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Market Insight - 3rd Quarter 2011

Investors have been thoroughly wrung out over the first 9 months of 2011. The first quarter of 2011 was the best first quarter in over two decades. Then markets took a tumble in May and early June, but a strong finish during the closing days of June pushed the S&P 500 ahead, still managing a  5.98 percent gain. 

In July political dysfunction over the debt ceiling disheartened Americans and led to a global loss of confidence.  Markets wavered, investor sentiment sank, and the S&P downgrade of our debt and rising fear of European sovereign default sent the markets tumbling.  After the dramatic declines and wild swings of August, volatility shows no signs of easing and stock markets continue to test lower levels, without signs of a recovery.

Investor psychology remains at the lowest level since March 2010, the low point of the last recession. Volatility magnifies fear and uncertainty; in August and September we had 29 days when the Dow's daily moves were greater than 1 percent, and 15 days when the swings were greater than  2 percent.  After stocks fell, many investors ran. By the end of September approximately $71 billion had been withdrawn from US stock funds, according to the Investment Company Institute. Yet we know periods like this are typically the worst time to change your investment strategy.

The Numbers

Third quarter 2011 was the worst quarter since the 3Q 2008. That says a lot. Almost all asset classes except high grade bonds were battered. The Dow lost 12% in the third quarter, and ended down 5.7% YTD.  The broader S&P 500 did worse, losing 14% for the quarter and 10% YTD. Smaller stocks, measured by the S&P Small Cap 600, fell 14% YTD. Worse damage was done to global shares; the MSCI EAFE index of developing countries plunged 19% for the quarter and 15% YTD. Emerging markets were bloodied; the MSCI EAFE Emerging markets index lost 22.6% for the quarter and 21.9% since December.

Bond prices were driven up by investors seeking a safe haven, and offered the only respite. Yields on the 10 year US treasury fell to 1.71%, the lowest level since the 1940s.  IEF, the exchange traded fund tracking the Barclays 7-10 year bond index gained 13.96%, while TLT, the ETF tracking the Barclays 20 year plus US Treasury index, gained 32.06% YTD.

Portfolio Strategy

While diversification among stock classes provided little shelter in the third quarter, your asset allocation among stocks, bonds, cash and real estate has helped to mitigate some of the damage. We began lowering or moderating stock allocations for many clients early in the year; this has provided some insulation. Cash reserves remain at strong levels. Bond prices in most sectors of our clients' portfolios rallied sharply. 

Markets like this are disheartening, but they are predictable. Each TBG client's allocation is designed  to provide continuity, overall return, and the ability to maintain investment discipline in both good and bad markets. We know from experience that investors who persist in a flexible but consistent investment strategy will get through these periods of turbulence for the markets, and participate in both recovery and real growth as the economy and financial markets regain strength and momentum. As market weakness shrink stock allocations, our investment strategy will build these up again at lower prices, and make the eventual recovery of value more robust.  We remain cautious, though, over the short term, as there are still significant downside risks.

 

SPDR S&P 500 12 month Graph

Click to Enlarge

 

Three Things That Need to Happen Now

Three things need to happen before markets stabilize and make real sustainable advances.  First, a permanent and significant rescue plan for the Euro and a tacit guarantee of sovereign debt by the EU.  The stronger countries reluctance is thoroughly understandable, but nothing less will satisfy global markets at this point.  European melodrama is holding global markets hostage; the tail is wagging the dog.

Second, return to effective fiscal policy in the U.S.  The “Super Committee”, meeting now and charged with very specific deficit reduction targets, represents an opportunity for both parties to put aside the most toxic partisanship, and identify a plan for deficit reduction, tax reform, and greater fiscal responsibility.  A little success in this area would also raise the abysmal perception of Congress and the government, a major contributor to the general sense of despondency.

Third, a bipartisan “new deal” program for residential real estate. We need a FEMA for housing. So far, attempts to help the moribund real estate market, with special loan programs and foreclosure mitigation has been half hearted, stifled in beaurocracy, pitifully undersized, and ineffective at reaching hundreds of thousands of middle class Americans who have lost, or are in danger of losing their homes.  The reductions of home equity, the impact of foreclosure on whole neighborhoods, the decline in the conditions of our home stock; these are the most damaging problems and most daunting challenges.

Steven Weber
The Bedminster Group

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