On Independence Day, I enjoyed watching a wonderful fireworks show. As I was thinking about it, I could not help but think that from a market perspective, we saw some real "Fireworks" during the 2nd Quarter of this year.
The purpose of the Market Commentary is to explain what has occurred in the market place and to outline what is expected in the coming months and the next year ahead. At the end of the 1st quarter, the market was sluggish, and the S&P 500 Index was slightly breaking even. There were significant concerns about the "Sub-Prime Lending Story" and how the effects of it had the ability to rock the market. What unfolded during the 2nd quarter was shocking and surprising and left us oohing and ahhing like we did on July 4th.
I would like to start with the positive events of the second quarter. The main factor to the solid investment performance is basic and reassuring: big business is on solid ground. The fact that so many companies were posting very strong corporate earnings is what led the surge of the market in April and May. In addition, the amount of merger and acquisition activity was significantly higher than expected. These two factors gave consumers greater market confidence, which paved the way to outstanding market performance. The S&P 500 Index went up by 6.28%, taking the year-to-date numbers through the end of June to 6.96%. One sector in particular, the Mega-Caps or the giant household name companies, led the charge. Some of the companies with outstanding returns were Bank of America, Wal-Mart, P&G, and Johnson & Johnson.
While it is easy to focus on what went right, we should also review the potential stumbling blocks. We came into the quarter with strong concerns over the "Sub-Prime Lending Story." The Sub-Prime Lending Story goes back as far as five years when interest rates were at all-time historic lows. That period was a golden era for all banks, mortgage companies, and other lending institutions. The market was so competitive that many relaxed their credit standards to capture more business. One of the red flags discovered after the fact was that an alarmingly high percentage of interest only, or adjustable rate mortgages, were granted to consumers. What made these mortgages attractive is that they are issued at lower rates, which translate into lower mortgage payments, but the rates (and payments) adjust with interest rates. With interest rates at all-time historic lows, people believed this was a way to stretch their dollar further, however, it was really a recipe for disaster. That disaster began to emerge in early 2007 and is expected to peak in the late summer months with a record number of home foreclosures. While the Sub-Prime Lending Story occurred as expected, the real surprise is that its damage was contained to the real estate sector and has not truly affected the overall market. The fact that we dodged what we expected to be a major bullet contributed towards the success of the market year-to-date.
What lies ahead? Historically, the third quarter is the worst quarter of the year, with August being the worst month of the year. This statistic occurs because most business cycles lag behind in the summer months in large part due to employee vacation schedules. Another concerning factor as we enter into the 3rd quarter is the price of oil and its impact on gasoline prices. Gas has been all over the board this year and has had a variance of almost 70% from its low point to its high point. At the time of writing this commentary, oil has bared its teeth again and is trading at $72 per barrel. The prices are in the spotlight this time of year since consumption levels are higher during the summer months, and we are again heading right into hurricane season. While most experts believe that the market is positioned to be relatively flat in the 3rd quarter, and potentially spectacular in the 4th quarter, almost all agree that a bad hurricane season could change the overall market outlook for the remainder of 2007.
As we continue forward through 2007, and edge closer to a national election year, I warn everyone to invest carefully. While the experts are optimistic, I am cautiously optimistic. We have seen the Dow Jones jump from 12,000 to almost 14,000 in an incredibly fast time period. Both the Dow Jones and S&P 500 Index are trading either at, or near, all-time highs. My message is to enjoy it, but to realize that this wild ride we are on does not, or will not, last forever. I would challenge all investors to remember the pain they experienced from the markets in 2000, 2001, and 2002. We were coming off of a decade of nearly double-digit returns annually. No one saw the end in sight until it was in our rear view mirrors, and a lot of people lost a lot of money. We are again at a very critical time period. I would encourage any and all participants to make sure your account is properly allocated and balanced in such a way that you will do well in good markets and be protected in bad markets.
In managing the AdviseMe! program, we have always taken a prudent view of the market and the investments that we have chosen. Early in 2nd quarter, to brace for what we thought the Sub-Prime Lending Story may do to the market, we lowered the risk levels of our portfolios across the board. The result is that our portfolios still did very well in what was a great quarter, but more importantly, we are well positioned for whatever may take place in the market during the next few months.
I have been asked by a number of participants to list which sectors are hot and what’s not. We see the international markets continuing to be strong through the remainder of 2007. While China has hit a few bumps in the road, we expect very good things from China, India, and Japan. Domestically we are sticking with the large blue chip value funds based on the success mentioned in the Mega-Caps, but believe there may be an opportunity for growth funds later in the year. We are also considering bond funds and balanced funds as a safe way to support our accounts against more expected market volatility.
On the “what's not” list, I would tell everyone to avoid real estate funds based on the Sub-Prime Story mentioned above. In addition, proceed with extreme caution in the small and mid-cap funds.
As the summer heats up, remember to wear lots of sunscreen, drink plenty of water, and do not get too caught up in the craziness of the market. The market has been up an average of 10.4% over the last 50 years, but if we pick any given time period, it may be better, or certainly worse. As we say in all our education meetings, it is not our intent to make anyone into an investment expert or a retirement expert. That is why we are here, and if we can help in any way; please do not hesitate to contact us. We appreciate your continued support.