Market Commentary: February 2007
There are times in which the “story” of the financial markets seems like cryptic noise on a day-to-day basis, and one can only decipher the directional meandering at the end of some period of time. In this forum, we report on a monthly basis the results of incremental changes over a period of roughly thirty days.
Sometimes, however, the story for the markets for a given period is written in a day or two. Such was the case in February, as global equity markets reintroduced investors to volatility to a degree that has been absent for several years. In our January commentary, we closed with the following remarks:
“The possibility of a meaningful surge in oil prices, reignited inflationary pressure, or a restoration of Fed tightening, although unlikely, could return volatility to the market, especially within the context of a reasonably upbeat economic forecast. As always, prudence dictates diversification across asset classes, market capitalization, and style, as a lower return scenario should not imply lower risk.”
As is typically the case, the specific tipping point or timing for any market correction (i.e. – the return of volatility to the market) is, as a practical matter, virtually impossible to forecast. We could not have predicted that the Chinese equity market would lead the downward move any more than we could predict that former Fed Chairman Alan Greenspan, in a moment of previously uncharacteristic – and perhaps ill-advised – frankness, would suggest that the U.S. economy could be headed toward recession later this year. Nonetheless, the selloff at the end of February overwhelmingly was the story of the markets for the month. If you are interested in our specific comments related to the market correction, we have prepared a separate commentary that relates our views. That commentary is available at www.pmfa.com.
Beyond the volatility in the equity markets, February also provided further evidence of a continuation of the overall slowdown in the economy. Perhaps the most noteworthy piece of economic news was the substantial downward revision of fourth quarter GDP from 3.5% to 2.2%. While the revision no doubt dampens sentiments about the overall expansion of the economy, this figure is more in line with the trend in growth that took hold of the economy in the second quarter of last year. Nonetheless, we (along with many others, including Fed Chair Ben Bernanke) see little change in the overall economic situation. In a statement made to Congress on the last day of the month, Bernanke reiterated the Fed’s expectation that the economy will continue to grow at a “moderate” rate. The Fed appears to remain cautiously optimistic that inflation will continue to trend downward without additional interest rate hikes being necessary, despite a slight up-tick in core consumer prices. During January, the 12-month trailing core Consumer Price Index (CPI) crept up to 2.7%. Unemployment remains at low levels, although some hints of a softening in the labor market exist. While January’s unemployment rate of 4.6% is only 0.2% above October’s five-year low, consensus expectations for a slowdown in the rate of job creation and a continued gradual uptick in the unemployment rate should also help alleviate inflationary pressures and could potentially set the stage for some easing of short-term interest rates later this year.
Most segments of the U.S. stock market ended February lower despite being up for much of the month. The broad equity pullback on February 27th represented the largest one-day market drop in nearly four years and effectively erased much of the equity market’s previous year-to-date gains. For the month, large cap stocks fell nearly 2.0% (S&P 500), while small cap stocks lost 0.8% (Russell 2000). Mid cap stocks, as measured by the Russell Midcap Index, did manage out a slightly positive return of 0.2%.
As with domestic stocks, strong early performance by international stocks was dashed away in the waning days of February. Before the sell-off, foreign markets had overcome interest rate hikes in Japan and the expectation of further tightening by the European Central Bank to push both Japan’s Nikkei Stock Index and Europe’s Dow Jones Stoxx 50 Index to multi-year highs. Despite the sell-off, the MSCI EAFE Index still managed a 0.8% return thanks to weakness in the dollar relative other currencies. Denominated in local currencies, the MSCI EAFE Index actually fell 0.5%. Emerging Market stocks fared even worse as the MSCI Emerging Market Index fell 0.6%, even with a fractional currency tailwind.
The positive performance of the fixed income markets was evident even prior to the downturn in the stock market. Concerns ranging from weakness in riskier bond asset classes to rising tensions over Iran’s nuclear program prompted investors to trim positions in riskier assets and reallocate to high quality bonds. The volatility in the stock market in the final days of February further exacerbated investors’ move to bonds. On the strength of that rally, the Lehman Brothers Aggregate Bond Index returned 1.5% for the month. The Lehman Brothers 1-3 year index indicated that short-term bonds were up 0.8% during the same period. Falling in line with their taxable counterparts, intermediate term municipal bonds led short-term munis. The Lehman 5-year Muni Bond Index returned 0.9%, while the Lehman 3-year Muni Bond Index returned 0.7% during February. Foreign bond investors were rewarded with positive returns for the month, as the Citi World Government Bond Index returned 1.2%. Investors who held bonds denominated in foreign currencies were the beneficiaries of additional return from the falling dollar. Against the Euro and the Yen, the dollar fell 1.9% and 1.6%, respectively for the month. The February returns of the MSCI Emerging Markets index denominated in local currencies and the dollar denominated version were virtually the same, indicating that the dollar did not materially move relative to an aggregate basket of local emerging market currencies.
As the economy edges toward more moderate growth, the possibility that too much slowing has occurred may become a greater concern. In these situations, investors find themselves in the precarious position of having to weigh investments against a more uncertain backdrop. Volatility often marks these times. Though stark short-term market corrections may result, these provide a relief to pressure that could otherwise result in a market bubble. As we all remember from the tech stock bubble burst in the early 2000’s, such events are much more devastating than the comparatively benign volatility experienced recently. In addition, a market retrenchment such as the one that began on February 27th serves to remind investors of the potential risks always present in the market.
Some have characterized investors' recent actions as rush to liquidity, without regard for asset class. Typically in highly volatile markets, investors resolve to limit downside risk by reallocating assets to higher quality asset classes. This may continue be the case as the market recovers, especially if volatility remains higher than it has been in recent years. In such an environment, we would anticipate that our prior tactical reallocations to reduce risk and enhance portfolio positions in higher quality investments may prove beneficial as the markets cope with the new volatility trends.
Although the market appeared to stabilize in the days after the selloff, we believe that the possibility of further market volatility remains a real risk. Despite this, we believe that investors with a well developed strategy will be able to weather market dips. While it can be difficult to view market corrections as an opportunity rather than a loss of capital, maintaining a long-term view and using such opportunities to rebalance one’s portfolio in a prudent manner allows the investor to benefit from market volatility and the sometimes irrational decisions of market participants motivated by short-term fear or greed.
Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.
Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other source believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.
Plante Moran Financial Advisors publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the sectors mentioned herein may not be appropriate for you. You should consult a representative from Plante Moran Financial Advisors for investment advice regarding your own situation.
