Recapping the fourth quarter; housing, loan losses, high energy prices

The volatility seen in the late summer months returned with a vengeance in the fourth quarter, as a worsening housing recession, sizable loan losses, high energy prices and worries about the strength of consumer spending kept investors on the defensive in most global markets.

A number of financial firms announced larger-than-expected write downs on their mortgage or other debt holdings during the quarter, as the prices of even AAA-rated collateralized securities fell sharply and demand for the asset-backed commercial paper used to fund those holdings largely dried up. Liquidity conditions in the short-term money markets remained tight, despite repeated injections of funds by the Federal Reserve and other major central banks, and 50-basis-point reductions in the Fed's two main policy rates, the Federal Funds Rate and the Discount Rate.

U.S. Stock Market

Most major U.S. equity benchmarks saw losses during the quarter, with the financial and consumer discretionary sectors hardest hit. However, energy and utility stocks generally posted gains, as strong global demand and tight supplies continued to push oil, gas and coal prices higher.

The major equity indexes followed an erratic course during the fourth quarter, with both the Dow Jones Industrial Average and the S&P 500 Index hitting record highs in early October, only to fall sharply after credit conditions appeared to deteriorate in early November. The market's decline bottomed out late in the month, but moved in a seesaw pattern, with considerable daily volatility, through December. The S&P 500 Index rose or fell by 1 percent or more in 19 out of 41 trading days, or almost half, in the final two months of the year - compared to just two days in the same 2006 period.

The end results, however, were only modest losses on most major equity benchmarks. The S&P 500 Index shed 3.33 percent during the quarter, but still showed a gain of 5.49 percent for the year. The Dow Jones Industrial Average ended the year at 13,264.82, down from the peak of 14,164.53 that it closed at on Oct. 9, but above its 2006 year-end level of 12,463.15.

The NASDAQ Composite Index, with relatively lower weights in the hard hit financial and consumer discretionary sectors, fared somewhat better. The tech-heavy NASDAQ lost 1.83 percent during the quarter, but returned 9.81 percent for the year.

With the economy widely expected to slow, investors generally showed a pronounced preference for stocks thought to have higher-than-average long-term growth prospects.

The small-cap sector, which is generally thought more vulnerable to cyclical downturns, was also weighted down by economic concerns.

U.S. Bond Market

U.S. fixed income markets were polarized. Concerns about credit quality and growing pessimism about economic growth fueled a rally in the Treasury Market, pushing yields lower and prices higher.

However, lower-quality credits, such as high yield bonds and many types of mortgage-backed securities, significantly underperformed.

On the other hand, treasury prices jumped, pushing yields sharply lower, as investors sought shelter from default risk. The yield on the 10-year Treasury Note fell to 4.04 percent by the end of the year, from 4.59 percent at the end of September.

The Fed responded to the renewed volatility in the credit markets by cutting short-term interest rates twice during the quarter and by creating a new liquidity facility to supplement the existing discount window.

The Fed lowered its target for the Federal Funds rate, which banks charge each other on overnight loans, to 4.5 percent at the end of October and 4.25 percent in early December. The Discount Rate, which the Fed itself charges on short-term loans to member banks, was cut to 5 percent and then to 4.75 percent.

The U.S. Economy

Many of the quarter's difficulties stemmed from a rapid unwinding of the real estate boom that began earlier in the decade. Falling home prices and expiration of the initial "teaser" rates on some types of adjustable rate mortgages continued to push loan defaults and foreclosures higher, sending ripple effects through the banking system and the economy.

U.S. GDP growth appeared to slow sharply during the quarter while the unemployment rate edged higher.

The economy appeared to decelerate sharply in the fourth quarter, as the housing downturn, tighter credit conditions and hints of slower consumer spending during the Christmas shopping season all put a brake on growth.

Citi economists estimate U.S. Gross Domestic Product rose at a meager 0.6 percent rate in the fourth quarter, versus surprisingly strong 4.9 percent growth in the third.

Labor market conditions deteriorated as the year ended, with the Labor Department reporting that the unemployment rate rose to 5 percent in December, from 4.7 percent in September.

Inflation indicators were mixed, as oil prices neared the $100-a-barrel mark and the annual consumer inflation rate - including both food and fuel prices - passed 4 percent in November.

However, "core" inflation, which excludes volatile food and energy costs, remained better behaved, with the core CPI rate at 2.33 percent in November, only slightly higher than September's 2.13 percent.

Retail sales growth appeared relatively steady through the fall months, seeming to defy widespread predictions that falling home prices and growing economic uncertainty would force consumers to cut back.

However, sales were considerably less impressive in after-inflation terms. Major retailers and on-line merchants generally reported slender sales growth in the Christmas shopping period, with heavy discounting.

International Equity Markets

Developed international equity markets also retreated during the quarter, but most emerging markets continued to post positive returns. Most emerging regions showed sizable gains for the year.

A weaker U.S. dollar helped boost international returns for U.S. based investors.

Developed equity markets outperformed the U.S. market, on average, thanks in large part to a continued decline in the U.S. dollar.

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.