Third Quarter, 2007 Economic and Market Commentary

Economic Environment

During the third quarter, gross domestic product improved, consumer spending remained firm and equity markets, although volatile, rebounded to all time highs. Although this may sound like a very positive story, an ominous sentiment overshadows the entire economic picture, at least in the United States. It may be wishful thinking to conclude this is a case of paranoia, as these sentiments appear to be supported by well founded concerns.

As consumer spending has shown good absolute strength, it is also a fact that the trend reflects a downward path that goes back close to two years now. It is also clear that any excess housing equity, if indeed any exists, will not be available to finance additional consumer spending. This is assured by home prices, which posted their steepest decline in 16 years, according to the S&P/Case Shiller® 10-city price index. Also, inventories of unsold houses now sit at over 10 months, an 18-year high, while the fallout from the sub-prime mortgage fiasco still plays out.

General commodity prices across a wide swath of products continue to reach historical highs. This persists well beyond the price of energy, which is reaching levels which would have readily been thought obscene just a few years ago. This commodity price inflation is now pervasive amongst a large number of major commodity groups, including metals and grains. Couple this commodity inflation with a dollar which is at historical lows against major currencies and it is impossible to conclude that the economy will not soon confront a significant inflationary damper.

These factors increase significantly the chances for a consumer driven recession. This type of recession, compared to one driven by reductions in capital spending, historically has tended to be longer and more severe. This scenario would also generally be expected to have a commensurate impact on corporate profits, which would then result in lower equity pricing generally.

The above somewhat explains the overall malaise that can be seen concerning the outlook for the economy and markets. But even in light of the apparent inevitability of this weakness, your investment policy should not change. This is because the timing and extent of any weakness is still very much an unknown, if indeed this prognosis is accurate. Also, as negative as this outlook may appear, there are a number of factors which may counter or mitigate its impact. For example, equity valuations are arguably still at reasonable levels and may well help cushion downward equity pricing moves. Further, the Fed still has the capacity to further decrease interest rates to increase the level of economic activity. Lastly, a mild recession may actually be somewhat favorable to the economy longer term, in that pricing levels may moderate significantly.

Despite the potential of continued volatility and uncertainty, we continue to suggest that you remain committed to an investment policy which dictates that only funds not needed for the near to intermediate term be directed toward growth. Funds that are required for the near to intermediate term, (generally defined as within the next seven years), should be maintained in cash and fixed income holdings. This will allow you to weather the inevitable downsides that are inherent in equity investing, while greatly enhancing the probability that you will participate in the equally inevitable recoveries.

Equity Markets

With the exception of international emerging markets which remained very strong during the quarter, most worldwide equity prices moderated significantly. Large capitalization issues, both domestically and internationally, generally provided nominal returns. Broader domestic markets experienced minor declines. Real estate investment trusts were relatively flat, which may be somewhat surprising given the state of residential real estate as well as the problems in the sub prime mortgage markets. This is mostly attributable to the commercial orientation of the REIT index.

Even in light of some dampening of returns seen during the quarter, the full year statistics still reflect very strong numbers. A weakening dollar has enhanced the returns of international sectors significantly. For the growth component which we maintain, the following chart will show the period returns for the various benchmark sectors and their representative index.

Benchmark Sector


3 Month





Large-capitalization Domestic

S&P 500



Mid-capitalization Domestic

S&P 400



Small-capitalization Domestic

Russell 2000



Developed International Mrkts




Emerging International Markets




Real Estate Investment Trust

DJ Wilshire REIT