U.S. and international financial markets faced formidable obstacles in the first quarter, as credit conditions remained extremely tight and economic activity slowed both at home and abroad. The financial sector was particularly hard hit, with banks and other lenders in the U.S. and Europe announcing billions in losses on sub-prime loans and other types of mortgage debt.
Major U.S. equity benchmarks generally posted losses, in some cases sizable ones. At its low point for the quarter, on March 10, the Dow Jones Industrial Average closed just a few hundred points above one common definition of a bear market - a 20 percent decline from a previous peak (in this case, the 14,164.53 reached by the Dow in October of last year.) However, market sentiment improved somewhat after the Federal Reserve helped arrange the takeover of a troubled Wall Street investment firm, triggering a modest rally near the end of the quarter.
Major U.S. equity benchmarks experienced an exceptionally volatile quarter, with the Dow falling from 13,264.82 at the end of December to a low of 11,740.15 in early March, before rallying to 12,262.89 by the close of the quarter. All told, the industrial average rose or fell more than 1 percent on almost half (29 out of 61) of all trading days during the quarter. That was up from just 7 of 61 trading days in first quarter of 2007, before the credit crisis erupted.
Concerns about the strength of the economy and expected earnings growth translated into a reduced appetite for stocks perceived as richly valued. Dividing the stocks in the S&P 500 into five equal groups, or quintiles, the quintile with the lowest average price-to-earnings ratio (a group that also included many firms with negative earnings) collectively lost 9.7 percent during the quarter. The quintile with the highest PE ratio lost 15.3 percent.
Alarmed by the deterioration in liquidity conditions, the Fed cut short-term interest rates dramatically over the quarter and opened its lending facilities to non-depository financial institutions. However, interest rates on private money-market instruments remained abnormally high, while yields on Treasury bills - often viewed as havens in times of financial instability - plummeted.
U.S. fixed-income assets followed diverging paths during the quarter. While longer-term Treasuries rallied - although not as dramatically as T-Bills - most private credit instruments showed slender gains or outright losses. Instruments rated below investment grade, such as high-yield bonds, were particularly hard hit. The municipal bond market was negatively affected by news that credit agencies were reviewing the ratings of several large bond insurers.
These trends left Federal Reserve officials facing a difficult dilemma: How to bring down punishingly high money market rates and credit spreads without undermining confidence in the U.S. dollar or worsening inflationary pressures. The Fed cut interest rates three times during the quarter, bringing its target for the overnight Federal Funds Rate down to 2.25 percent from 4.25 percent at the end of 2007.
Perhaps because of these measures, as well as a revival in market confidence following the Fed's arranged merger of a major Wall Street firm, credit spreads narrowed in the closing week of the quarter. However, market conditions remained very fragile, with trading in many types of mortgage-backed or collateralized securities virtually paralyzed by an absence of bidders.
International equity markets struggled during the quarter, although gains by several major foreign currencies against the U.S. dollar partially offset local currency losses. Developed international markets on average slightly outperformed the S&P 500 Index. Emerging equities, which had largely avoided credit-related problems last year, were finally dragged lower by growing worries about the strength of key export markets.
• 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.