Second Quarter, 2008 Economic and Market Commentary

Economic Environment

Volatility, driven again predominantly by the financial sector, housing market and surging commodity prices, once again wreaked havoc on the financial markets in the second quarter. According to the traditional definition of a bear market, we officially entered bear market territory with the Dow Jones Industrial Average being down 20% from its October 2007 high. Even without this "official" announcement, it has been evident for some time now that we are in a bear market cycle, as investors are still not convinced that the worst from the credit crisis, housing market and the rapid rise in oil prices is behind us. This is evidenced by the plunging U.S. consumer confidence index, which fell to its fifth lowest reading ever in June.

An analysis of the S&P 500 Index over the long term will clearly show that bear markets are inevitable. Since World War II, there have been nine bear markets, not including the current one. These down markets have resulted in a mean decline of 32.6% and on average, occur roughly every six years. The typical bear market has lasted an average of 14 months and taken approximately 12 months from their bottoms to regain the lost ground.

The bright side to bear markets is that they eventually end and, when they do, tend to recover significantly thereafter, posting an average return of 185% lasting 70 months. The equity markets tend to over discount the bad news and unknowns of a deteriorating economic environment. Then, once the beginning of a recovery is seen, the lost ground is rapidly regained, as well as a significant premium. This is not to imply the end or the duration of the current bear market. Rather, the point is made to highlight the fact that bear markets must be expected and endured by a long term investor so that they can ensure they will participate in the eventual recovery.

It can also be hear that it is different this time. We have never had the dollar so weak, the price of oil so high, the emerging markets growing so fast, and a pending recession, all while inflation is threatening. You very likely do not recall the cover of the October 14, 1974 issue of Time magazine that showed Gerald Ford with his sleeve rolled up and arm muscle bulging with the heading "Trying to Fight Back: Inflation, Recession, Oil."

Outside the state of the credit markets and the deflating real estate bubble, there are many similarities to the conditions experienced in the mid 70's. While there are certainly many differences as well, however, the main point is that this is not the first time nor the last time our economy will deal with various economic bubbles, inflation and recession.

Despite the significant slowdown in the economy, surprisingly, GDP growth has yet to turn negative. This likely attributable to the impact of low interest rates, economic stimulus checks and booming exports due to the low valuation of the dollar. For all you hear about the housing market, and I am certainly not attempting to downplay its significance, housing and construction make up just 3.8% of total GDP, compared to consumer spending which makes up 70.8%. This would seem to indicate that the consumer will play a much larger role than the housing market recovery in dictating the duration and severity of the current economic slowdown. Consumer spending has been surprisingly strong recently, perhaps in some part to the economic stimulus checks. For example, May retail sales increased twice as much as was forecast. It will be interesting to see how consumer spending holds up once the economic stimulus checks have worked their way though the economy, as this will be a telling sign as to whether our economy may recover more rapidly or not.

Although write-downs by financials due to sub-prime losses continue to dampen S&P 500 operating earnings, earnings excluding financials generally remain in positive territory and have continued to grow respectably. This performance is being accompanied by record-generating levels of free cash flow as business spending on employment, inventories and facilities has been well managed during this current cycle. Free cash flow is available to enhance shareholder returns through new investments, higher dividends, share repurchases, or mergers and acquisitions. Such actions have yet to be acknowledged in the equity markets.

Inflation, especially as seen in fuel and food prices, seems to have replaced the housing market and credit crisis as the Fed's biggest concern. Oil prices again hit record levels during the quarter, crossing the $140 barrier, having more than doubled in the past year and increased annually by more than 25% if spread over the past 10 years. While the Fed did cut the federal funds rate another quarter-point in April to 2%, it held rates steady at its most recent meeting in June stating that "uncertainty about the inflation outlook remains high." This anti-inflation rhetoric helped the dollar increase 6.5% against the Yen and 0.6% against the Euro during the second quarter. It also has financial markets pricing in more than 100 basis points of rate hikes starting as soon as this fall. Contrarians, however, believe this timeline is too aggressive as they do not believe the Fed will raise rates until there is stability in employment, which jumped to a four-year high of 5.5% during the second quarter.

Equity Markets

Broad contraction in the equity markets in June resulted in weak returns for most benchmark indices for the quarter and year. These results have helped the first decade of this century to be on pace to be one of the worst performing decades in the history of the U.S. stock market since the 1930s Great Depression. Through the second quarter of 2008, the S&P 500 has returned just 0.1% per year on average. This shows the importance of a diversified portfolio, as alternative sectors, such as international and real estate, have helped to enhance the limited return of the S&P 500 during this period.

This impact of the U.S. economic slump on equity markets was not limited just to this country, as international markets have also struggled on their own. Both the EAFE and Emerging Markets indexes were down during the quarter. Although the domestic mid and small cap areas reflected some positive returns during the period, they were not sufficient to offset negative returns for the full year. The only bright spot for the year is seen in the emerging market area that is hanging on to a very narrow positive return for the full-year period.

Benchmark Sector


3 Month Return

12 Month Return

Large-capitalization Domestic

S&P 500



Mid-capitalization Domestic

S&P 400



Small-capitalization Domestic

Russell 2000



Developed International Mrkts




Emerging International Mrkts




Real Estate Investment Trust

DJ Wilshire REIT