I have been in this business for over 16 years now and have never experienced anything like the 3rd quarter of 2007. I recently tried to describe the market activity to a participant and compared it to Joe Turner’s 1950's hit song. First we were all Shaken, then we were all Rattled by the market, then the Fed adjusted rates and the market Rolled.
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 2nd quarter, the market was moving forward surprisingly well and the S&P 500 Index was up almost 6% for the year. We told our clients and participants when the market fell during the 3rd quarter, we were not surprised by the market correction, we were actually surprised by the run that took place during the 2nd quarter.
What really happened to shake the market to its core, and how in the world did it bounce back so quickly? A major factor contributing to the initial volatility occurred as a result of the sub-prime mortgage market. The sub-prime mortgage market is the market for consumers with weaker credit history. These consumers usually have higher debt levels, shorter employment history, less steady incomes, and/or a combination of all these factors. You can trace the starting point of the sub-prime market back to 9/11/01. Post 9/11, our financial markets were in a catastrophic position. In order to correct the market and spur the economy, the Fed lowered interest rates dramatically. This helped jump-start the economy and the Country started the long road to recovery. The Fed was well aware that credit was (and is) the economy’s life blood; if it becomes too hard to get, spending and investing will stall, short-circuiting economic growth. In the summer of 2002, with lowered interest rates and bond rates at historical lows, banks and other lending institutions lowered their standards for personal and business loans. The banks and lending institutions issued a high percentage of loans and mortgages under these parameters to less than credit worthy consumers.
Unfortunately, we are now paying for those loans issued in 2002. While the initial plan to spark the economy worked (the increased access to credit turned the market around), many of the people who received these loans forgot or weren’t aware that they came with a big catch. Many of the mortgages that the sub-prime consumers were able to get were either `interest only loans’ with clauses allowing banks to charge higher rates when interest rates were adjusted, or adjustable rate mortgages, issued with a set payment for 5 years after which the payment was adjusted based on interest rates. With interest rates at historic lows in 2002, these loans were a recipe for disaster. Interest rates realistically only had one way to go – up! By the summer of 2006, the Fed had raised interest rates 17 consecutive times, raising rates ¼ of a percent each time. For “non-fixed” mortgages, the cost of the loan increased significantly, which hit consumers very hard. Not surprisingly, we have seen a 100% increase in the number of foreclosures over the same time a year ago. This problem has now snow-balled. The real estate market has the highest amount of inventory since the 1970’s and the average home price in America depreciated by 6% in the last year. It’s no wonder the market was affected!
So, despite a current robust market, and continued economic growth, we were hit between the eyes by the sub-prime market, housing market, and real estate sector. The Dow Jones hit its all-time high on July 19th of 14,121.04, then proceeded to slip to its recent low-point of 12,455.92 on August 16th. That is a decrease of 13.3% in less than a month. The Fed was quietly watching everything unfold, then called an emergency meeting after the close of business on August 16th. The Fed lowered the discount rate, which directly affects mortgages and lending institutions. Overnight, this move gave that industry an $8 billion dollar surplus, and started the market turnaround. The Fed indicated, if need be, that they would take more dramatic steps at the next Fed meeting to help spur what had suddenly become a sluggish economy. The Fed clearly did their part when they lowered interest rates by .50% at the meeting on September 18th. By doing this, consumer confidence has improved dramatically and, at the time of this commentary, the Dow has climbed back over 14,000, or recovered the 13% it lost from July to August.
So, the real question then becomes, how are we really doing and where do we go from here? My belief is that unless we have an unexpected catastrophic event (hurricane, tsunami, terrorist act), we are going to soar through the rest of 2007. Another thing to note from our crazy third quarter is that the third quarter is historically the worst quarter of the year, with August being the single worst month of the year. Both of those comments held true for 2007. Thankfully, the fourth quarter is known to be the best quarter of the year, with the holidays serving as a market stimulus. In addition, the Fed has two more meetings in 2007, on October 31st, and in December. Most analysts believe that they will lower interest rates at the October meeting but not make any adjustment when they meet in December.
As we look into 2008, we see continued economic and market growth, but we also see cause for concern. The second wave of sub-prime foreclosures is expected to hit during the 1st quarter of 2008. In addition, 2008 is a national election year and the market typically does not respond kindly to the uncertainty of having a new President. While I feel better about the market today then I did 90 days ago, I would still advise everyone to proceed with caution. While some are calling the July-August period a “market correction”, I have had colds that have lasted longer. We need to be happy that we bounced back so quickly and that we are poised to finish strong in 2007, but be aware that all markets, with the exception of the NASDAQ, are trading at or very near ALL-TIME HIGHS. While the history of the S&P 500 Index for the last 10 and 50 years is almost identical in its return of 10.5%, 2008 could prove to be a difficult year. As we sit on the top of the pyramid, this is a great time to take inventory of your investments. Now is the time to ensure that you are positioned to do well in good markets, and extremely well in down or volatile markets by diversifying your investments.
In our 3rd quarter update, we want to tell you what is hot, and what’s not, for the upcoming fall season. We continue to feel bullish on the international markets through the remainder of 2007 and into 2008. Domestically, while we continue to feel good about the mega-cap stocks that make up the large cap funds, we also feel that technology will be back in style for the remainder of 2007, and into 2008. Lastly, with the Fed lowering interest rates, for the safe investor, bonds become a good pick.
On the “what's not” list, I would tell everyone to avoid real estate funds based on the sub-prime story and proceed with extreme caution in the small and mid-cap funds.
In our managing of the AdviseMe!® program, we have always taken the “steady as you go” approach. We appreciate the feedback from the many participants who commented on our pro-active reallocation to significantly reduce risk prior to the market downturn in July. One term that I focus on in running AdviseMe!® is how we are “positioned at all times”. While we want each participant to earn the highest return possible, our approach seeks to earn that return in a prudent and responsible way.
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As the leaves start to change, and the days get shorter, try not to get caught up in the day-to-day ups and downs that take place in the market. If you do, you will drive yourself crazy. Please remember what we say in all our education meetings, that 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.