Insights
Market Commentary - 3rd Quarter, 2007
The third quarter of 2007 was yet another example of why market timing can be such a difficult strategy to pursue without use of hindsight and a crystal ball! As illustrated in the chart below, the Dow Jones Industrial Average rose to an intra-day high of 14,095.59 on July 17th, barely two weeks into the third quarter. Amid near market hysteria, during the height of the sub-prime market meltdown, the market then spiraled downward to an intra-day low of 12,455.91 on August 16th, before surging back to a new intraday high of 14,147.29 at the beginning of the fourth quarter, just two weeks later on October 1st!
In August the problems in the sub-prime sector of the mortgage market spread to other credit markets around the world, resulting in a full-blown liquidity crisis. While the central banks in Europe and Japan began adding liquidity to the market, it wasn’t until August 17th that the US Federal Reserve acknowledged the crisis and lowered the discount rate ( the rate at which commercial banks can borrow directly from the Fed against a broad range of collateral, including treasuries and agencies, municipal and corporate securities, CDs and commercial paper), rather than cutting the Federal Funds Rate (the interest rate at which commercial banks lend balances at the Federal Reserve to other commercial banks on overnight loans) in an attempt to provide liquidity, contain the freefall and calm the markets.
While the Fed’s focus has been keeping inflation in check, this move, while not an outright easing of monetary policy, was an acknowledgment that slower growth was likely in the face of the pervasive weakness evident throughout the housing market, along with the reduced availability of credit. Though many economists continue to see the outlook for the US economy as favorable, given strong corporate earnings and a pickup in GDP, the credit markets overall have come under tremendous pressure.
In it’s formal meeting on September 18th, the Fed cut the Fed Funds Rate by 50 basis points, or ½ of 1%, which subsequently buoyed both the stock and bond markets. Note also in the chart below, the dramatic plunge in Treasury rates in the flight to quality, before returning to more normal levels toward the end of the quarter.
10 year Treasury Note Yields
8/1/07 – 9/28/07
Source: WSJ
Interest rates during this period declined (driving bond prices higher), particularly in the shorter maturities, allowing the yield curve to steepen considerably into a more normal shape from it’s relatively flat slope during the previous quarter.
US Treasury Yields (%) |
3-Mo |
6-Mo |
2-yr |
3-yr |
5-yr |
10-yr |
30-yr |
December 31, 2006 |
5.01 |
5.08 |
4.81 |
4.73 |
4.69 |
4.70 |
4.81 |
June 30, 2007 |
4.80 |
4.94 |
4.86 |
4.88 |
4.92 |
5.02 |
5.12 |
September 30, 2007 |
3.46 |
4.16 |
3.99 |
4.02 |
4.25 |
4.59 |
4.87 |
Chg in Yield (6/30 - 9/30) |
-1.34 |
-0.78 |
-0.87 |
-0.63 |
-0.67 |
-0.43 |
-0.25 |
On the other hand, spreads (the difference between the risk free interest rate offered on US Treasury issues and similar maturity credit instruments), which had begun widening since the onset of the credit crisis earlier in the year, widened even more dramatically during August, as few, if any investors were willing to buy anything other than Treasuries. This was particularly evident in the mortgage market and in the lower quality market sectors, and according to one source, BBB sub-prime floating rate issues, widened out with a spread of -5,285 basis point to US Treasuries, reflecting an interim loss of nearly 53%! As fears over insolvency increased, investors concerns intensified. This was due to the fact that there was no clear information regarding which vehicles (including certificate of deposits and money market accounts) and portfolios were exposed to sub-prime-related obligations and to what extent.
Marketability and liquidity during the worst of that panic period was impacted dramatically during August, though performance returns for the quarter overall were positive, as noted in the chart below. High yield bonds had a poor showing for the quarter, but bounced back considerably during the September period, with one of the more attractive relative gains in the bond market. That said, markets have a tendency to over-react, both on the upside as well as the downside, and this time was no different.
By the end of the quarter, investors had gained a bit more confidence, and performance in both the stock and bond markets recovered smartly. The US Stock market, as represented by the S&P 500 Index, posted a gain of 2.03% for the quarter, advancing 9.13% year to date, while international equities, as represented by the MSCI EAFE Index (Europe, Asia and the Far East) rose 2.18% and 13.15% for the third quarter and year-to-date periods, respectively. The bond market, on the other hand, represented by the Lehman Aggregate Bond Index, rose 2.84% for the quarter, but was up a mere 3.85% year-to-date.
While we continue to advise our clients on the merits of diversification, as well as adherence to a time horizon and investment objective that meets their overall financial plan, we also find it prudent to stay focused during periods of market volatility and avoid panic selling and irrational investing behavior. To this point, note the chart below illustrating the performance of the S&P 500 following three of the past financial crises: the 1987 Market Crash, the 1998 Crisis of the Emerging Markets and Long Term Capital Management Company, and September 11, 2001. In all three cases, the Federal Reserve reacted swiftly by providing substantial liquidity and cutting the Federal Funds Rate.
Performance of the S&P 500 following three financial crises
Source: S&P and IIM estimates
Note that the stock market recovered to higher levels three months after the Fed began providing liquidity in all three periods. Returns, however, in both 1987 and 1998, were also notably higher 12 months later. While 2001 was an exception, it can be argued that the economy was already in recession by the time the Fed acted and was still feeling the after-effects of the fall out from the technology bubble in which P/E (price to earnings) ratios were dramatically higher than they are today. Bear in mind that while past performance is no guarantee of future performance, historical perspective tends to impart lessons from which we can learn.
As we head into the fourth quarter, the stock market has broken into all time high territory. We acknowledge that the housing market remains under pressure and will likely continue to be a drag on the US economy well into 2008. Though this scenario may create stress in the marketplace, it is also likely to provide a healthier environment for the future.
Another obvious concern reflects the notable decline of the US dollar and the general widening of the trade deficit. While most currency experts expect the dollar weakness to continue, it has created record export demand, and is likely to present an interesting opportunity in the intermediate term as the effects are likely to help stimulate economic growth in the US.
Percent Appreciation vs. U.S. Dollar, Year-to-Date 2007
Looking ahead, we reiterate our belief that a well diversified, high quality “core” portfolio is key to achieving one’s long term investment goals. However, we also feel that the addition of complementary strategies, which incorporate alternative asset classes (which may further diversify and mitigate risk) as well as those that afford more defensive strategies (seeking to take advantage of opportunities in volatile and/or consolidating market environments), effectively summarizes the advice we share with our clients in individual meetings. As always, we look forward to hearing from our readers and invite you to share your thoughts with us as well.