4th Quarter 2007 Review

From the Desk of Ron Rowland

The financial markets can be confusing and overwhelming. Financial media outlets are seemingly ubiquitous with news channels broadcasting an unbroken stream of market news. Adding to the confusion, these various sources often reach contradictory conclusions, change their views, or the market responds in an unanticipated way. For a good example, consider this last quarter.

July began on a positive note. Manufacturing reported strength in the overall economy. The Dow Jones Industrial Average climbed to new all time highs, cresting above 14,000 points. Nobody knows when it is time for a turnaround, and July 2007 was no exception to this rule. Almost before the euphoria could lapse, the market suffered a series of sharp declines.

When subprime mortgage problems resurfaced this summer, the market finally began to grasp the real issue - unaccountable debt. Trendy new financial instruments like collateralized debt obligations (CDOs) turned out to have an unexpected downside. Institutional credit markets (commercial paper) literally froze. When investors don't understand their assets, what do they do? They sell. In this case, they sold en masse.

Comparing this quarter to a roller coaster ride almost belittles a roller coaster. The market had all the trappings of a made-for-TV movie, complete with exploding commentary from financial analysts, reaction from an untested Federal Reserve chairman, and enough market gyrations to make a futures trader queasy. Third quarter 2007 was a ride to remember.

Times like these may be a primary reason you employ professional asset managers to guard your hard-earned savings. Instead of personally suffering through wild swings of alternating short covering and profit taking, you were able to concentrate on what you do best: work, retirement, life. We hope you will continue to do so. The CCAM team works hard to provide the best money management possible - striving to protect you from disastrous market moves and keeping you vested for the gains.

The Quarter in Review

The final quarter of 2007 brought more turmoil and volatility to the financial markets. The major domestic benchmarks were down but in most cases managed to end the year with small gains.

Headlines throughout the quarter continued to revolve around the housing sector's breakdown and the subprime mortgage crisis, along with the repercussions of both. The word "recession" began appearing in respectable publications, while the Federal Reserve embarked on a campaign of rate-cutting and liquidity management in an attempt to contain the damage. Wall Street firms began to admit their losses, and not coincidentally several high profile executive changes followed soon after. As the quarter and year ended, consumer spending appeared to be on the decline. This sparked even more talk of recession and its impact on corporate profitability.

Looking at the fourth quarter by investment style, large-cap funds generally outperformed small-caps and growth did better than value. The best performers tended to be large-cap growth. There was significant variation within the style box. iShares S&P 500 Large Cap Growth (IVW) was off -1.6% for the quarter, while iShares S&P 600 Small Cap Value (IJS) fell -6.8%. Why this gap of more than 5%? We suspect it has to do with the availability of credit. Small cap companies are more dependent on bank loans to finance their business plans, and bank credit dried up in the last half of 2007. Value stocks tend to be less creditworthy as well, so small-cap value was hit in two ways.

There were also big winners and big losers in sector action. Energy funds climbed as crude oil prices approached the $100 mark. Utilities, consumer staples, and health care are traditionally "defensive" sectors that are less connected to economic growth, and all performed well in the quarter. The laggards were financial services and consumer discretionary – both of which suffered as the mortgage market fell apart and consumer confidence fell.

Outside the U.S., certain emerging economies seemed to have their own private bull markets in the fourth quarter. The so-called BRIC countries – Brazil, Russia, India, and China – led the way with substantial gains but typically high volatility. A major decline in the U.S. dollar gave many international funds an extra boost, but performance was impressive even in local currency terms. Japanese markets remained weak, and most Japan funds had losses for the quarter.