Thursday, July 5, 2007

News - June 2007

Volatility in the financial markets spiked again this month. Unlike earlier in the year, the June spike in volatility was in response to higher interest rates. For several days this past month, it seemed that the DOW Industrial Average gained or lost 100 points each day. If interest rates remain at the new plateau or rise higher, the increased volatility is likely to continue.

The 10-year bond is important because it serves as a benchmark influencing mortgage rates and other consumer and business borrowing costs. The 10-year treasury reached a five year high during the month of June, eclipsing the 5.25% mark before backing off a bit by the end of the month. While an increase in interest rates can occur because of increasing inflation and inflation expectations, interest rates can also reflect the economic growth expectations.

Current economic strength has all but eliminated the possibility that the Federal Reserve will decrease interest rates later this year. The market increase in rates this month leads to several observations about future economic prospects and inflation. First, the financial markets have adjusted, assuming the Federal Reserve will not lower interest rates later this year. The bond traders, who are generally less optimistic about economic prospects, have now embraced the thought of a stronger economy as they have sold bonds, requiring higher returns. While increased interest rates can indicate higher inflation, the fact that shorter term rates have remained stable probably suggests that inflation is not the cause of recent interest rate changes. Many analysts have commented that the increase in rates is due to an improved economic outlook, with foreign economic strength the likely source of much of the improved outlook for the U.S. economy.

International stocks continue to provide relatively superior returns than the U.S. stock market, as the developed international markets have gained 10.3% and the emerging markets have advanced over 15% for the year. The expanding developed and emerging international economies have been a significant factor in assisting the further growth of American corporations doing business in international markets. Contrary to past years when the U.S. economy sustained international economies, the U.S. economy is benefiting from the faster growing economies in Europe, Latin America and Asia. American corporations are earning an ever-increasing share of their profits from doing business abroad, much to the benefit of the American investor.

The capricious month of June provided a small 1%-2% pullback for most indices, but for the year, stocks have advanced soundly. The S&P 500 has gained 7% for the first six months of the year but retreated 1.7% for the month of June. The technology-laden NASDAQ was the best performer of the major indexes for June with a flat performance, while advancing 8.2% for the year. The DOW was off 1.5% for the month, but has done well for the year, returning 8.8% year-to-date.

Financials, despite relatively inexpensive valuations and high dividend yields, have been notable laggards for 2007. Real Estate stocks have also been laggards as interest rates have moved higher this year. A popular Financial ETF is slightly negative at -0.6% for the year, while a popular Real Estate ETF is off 9.2% year-to-date through June 30th. Real Estate Investment Trusts have outperformed the broader market for the past few years, so the correction in that sector may be warranted with their stretched valuations, regardless of the increase in interest rates.

Economic growth was sluggish during the first quarter as the commerce department reported a 0.7% increase in GDP. Economists expect GDP growth to improve to the 2% level later in the year. We believe the major change was that global growth expectations were recalculated higher while inflation remains a concern (but still in the realm of the target range). Reports in the middle of the month pointed to low inflation with the exception of higher gasoline and energy costs. We believe the economy will be able to absorb these higher energy costs while limiting the effect on other goods and services. Retail sales will likely indicate whether a softer housing market and higher energy costs are affecting the consumer.

Bonds are now trading at levels which make them a more attractive investment than they were just a few months ago. Bond yields have risen 75 basis points since earlier this year, lifting the income an investor will receive from these investments. While rising yields makes bond investments more attractive now, the higher yields push down bond prices, negatively affecting existing bond positions.

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