Commentary and Articles

3rd Quarter 2007 Quarterly Synopsis

“Up the down escalator”

The market correction this commentary has discussed as being overdue showed up in the 3rd Quarter but did not stay around long. By the closing day of the quarter, markets had regained losses that, at mid-quarter had seemed to signal impending doom for the global economy.

After the significant gains of the 2nd Quarter, equity markets were quick to retreat as news of problems with sub-prime mortgages began to surface. For these loans previously made to homebuyers considered to be higher credit risks, the potential write-offs and increasing delinquencies gave investors concerns that banks may suffer high losses. Even as liquidity available for borrowing dried up almost immediately and mortgage rates began to climb steeply, we were telling clients that the mortgage market crisis was overblown in the media given the relatively small percentage of mortgages that actually make up the sub-prime market. Even though we were not overly concerned by the sub-prime media frenzy, we did discuss the underlying issues which have concerned us for some time.

By the middle of August, the Standard & Poor’s 500 index was down 8.90% and investors were accounting for the higher levels of risk by driving stock prices down in huge day-to-day sell-offs. We released a first ever Interim Commentary titled “For such a time as this,” which reassured investors and said, “Historically speaking, the current movement in security prices is not unprecedented. We are reminded of the 4th Quarter of 2002, in which some accounts were down by over 4% only to rebound by more than 12% in the 1st Quarter of 2003.” By the end of the 3rd Quarter, the equity markets had, in fact rebounded sharply, up 10% from the trough, helped by a surprising 0.50% cut in both the discount rate and the Fed funds rate. The added liquidity enhanced hopes that the sting of soft housing markets and increasing oil prices would not drag the U.S. economy into recession.

While the risk of recession is not gone, it has diminished with the Federal Reserve rate cuts. However, the U.S. consumer is not likely to be as optimistic as equity investors. As in previous quarters over the last year housing prices continue to slide. The lack of liquidity offered to consumers through home equity will have an effect on economic growth until inventories of new and existing homes begin to come in line with demand. Oil prices too, continue to rise with the quarter-end price at $80 per barrel. Both of these factors are reflected in the lower GDP growth estimate for the 2nd Quarter of 3.8% annualized, down from 4.0% previously projected.

Offsetting these concerns, employment numbers continue to stay strong and jobless claims dropped for the final week of the quarter. The continued strong employment is certainly good news for economic growth, but combined with the higher fuel and food prices and the interest rate cut, it could signal inflationary pressure on the horizon which would hurt both stock and bond markets. The recent protracted slide in the value of the U.S. Dollar signals the global economic community’s concern over just such risks in the U.S. economy.

As the interim commentary and our other commentaries have discussed, these are precisely the risks we seek to avoid in constructing prudent portfolios. In 3rd Quarter 2007, we lessened our exposure to Emerging Markets because the lack of liquidity as global capital sources tighten credit policies hurts this sector most. This effects returns in the short-term, but also reduces a significant risk. Our increased exposure to Natural Resources benefited portfolios as fuel and commodity prices rose while stocks declined. In fact, Gold finished the quarter at the highest point since 1980. In stocks, Energy sector names did well for the quarter as did Focus List holding Aflac (AFL, NYSE). Consumer Goods sector names Pepsi (PEP, NYSE) and Proctor & Gamble (PG, NYSE) also produced nice results.

Bond holdings did well for the quarter, benefiting both from the flight to quality in the initial half of the quarter and the rate cut environment of the second half. International Bond holdings were also helped by the Dollar’s slide as interest payments in foreign currencies purchased more local currency.