Financial Market Commentary 3rd Quarter of 2007

Summary of Quarter

The continuing fallout from the subprime lending crisis was fully felt in the third quarter. Our commentary from the second quarter discussed that crisis and how it formed so in the interest of saving space and time, please refer back to that commentary for details. The bottom line on the quarter from a stock market point of view is that it was positive. The S&P 500 finished up 2.03% for the quarter on a total return basis. However, if you follow the markets on a daily basis, you know that in the middle of the quarter (specifically from 7/19/07-8/15/07), the S&P 500 fell over 9%! That drop made for some uncomfortable vacations in the Hamptons for the Wall Street crowd this past summer.

Helping the stock markets to recover from the mid-quarter depths was the unanticipated cut in the discount rate by the Federal Reserve in August. The discount rate is the rate at which banks can borrow from the Fed in times of need. Banks rarely borrow from the Fed, but the move was a show of support for the credit markets that the Fed was willing to help. The second big boost to the quarter for stocks came at the September Fed meeting, when the federal funds rate was lowered 50 basis points. This was the first rate cut in four years. The fed funds rate is more closely tied to the rates you and I live with day-to-day as it is the baseline lending rate to which many mortgages and credit cards are linked. Both of these Fed actions put many of the credit fears on hold and helped the stock markets to head higher.

International equity investments in stock continued to do well, even though they did experience some spillover effect from our credit woes in the US. A large United Kingdom bank and several Asian investment companies suffered from their exposure to our credit markets (owning US debt tied to subprime loans). In general, though, the economic strength in Europe combined with the weak dollar kept foreign assets and markets appreciating nicely. For the quarter, the EAFE index was up 2.25%. Smaller stocks suffered as they typically do when there are recession fears on the horizon. The theory is that in an economic slowdown, smaller companies have less ability to increase prices and are more domestically based so they see sales drop faster than the large multinational companies like GE. For the quarter, the Russell 2000 (a small-cap stock index) was down 3.08%.

Fixed income investments were extremely volatile in the quarter since this “crisis” was all about credit and lending. In general, though, the turmoil did the bond markets a favor by getting the traditional relationship of “risk versus reward” closer to historical norms. By that I mean that the best credits with the least risk performed well in the quarter. The bonds with the most risk performed worst. Importantly, credit spreads (a measure of risk that indicates how big a premium borrowers require for riskier assets versus Treasury bonds) increased for the quarter as bond investors closely examined the credit quality and the risk of their bonds. The Lehman Brothers Aggregate Index was up 2.84% for the quarter, outperforming most stock indices.

What Lies Ahead for the Markets?

As we stated last quarter, we believe our US economy, and the global economy to which we are increasingly linked, is too diversified to be brought to its knees by any one industry (housing being the case this time). Yet, we do feel it is premature to think that, with one Fed rate cut and one month of modest pain, the entire credit crisis has been put behind us, with smooth sailing going forward. Big finance deals like Chrysler’s buyout are getting done, but plenty of smaller deals are getting cancelled or restructured at less favorable terms than originally negotiated. Historically, the full impact of most Fed activity is not felt for 6-9 months after the Fed changes rates. I think the financial sectors of our economy (particularly banks and investment bankers) will be feeling the pain of subprime mistakes for a few more quarters. When a python swallows a pig, it takes a while for the pig to move through the python!

We remain fully invested but are cautious going forward concerning how we balance our overall portfolios. We currently (and have for a while) favor large-cap stocks over small-cap stocks. We continue to remain fully invested internationally. We also are starting to balance equity styles equally between growth and value. For the past few years, value investing has dominated in performance versus growth investing, but the cycle seems to be closing and we are making sure we have exposure to both. On the fixed income side, we have started to modestly increase duration (invest in longer-term bonds). As yields and spreads on investment grade bonds have moved higher and back toward more historical trading ranges, we have extended portfolios. This move should enhance income flow and performance of our fixed income portfolios over the long term.

Enjoy this great fall weather and I look forward to updating you on the full year in a few short months.