The Return of Volatility Could Not Stifle Returns
3Q 2007
As the third quarter began, investors seemed content watching both the Dow and the S&P 500 establish new alltime highs on the back of “merger mania”. The financial press seemed to cover this story almost point by point as major trading milestones were approached.
However, by the middle of July, this attitude of passive optimism was overcome by the realization that problems in the subprime-mortgage market might be more widespread than once believed. Almost overnight investors stopped buying bonds backed by these more risky loans, and the credit markets went into a virtual tailspin. Investors sought the safety of government bonds, which aggressively pushed prices up and yields down. Fear of risk ultimately spread to stocks and volatility measures increased noticeably. Between July 19th and August 15th, the Dow sank by more than 8% while experiencing 13 days with a 100 or more point move (ranging from down 387 points to up 281 points).
Things began to turn around in the second half of August after the Federal Reserve Board and other central banks began injecting cash into the global financial system. The markets also began to anticipate a Fed rate cut at the September 18th policy-making meeting. When the Fed delivered an even larger-than-expected 0.5% cut to the Federal Funds rate, the markets really shifted back into high gear. On a returns basis, September ended up being one of the year’s best months, helping to salvage a positive quarter.
A couple performance trends that emerged during the third quarter are outlined below:
- Large stocks outperformed small stocks — something many analysts have been predicting on the premise that large companies are best suited to weather a more slowly-expanding economy.
- Growth stocks outperformed value stocks — a drastic change from the last seven years.
- International stocks, particularly the volatile Emerging Markets, performed well as returns were enhanced by ongoing weakness in the US dollar.
Some Wall Street analysts caution that the underpinnings of the latest stock rally remain fragile. There could be more bad news from the credit crunch. Further interest-rate cuts from the Fed may not materialize, may not produce the economic growth investors are hoping for, or may even spark higher rates of inflation.
Still, investors are hoping skies remain clear through the end of the year, allowing the recent stock-market climb to continue. Credit markets are said to be calming, once again allowing borrowers to get the cash they need. Retail gasoline prices have remained below $3 a gallon despite the surge in crude-oil prices to more than $80 a barrel — good news for consumers, who drive a big portion of economic growth.
We’ll keep watching, so you don’t have to.