Markets turn volatile after Dow reaches new high

Worries about the U.S. economy - combined with a sharp correction in China's stock market - rattled the capital markets in the first quarter, although most equity and fixed-income benchmarks still finished the period with modest gains.

The U.S. stock market surged in the first two months of the quarter, with the Dow Jones Industrial Average setting a new record high of 12,786 in late February. However, the Dow soon experienced its biggest one-day loss in almost four years, falling more than 416 points, or 3.3 percent, on February 27.

Analysts cited a number of factors to explain this reversal. The immediate catalyst was a large one-day drop on China's Shanghai stock exchange, which sent shock waves through other Asian markets and triggered an abrupt rise in U.S. dollar value of the Japanese yen - the currency of China's largest creditor.

At the same time, however, U.S. investors also grew apprehensive after former Federal Reserve Chairman Alan Greenspan warned an economic recession is possible - although far from certain - later this year. This, combined with continued softness in U.S. housing markets and rising defaults on the so-called "sub-prime" mortgage loans, cast doubts on the expected strength of future corporate earnings.

The resulting correction pushed stock prices lower through the first week in March. Bond yields, which tend to move in the opposite direction of bond prices, also fell, as more investors anticipated that a slowing economy would lead the Fed to cut short-term interest rates later this year.

However, equity market conditions improved in the latter half of March, thanks to better economic news and a return to financial stability in Asia. The Dow ended the month at 12,354, a modest decline from 12,463 at the beginning of the year, but dividends converted that result into a positive quarterly total return of 0.48 percent. Bond prices, on the other hand, fell as expectations for a major Fed easing receded.

Despite the correction in China, major foreign equity markets generally outperformed the U.S. stock market in the first quarter, thanks in part to a weaker U.S. dollar, which tends to increase the returns on foreign securities for U.S.-based investors. In the developed world, Asian and Pacific exchanges modestly outperformed Europe equities, both in local currency and U.S. dollar terms. In the emerging markets, Latin America was the leader.

The U.S. Stock Market

After fluctuating considerably over the course of the first quarter, most major equity benchmarks posted modestly positive returns for the period. The S&P 500 Index, returned 0.64 percent, bringing its gain for the 12 months ending in March to 11.83 percent.

So-called defensive sectors - those thought less exposed to an economic downturn - predominated. Of the ten economic sectors tracked by Standard & Poor's, the Utility sector led the way with a 9.26 percent return. Utility stocks are attractive to many investors in times of economic uncertainty because they tend to have relatively sizable, and stable, dividend yields.

Financial stocks were the worst performers and were weighed down by the problems in the mortgage lending industry and expectations of softer earnings in the brokerage and banking industries.

For the second quarter in a row, small capitalization benchmarks generally out-performed large-cap indices, which were handicapped by negative returns on some of the market's largest stocks. The mid- caps were the best performers in the first quarter.

With investors showing a preference for defensive stocks, the value style of equity investing narrowly out-performed the growth style in the large-cap universe. But that advantage was greatly limited by weakness in the financial sector, which carries a heavy weight in the value universe.

The U.S. Bond Market

The U.S. bond market had an inverse relationship with the stock market during the quarter - initially rallying on signs of slower economic growth, then retreating in March as economic confidence improved. Most fixed-income measures posted gains for the quarter.

The Federal Reserve held short-term rates steady during the first quarter, with the Fed's key target rate, the Federal Funds Rate, remaining at 5.25 percent. Fed officials provided no clear read on their intentions during the quarter, citing both the possibility of a slowdown in economic growth and the risk of higher inflation.

Thanks in part to this interpretation, intermediate-term notes rallied more sharply than longer-term securities during the quarter. As a result, the yield curve (the spread between short- and long-term yields) un-inverted, with the yield on the 2-year Treasury note falling below the yield on the 10-year note for the first time since last August. A positive yield curve is generally interpreted as a sign that investors expect Fed policy to become less restrictive.

The U.S. Economy

Concerns about the health of housing-related industries dominated the economic scene in the first quarter. Sales of new and existing homes declined in many regional markets as did home prices, although some signs of stabilization emerged late in the quarter.

Adding to these concerns: Slower growth in retail sales, sluggish manufacturing activity and a puzzling reluctance on the part of many businesses to boost capital investment, despite rising profits. These factors all contributed to investor unease about the direction of economic and earnings growth.

These concerns, however, did not show up in the overall output figures. The Commerce Department reported that Gross Domestic Product grew at a 2.5 percent rate in the final quarter of 2006, slightly higher than initial estimates. As of early April, Smith Barney economists estimated that GDP expanded at a 2 percent rate in the first quarter and were predicting 2.4 percent growth for 2007 as a whole.

Some of the reasons for this optimism: solid employment growth, continued gains in personal income and a sustained consumer spending, particularly on services.

Although Fed officials voiced concern about potential inflationary pressures, consumer price indices remained relatively well behaved in the first quarter. The Labor Department reported that the core Consumer Price Index - excluding volatile food and energy prices - rose 2.72 percent over the 12 months ending in March, slightly higher than the 2.56 percent rise for 2006 as a whole, but below the peak rates of acceleration seen last summer.

Oil prices, however, remained a source of inflationary concern, as tensions in the Middle East - most particularly, an on-going dispute over Iran's nuclear program - kept security concerns at the forefront of attention. However, oil prices remained below the peaks reached during last year's war in Lebanon.

For more information, e-mail me at William.a.creekbaum@smithbarney.com or call 689-8704.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas Street, Ste. 200 Reno, NV 89509.