Monday, March 5, 2007

News - February 2007

The month of February marked the return of volatility to the stock market. After months of monotonous, steadily rising equity prices the market looks to be correcting. While that monotony is certainly enjoyable to investors, there were many who were not surprised by the interruption that eventually occurred. Unfortunately, predicting the timing of such an event is virtually impossible. Many market forecasts had expected the market to slump in the traditionally weak September to October period, but it never developed that way as the market advanced a very methodical 15% from the July period right through most of February.

For the month of February, the DOW, S&P 500 and NASDAQ were all negative at 2.5%, 2% and 1.9% respectively. Year-to-date as of February 28th, the DOW was down 1.2% and the S&P was down by 0.5%. Small cap stocks continue to outperform as evidenced by the Russell 2000 still being positive at 0.9% for the year. According to the Morningstar mutual fund category returns, Real Estate and Utilities continued their outperformance from last year, surging 5.3% and 3.4% for the year through February 28th.

Financials, the largest sector in the market, is the notable underperformer, along with the very largest capitalization companies as indicated by the poor performance in the DOW 30. Utilities and Natural Resources both were positive performing sectors for the month of February, while Financials, Health and Real Estate were notable underperformers, all falling more than 1.5% for the month.

Even though a 416 point drop in one day is significant for the market, on a percentage basis, it’s actually not as earth-shattering as it would have been had it happened in past years. For example, consider that the DOW plunge of 508 points in 1987 accounted for a 23% one-day clip in stock market value. The recent drop on February 27, 2007 was worth about 3.5%. Can you imagine the chaos and media frenzy today if the market erased 23% of its value in a single day? In fact, most corrections of this sort are good buying opportunities taking into consideration the economic and market fundamentals.

There are a myriad of explanations for the drop in the markets. The immediately obvious reason was a reaction to the Chinese market that was sold off by 9% the night before, although the Chinese market is fresh off an incredible increase of 130% for 2006. A market that has advanced at that pace for the past year is much more likely to see wild swings and much more volatility.

Another explanation was that retired Federal Reserve Chairman Dr. Alan Greenspan was forecasting a recession for the U.S. market in 2007. These comments were probably misconstrued, as he was explaining that a recession at the end of this year or next was possible, although not probable. Of course, some of the media and market analysts did not seem to care about what Greenspan was actually trying to convey; rather, they focused more on his use of the word “recession.” To some degree, a future recession is as possible as an expansion, although historically, the U.S. economy is expanding approximately 85% of the time.

There were some other explanations for the market drop that have been mentioned in prior editions of this column. First, sub-prime mortgage brokers seem to be feeling some discomfort. Although we haven’t specifically discussed the sub-prime market, the fact is that these lenders are now finding it more difficult to collect mortgage payments and, because of more stringent lending practices, are having a tough time finding new borrowers. Typically, sub-prime lenders, which account for a small percentage of all mortgages, are those companies lending to the more credit-risky borrowers who are much more likely to default on their loans when home prices fall and interest rates rise.

Another word frequenting the financial airwaves during the last week of February was “correction.” Some have said that the long-steady rise in the stock market could not continue without some relatively volatile re-pricing of equity prices. A correction is, in some ways, a more psychological event rather than a reaction to economic and market fundamentals. Investors have shown an attraction for safe investments by reducing their risk profiles, a trend which may continue in the short-term. Bond prices have risen in response to higher demand for lower risk as the 10-year treasury yield edges downward towards 4.5%.

We believe that corrections are inevitable. This specific correction probably would have happened at some point regardless of the other issues attributed to selling in the stock market. As much as investors might desire, equity prices never rise consistently and continuously unless you consider very long-term horizons. The important thing to remember is that it is foolish to try and predict when these events are going to happen. As such, it’s important to remain diversely invested in order to mitigate some of the volatility.

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