The second quarter started on a fairly optimistic note, but following a brief upswing from March to May, the markets experienced a sharp sell-off as underlying concerns about inflation and the fundamental strength of the economy resurfaced.
Energy costs, escalating prices and continuing turmoil in the credit markets weighed heavily on both domestic and foreign markets and in the U.S. the ailing housing sector showed no signs of improvement.
In particular, the price of crude oil which is now up more than 50% for the year continued to hover in record territory, spurred by anxiety over tight supplies and renewed tensions in the Middle East. That, in turn, contributed to gathering inflationary momentum that saw the Consumer Price Index jump 1.1% in June; the biggest monthly gain in nearly three years.
Equities
For the quarter, the S&P 500 lost 2.7% and the Dow Jones Industrial Average dropped 6.9% its third consecutive quarterly drop while the Russell 2000 small cap index stayed in positive territory with a slight 0.6% gain. The market’s slide in June was especially brutal as the Dow and the S&P 500 posted their worst one-month declines since September 2002.
Abroad, the picture for equities was much the same or even cloudier, confirming the growing correlation of global markets. In Europe, many of the same concerns that have roiled U.S. markets have taken European markets into bear territory. With the exception of commodity exporters, foreign markets broadly retreated as the MSCI EAFE Index registered a 1.93% decline for the quarter.
Fixed Income
There were few havens for investors in the second quarter and that included high quality fixed income. With the Fed caught between weak economic data and the specter of inflation, Treasury bonds responded with their worst run since 2004 with investors losing on average 2.1%.
For the quarter, the Lehman Aggregate Bond Index slipped 1.02% (but is still up 1.13% for the year), while the Lehman Municipal Bond Fund Index rose 0.63%. Generally, international fixed income trailed domestic fixed income for the quarter, mirroring the trend in equities.
A snapshot of the major market indices is presented below:
Some Encouraging Signs
No one can guess when the markets will hit bottom, but there are some potentially encouraging signs that a turnaround may be on the horizon. Here are a few things to consider:
- Smaller stocks are historically the first to rally in a recessionary recovery, possibly providing us with the first signs of a recovery.
- The bond yield curve has returned to normal after being inverted much of last year, a change that has been a harbinger of economic growth in the past.
- Many observers are saying the fundamentals underlying the oil market do not support current price levels.
- And, finally, the markets appear to be testing earlier lows and potentially laying the foundation for a recovery.
We believe heading for the sidelines at this point would be a costly mistake because a month like the June we just had suggests a bottom may be near.
In this trying and perplexing environment, an investor’s best friend (besides his or her financial advisor) is the ability to be patient and have a sense of perspective. The ability to think long term is how significant wealth is accumulated.
The markets and the economy continually go through cycles of expansion and retrenchment providing investors the opportunity to buy in at low costs. Understanding and taking advantage of these rhythms is how wealth builders prosper over time. Staying informed, diversified and maintaining the discipline of saving, even during periods of market turmoil, is the winning formula.
Strategy Review
Our current thinking is that as the economy continues to weaken; our elected officials will be inclined to over-regulate the financial markets. The $64 million questions are: What will this do to the economy and the markets? And how can we position our portfolios to take advantage of this less-than-optimistic scenario? In our estimation:
- Over-regulation and government incentive plans will weaken the government’s balance sheet further. Like any corporation, a weak balance sheet makes it less attractive to our trading partners. They will want more money for those products (such as oil), which will boost inflation, further weaken the dollar and make wider allocation into foreign securities more attractive.
- Taxes will probably go up, making municipal bonds more desirable than taxable bonds for investors in higher brackets.
- There will probably be back-to-work programs focused on improving the country’s infrastructure that will enhance exposure to related industries such as cement, steel, lumber, etc.
- Real estate values need to fall at least another 10% before we can begin to make a dent in the excess inventory of housing. This is deflationary. But it’s a deflationary asset rather than a deflationary expenditure, which means your house, is no longer a piggy bank that you can borrow from to pay those bills. That will impact discretionary spending and the economy.
- We will be drilling off-shore as well as building new refineries, wind farms and nuclear plants, but these are mid- to long-term solutions. I think there is a reasonable chance we will eliminate ethanol from our clean air program to relieve price pressure on corn and corn-related foods. It goes without saying we will buying smaller, lighter and hybrid cars to get better mileage. So as the country swallows this bitter pill and gradually eases its dependence on foreign oil, we will be seeking opportunities to take advantage of these basic economic shifts.
- One possibility that could make these scenarios wrong is if the price of crude oil slips back to the $50- to $70-per-barrel level as producer states attempt to forestall our government’s efforts to encourage development of alternate energy sources and drilling off-shore. If this occurs, we will have to revise our strategy.
These are not the only trends we see over the next few years. There is an aging population of baby boomers that will be demanding more and better health care services that will drive innovation. But energy independence is the key to long-term economic viability. It is also essential to rehabilitate the U. S. dollar and create jobs here at home for younger workers. All this presents a fertile field of opportunity for our portfolios.
