Sunday, August 5, 2007

News - July 2007

The credit markets have been spreading a wave of worry through the financial markets over the past month. Well documented issues with mortgage lenders and the housing market have been rippling through the financial services sector. There have been a few cases where a hedge fund or mortgage lender have been exposed to having taken on too much risk and have collapsed. But by and large the overall extent to which many of the most recognizable financial institutions are exposed to these issues remains unknown.

That uncertainty has spread through the debt and equity markets as investors require higher returns from bonds and have sold off many stocks in the near term. Two hedge funds run by the Wall Street firm, Bear Stearns, have been exposed as being nearly worthless. The funds were invested in mortgage products, but it appears that the funds were highly leveraged. The high degree of leverage more precisely lead to the downfall for their investors. That revelation along with general sentiment has put into question which other Wall Street firms and financial institutions could suffer losses related to mortgage loans, hedge funds and structured products that invest in these mortgage products.

The majority of the loss, however, is not necessarily attributable to Bear Stearns, but those who invested in these hedge funds. The financial institutions may face future litigation and will certainly lose some future management fees associated with these products. The fees are generally minimal in the context of the revenues and earnings these companies generate. The other negative consequence could be a lack of reputation which could linger on for some time.

As current investors have required higher returns for their corporate bond investments, current holders of corporate debt have seen their principle diminish. Many high yield bond funds lost over 3% for the month. As stocks slid during the month also these high yield investments didn’t provide as much protection or diversification as investments in risk free US treasuries.

Government bonds performed well for the month as investors chose to swap out of higher risk bonds and into safe secure US treasury bonds and notes. The yield on the 10-year treasury quickly retreated from the recent high of 5.3% to well under 5% again towards 4.8%. Rates coming back down seem to indicate that the Fed may need to lower rates in the near future instead of raising or standing pat.

The recent stock market events have definitely been taking their cues from the bond market. The government said that the annualized GDP growth in the second quarter was 3.4%, which was higher than expected, and marked the fastest economic growth since the first quarter of 2006. Consumer spending was lagging though as record setting oil prices and a reduction in home equity withdrawals seems to finally be taking its toll on the American consumer.

Many economists and analysts have remarked that the global economy is in the best shape as they have ever seen. The strength in the global economy continues to bring along the US economy from our perspective. While the declining dollar has some negative implications it also helps US exporters sell US manufactured goods at cheaper prices abroad. This should help reduce the trade deficit to the benefit of many manufacturers and workers here in the US.

For the month the large cap stocks held up much better than the smaller capitalization stocks, while commodities and international stocks held up even better. S&P 500 was down 3.1%, the DOW Jones Industrials was down 1.4% for the month of July. The Russell 2000 index of small-cap stocks retreated 6.8% and the mid-cap stocks were down 4.3%.

Financials and Real Estate related securities continue to be notable underperformers for the month and for the year as rising interest rates and the issues surrounding mortgage lending continue to hamper these two specific sectors. A popular financial services ETF was down about 9% for the month of July and is down about 8% for the year through the end of July. A popular Real Estate ETF was down over 7% for the month and is down a whopping 15% for the year through July 31st.

Although the financials, the largest sector in the market, have struggled the overall market has done reasonably well. There have been many headwinds to the market this year, but the S&P has advanced 3.6% for the year and the DOW Jones Industrials have managed and even better 7.3% gain from January 1st 2007 through July 31st 2007.

Technology, Telecom, Utilities and Natural Resources have all outpaced the gains in the broader indices. Exposure to international markets also continues to be beneficial to investors as the developed markets have gained nearly 8% year to date and the emerging markets have returned 15% through July 31st.

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