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.

Third Quarter 2007 Performance

The Third Quarter was another roller coaster ride that almost defied gravity on the downside and upside. The average general domestic stock fund was up 1.2 percent, according to Morningstar. The S&P 500 (a proxy for large stock performance in the U.S.) was up a respectable 2.1% (the ETF proxy used in the adjacent chart outperformed the index, generating a 3.1% return). The small and mid cap sectors of the U.S. markets did not fare as well.
International stocks in developed countries persevered and performed well. Interestingly, many specific country markets were down for the quarter which validates keeping your international portfolio diversified across countries and regions. A substantially weaker dollar bolstered returns from international investments this quarter so their returns were as good as or better than that of the S&P. The average foreign stock mutual fund gained 5 percent for the quarter.
International emerging-market funds continued on a tear, up 17%. Emerging markets refers to countries that are under developed and rural in nature. China and India are countries commonly referred to as having emerging economies. Growth in these regions has been astronomic (up 35% year-to-date).
Size mattered this quarter. The more super-sized your portfolio was (weighted toward the biggest large cap equities), the more bang you got for your investments. The strongest growth has occurred abroad this year and the US mega caps that have the largest international component to their earnings. The S&P500 ishares generated 3.1% third quarter while the S&P400 MidCaps and the S&P600 SmallCap ishares fell. International large caps also outperformed international small caps this quarter for the first time in years.
Growth also stole the spotlight, outperforming value despite capitalization (cap size) and country. S&P500 Growth ishares were up 5% for the quarter while the S&P500 Value ishares gained only 1.7%. This pattern was true for the smaller cap indices such as the S&P400 and S&P600 ishares, with the value shares falling and growth shares holding their value.

The reintroduction of risk was very apparent in the bond market, with high quality bonds rising in value and low quality falling. Scared by the upheaval in the credit markets, investors began piling into high-quality bonds, drove the Lehman Brothers Aggregate Bond Index up 2.8%, and caused yields to fall. For example, the yield on the U.S. 10-year Treasury note settled at around 4.5%, down from about 5.2% in mid-June. (Because bonds offer a fixed coupon, their yield--the coupon rate as a percentage of the price of the bond--shrinks as bond prices rise.) The popularity of Treasuries (flight to quality) also caused the Merrill Lynch U.S. High Yield Master Index, an index of low-rated (junk) corporate bonds, to post a modest 0.12% loss for the quarter.
Other parts of the fixed income markets have not fared as well. The subprime mortgage-backed market is nonexistent, making it impossible to gauge the value of many existing securities. Many banks are writing them off as worthless. Despite this nuclear melt down, the Eaton Vance Institutional Floating Rate has performed well: although it fell 1.8% for the quarter, it is still up 2% for the year.
Commodity futures performed well this quarter due to the surge in oil prices, which breached the $80 a barrel level. The PIMCO Commodity Real Return Institutional Fund rose 10% in the third quarter generating a year-to-date return of 13%. The iPath Dow Jones-AIG Commodity Index rose a more modest 6% during the quarter and 10% for the year.

Emerging-market short-term bonds (PIMCO Developing Local Markets) continue to perform well despite volatility in the fixed income arena. Year-to-date the fund is up 4.5% primarily due to declining value of the dollar against other currencies.

Libby Mihalka, CFA