Economic Environment
The first quarter of 2008 will be remembered for the monumental collapse of Bear Stearns. Facing bankruptcy due to massive exposure to subprime mortgages and the rapidly unfolding credit crisis, the Federal Reserve and U.S. Treasury were forced to step in to facilitate the sale of Bear Stearns to JPMorgan Chase at a bargain basement price. The intervention was purported to be necessary in order to avert a collapse and resulting ripple effects throughout the financial system, which may have been catastrophic. I will leave it to you to determine whether such governmental action is appropriate, but from this stage, it appears, at the very least, that it was somewhat effective.
Add to the credit crisis, oil prices that stand at over $115 per barrel, and it is no wonder that the U.S. consumer sentiment index is at its lowest level since March 1982. Oil prices were also the primary culprit for rising inflation fears and pushing the overall consumer price index (CPI) to 4.0% year-over-year and the producer price index (PPI) up 1.1% in March. Compounding the problem was, that for the first time in decades, food inflation became a major concern as food inventories remained low around the world causing food prices to rise 1.2% in March. If there is a bright side to the inflationary picture, perhaps it can be seen in core CPI, which excludes food and energy, and held steady at 2.3% in annual change.
The job market, which had managed to remain somewhat steady during the past couple of quarters, despite all the negative economic circumstances, finally showed signs of significant weakness during the quarter. The Labor Department reported that non-farm payrolls fell by an estimated 80,000 in March, marking the largest decline since March 2003. Furthermore, the unemployment rate surged to 5.1% in March, the highest it has been since September 2005, although historically still well below the average rate of 5.6% in 1950.
The consumer housing sector continues to be a significant impediment to the resumption of strong economic growth. Prices in most major markets continue to fall and inventory levels continue to increase, as does the rate of foreclosures. Potentially beneficial interest rate cuts by the Fed have been stymied in this sector, due to the fact that lending conditions have tightened significantly at the same time. Rapid recovery in this situation does not appear likely as $800 billion in adjustable rate subprime mortgages will reset to higher interest rates over the next two years.
Given this “perfect storm” of financial market turmoil referenced above, it was no surprise that the Fed acted swiftly and aggressively and cut the federal funds rate three different times during the quarter, ultimately landing at 2.25% from 4.25%. The 2.0% drop in the quarter, and 3.0% drop from last fall, is the most aggressive easing since the federal funds rate became an explicit target of policy in the late 1980s. The easing may still not be over, as futures markets have already priced in a further 50 basis points cut by mid-year. Furthermore, the federal government approved a $150 billion economic stimulus package during the quarter, with roughly $100 billion in tax rebates due to be sent out this year, in an attempt to further promote consumer spending.
Although it is probably only a technicality at this point, in light of all the difficult economic issues mentioned above, the economy has still not posted a negative quarter of GDP growth, two of which are necessary to define a recessionary period. Nevertheless, I believe many analysts would assert that the markets definitely are pricing in a fairly significant economic downturn. Since 1948, there have been 10 recessionary periods and the average length of these recessions has only been 10 months. The average return of the S&P 500 during these recessions was a positive 1.4%, and the average return of the S&P 500 during the six months after these recessions was 10.6%. Thus, even if we are in or should enter into a recession, there is some argument that the equity market returns may be muted for the period and then show significant improvement thereafter.
To conclude, using history as a guide, recessions are typically short in duration and there is no strong positive correlation between a recession and the equity market returns. Your investment policy dictates that only funds not necessary for at least several years should be directed towards growth. This time frame will often include recessions, but more importantly, will likely just as often include significant recoveries. It is imperative that you maintain the equity exposure during weaker periods, as the recoveries can arrive rapidly and inexplicably.
Equity Markets
For the second consecutive quarter, all domestic capitalizations and styles of management lost some value. In addition, international equity market returns were down in a significant majority of countries, resulting in losses in most international benchmarks and reversing a five-year trend of solid international returns. If not for the declining U.S. dollar, international returns would have been even worse for U.S. investors, as returns were far worse for foreign stocks valued in their local currencies. Dollar weakness was the only factor that allowed foreign developed-country equities to outperform U.S. stocks (in dollar terms) during the quarter. The emerging markets sector lost the most ground in the foreign stock category, falling nearly 11.0% during the quarter. This reversed a trend of six consecutive quarters of positive returns and several consecutive years of exceptional gains in the international emerging market category.
The S&P 500 fell 9.5% during the quarter, its worst quarterly return for any calendar-year quarter since third quarter 2002 and the worst quarterly start to a calendar year since 2001. Likewise, the NASDAQ suffered the largest quarterly loss among all major indexes, falling nearly 14% during the quarter, also its worst quarterly decline since 2002. Nevertheless, even in light of these large price declines, domestic equity valuations (based on price-to-earnings) stood below historical averages for stocks across all areas of the market capitalization spectrum. Foreign equities were also reasonably valued relative to their historical averages.
Real estate investment trust stocks returned a positive 1.4% during the quarter, proving again their importance in a diversified portfolio, as historically, they are not as strongly correlated to the U.S. and international stock markets.
Continued weakness in most equity markets around the globe took a toll on the full-year return statistics for most major benchmarks. The chart below reflects the quarter and annual return for each of the benchmarks included in the firm model growth component.
|
Benchmark Sector |
Index |
3 Month Return |
12 Month Return |
|
Large-capitalization Domestic |
S&P 500 |
-9.5% |
-5.1% |
|
Mid-capitalization Domestic |
S&P 400 |
-8.9% |
-7.0% |
|
Small-capitalization Domestic |
Russell 2000 |
-9.9% |
-13.0% |
|
Developed International Mrkts |
MSCI EAFE |
-8.9% |
-2.7% |
|
Emerging International Mrkts |
MSCI EMF |
-11.3% |
18.9% |
|
Real Estate Investment Trust |
DJ Wilshire REIT |
2.1% |
-18.8% |