Market Commentary: October 2005
The fundamentals supporting positive equity performance appear to be largely intact due to the easing of oil prices, reasonable stock valuations, and surprisingly positive Gross Domestic Product growth and strong earnings in the third quarter. Why have these developments not translated into better market results? There continue to be a number of headwinds to be overcome, and these uncertainties are unquestionably being priced into stocks.
Even before Hurricanes Katrina and Rita devastated the Gulf Coast region, disrupting energy production and sending prices rapidly and significantly higher, the Fed was warning about the risk of inflation. Spiking oil prices only exacerbated the problem, increasing the trajectory of producer and consumer prices, temporarily crushing consumer sentiment in the process. The domestic automotive industry, already struggling, was dealt multiple blows in the process. Sales of some of their most profitable models, which also happen to be among their least fuel efficient products, tapered off as part of America’s renewed interest in energy conservation. Delphi’s declaration of bankruptcy in early October perhaps marked another watershed event for not only the automobile industry, but for all U.S. manufacturing as well. To be certain, these sources of uncertainty weigh heavily on the minds of investors, even to the point of perhaps creating unnecessarily pessimism.
For the month, the S&P 500 Index lost 1.6%, noteworthy only in its resilience relative to the rest of the market. Smaller companies and international stocks all fell nearly twice as far. The Russell Midcap and 2000 Indices declined 3.0% and 3.1% respectively. Year-to-date, mid caps still easily lead the domestic markets, but large caps have cumulatively outpaced small cap issues by nearly 1.0% for the year. The EAFE index of international developed stock markets also slid 2.9%, dragging its year-to-date return back to 5.9%. International stock valuations still look favorable relative to domestic markets and have more than kept pace with the broad US market year-to-date.
The domestic fixed income markets continued on their see-saw sideways path, generally losing ground during the month. The Lehman Aggregate Bond Index slipped 0.8%. Intermediate duration municipal bonds held up better as the Lehman Muni Bond Index 5-year lost 0.4%. International bond markets also lost ground, although the Citi World Government Bond Index Hedged continues to easily outpace domestic bonds with its 3.6% year-to-date return.
More often than not, equities rally in the closing months of the year. In 2004, the strong fourth quarter made the difference between what had been a flat market and what ended as a decent year for stocks. Thus far in November, we are seeing some strength that could again push currently mediocre returns into a more palatable range by historical standards. Given the tailwinds of sustainable economic growth and better-than-expected earnings, this rally certainly has the appearance of being fundamentally based rather than speculative. Even with elevated energy costs, the economy appears sufficiently resilient to continue to provide this fundamental support for the foreseeable future.
