The Quarter In Review, Riding the Roller Coaster
By: Marjorie L. Fox, JD, CFP, AIF
Riding the Roller Coaster. . . . Commodities, the worst performingasset class of 2006, turned in the best performance of the third quarter. The price of oil soared above $80 abarrel, and gold ended the quarter at $742 an ounce, its highest close sinceJanuary 1980. Although REITs, thebest performing asset class of 2006, recovered from their second-quartersell-off, they remained the underperforming asset class year-to-date.
Nonetheless, the story of thethird quarter was a worldwide liquidity crisis and turmoil in global stockmarkets. As a measure of thevolatility, it took the S&P 500 stock index a mere 27 days to skid 12% fromits mid-July peak to its mid-August low, and then just 51 days to rebound toanother new high.
Credit Market Turmoil. . . . The third quarter began with signs oftrouble in the sub-prime mortgage markets, as borrowers with spotty credithistories defaulted on their adjustable loans. Nevertheless, a wave of acquisitions and share buybackspushed the S&P 500 stock index to a record close in mid-July.
These concerns about subprimemortgages then spread to the broader credit markets, and a flight to qualityensued. Investors retreated to thesafety of U.S. Treasury securities, pushing prices up and yields down. The interest rate on safe-harborthree-month Treasury bills fell more than one percentage point in August to3.9%, a drop that is comparable to the declines right after the September 11,2001 terror attacks. The yield onthe benchmark 10-year Treasury note ended the quarter at 4.5%, compared with5.3% in mid-June. In contrast,high-yield (lower credit quality) bonds suffered as prices fell and spreadswidened significantly. Stockstumbled.
Fearing that credit marketturmoil would lead to a global recession, central banks worldwide injectedbillions of dollars into the banking system. During the third quarter the Federal Reserve lowered itsdiscount rate - the fee charged on direct loans to banks - by one percentagepoint, to 5.25%, and stocks rallied. However, continuing concerns about the economy led the Fed to cut thefederal funds rate - the fee charged on loans between banks - by half apercentage point to 4.75% on September 18th, the first rate cut since2003. Stocks here and abroadcontinued to rally into October - until their recent pullback.
The Falling Dollar. . . . A result of falling interest rates is aweaker dollar. After the Fed cutinterest rates on September 18th the U.S. dollar hit a record lowagainst the euro and dropped to parity with the Canadian dollar for the firsttime in more than 30 years.
The downside for U.S.tourists: a vacation abroad ismore expensive. And, furtherweakness will likely exacerbate inflation pressures by encouraging foreignmanufacturers to raise their prices in order to preserve profit margins.
The upside is not only reflectedin third quarter returns of international equities for U.S. investors, but alsoin the returns of large, multinational U.S. companies that benefit from theweaker currency. A weaker dollarhelps boost U.S. exports by making them relatively cheap on world markets. The Commerce Department recentlyreported that U.S. exports rose to a record high of $137.7 billion, reflectingstronger sales of U.S. farm goods, auto parts, and other manufacturedgoods. A weaker dollar alsobenefits U.S. companies that have extensive service operations abroad, such asMcDonald's and Coca-Cola, because the profits they earn in foreign currencies areworth more when brought home and converted into dollars.
In Summary. . . . Just as there is an upside to the falling dollar- stronger corporate earnings and a more resilient U.S. economy - there is anupside to the volatility of the equity asset classes. Historically, the capital markets have rewarded investorsfor riding the roller coaster with higher investment returns. Diversification will dampen the volatility,but it can still be a wild ride. So, hold on!