsters, oil prices and inflation, delivered a one-two psychological blow to the markets. Investors had been lulled into feeling safe by the early spring rally that had pushed the market averages into positive territory for the year. Of course, everyone knows that you can never be safe until the hero, Obama or McCain, captures the monsters and saves the economy. But I am getting ahead of myself; let’s first talk about the second quarter.

So a sharply negative first quarter was followed by two months of positive returns, but the selloff resumed with a vengeance in June, with large-cap stocks dropping over 8%, resulting in a 3% decline for the second quarter. Surprisingly, Mid Caps and Small Caps hung on to have a positive quarter with the S&P400 Mid Caps rising 8.7% and the S&P 600 Small Caps up 3.5%.

Value stocks fell across the board, which is not surprising since the financial, mortgage and housing stocks are all in bad shape. Conversely, Growth stocks were positive across all market caps. Domestic high-quality bonds were down just over 1% for the second quarter and up just 1% for the year. Though not a good return in a normal environment, bonds did provide balanced investors with a modicum of protection from stock-market losses, which is part of their role.

Being diversified outside of U.S. stock market didn’t help much. Developed international markets fell 2.3% for the quarter and are down almost 11% year-to-date. Emerging markets were positive for the quarter earning 2.2% but are still down almost 10% for the year.

Interestingly, international bonds have performed well this year. They are one of the least risky ways to profit from the declining dollar. Emerging market debt has performed admirably, reflecting the rise in third world countries on the economic world stage. PIMCO Developing Local Markets was up 3.3% over the quarter and 5.8% year-to-date. PIMCO Foreign Unhedged that invests in developed countries was down 5% for the quarter but still up 5% for the year.

The only relief domestically was in the commodities markets which have profited from rising food, metal and oil prices. Unfortunately, commodities look like a speculative bubble that is going to pop.