Fed rate cut helps calm volatile markets

A difficult quarter ended on a more positive note for the capital markets, as a larger-than-expected rate cut from the Federal Reserve triggered rallies on Wall Street and overseas. Most major U.S. equity benchmarks posted moderately positive returns.

Signs of a slowing economy added to market uncertainty in the third quarter. Sales of new and existing homes fell, as did home prices, leading some investors to worry about the impact on consumer spending.

With inflationary pressures apparently ebbing despite record-high oil prices, the Fed reacted in mid-September to the turmoil in the credit markets by cutting its target for the key overnight Federal Funds Rate to 4.75 percent from 5.25 percent. The Fed lowered the discount rate - the rate it charges on loans to member banks - to 4.75 percent.

U.S. stock market

After stumbling in July and early August on the mounting woes in the housing industry and the global credit markets, the U.S. stock market rebounded sharply following the Fed's rate-cut decision, pushing the Dow Jones Industrial Average to 13,895.63 by the end of the quarter - not far below the high of 14,000.41 the Dow reached in mid-July.

The S&P 500 Index, meanwhile, also regained much of the ground lost during the summer slump, finishing the quarter at 1,526.75. Including dividends, the S&P 500 returned 2.03 percent for the quarter and 9.13 percent for the year to date through September.

Relative strength in the technology sector helped the tech-heavy Nasdaq OTC Composite Index modestly outperform the broader market. The Nasdaq returned 3.78 percent for the third quarter and 11.85 percent for the first nine months.

With the strength of the U.S. economy and the outlook for corporate earnings both in question, investors showed a marked preference for the growth style of investing, reversing a long-running trend. It was the largest quarterly advantage for the large-cap growth benchmark since the final quarter of 2001.

The bond market

Global credit markets were roiled by a rise in U.S. mortgage defaults, particularly on loans to less creditworthy homeowners. This brought trading in some types of asset-backed securities to a virtual halt in August and early September. Treasury prices rose, pushing yields lower, as investors sought to reduce their exposure to credit risk. The 10-year Treasury Note, a popular benchmark, ended the quarter yielding 4.59 percent, down from 5.03 percent at the end of June.

The Treasury yield curve - the spread between yields on short-term and longer-term instruments - steepened during the quarter as investors began to anticipate the effects of additional Fed rate cuts.

The economy

While Commerce Department reports showed the economy expanded at a robust 3.8 percent annualized rate in the second quarter, Citi economists estimate growth slowed to a 2.4 percent annual rate in the third quarter as the effects of a sharp contraction in home starts and sales rippled through the economy. Some economists warned that falling home values could lead consumers to tighten their belts, although other analysts consider those fears overblown.

Adding to the uncertainty: Erratic reports on the state of the U.S. labor market. The department revised its estimates for August and July to show moderate job gains in both months, and reported that the economy added 110,000 jobs in September. The unemployment rate, however, did rise slightly, to 4.7 percent from 4.5 percent in June.

Corporate profits remained at historically high levels, a hopeful sign for future capital spending and employment. The Commerce Department reported that corporate profits, adjusted for the impact of inflation on inventory values and depreciation charges, rose 6.12 percent in the second quarter, up from a 1.08 percent gain in the first quarter.

International markets

International equity markets generally moved in tandem with the U.S. market during the quarter, but suffered slight losses in local currency terms. However, a decline in the value of the U.S. dollar against the euro and the Japanese yen produced slightly positive returns for U.S.-based investors. Emerging markets strongly outperformed.

As a result, Morgan Stanley Capital International's Europe, Australia and the Far East, or EAFE, Index - a popular benchmark for non-U.S. developed world markets - lost 2.47 percent in local currency terms but gained 2.23 percent in U.S. dollar terms, narrowly beating the S&P 500 Index. For the year to date, the EAFE remained solidly ahead with a 13.57 percent return.

For more information, e-mail william.a.creekbaum@smithbarney.com or call 689-8700.

Smith Barney does not provide tax and/or legal advice. Please consult your tax and/or legal advisors for such advice.

• 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.