3rd Quarter 2008 Review

From the Desk of Ron Rowland

I do not have to remind you that markets fell hard in the last few weeks. To me, the saddest part is the innocent bystanders who were hurt - workers who rely on their pensions and have no control over the misdeeds that created this huge mess. Hopefully people will learn from this experience that taking responsibility for their own retirement income is a worthwhile goal. Your employer and your government are not able to protect you from loss. Your best chance: save more, spend less, and think long-term.

My colleague, John Schloegel, recently penned an eloquent essay that does an excellent job of expressing my thoughts. I would like to share it with you now.

Re-Booting America
By John Schloegel

We are undergoing a significant change in America. Political and market forces are dramatically altering the psychology of each of us. I am especially bullish for the long term as I think the moral and ethical fabric of society has been exposed, and we don't like what we see.

Investors (and voters) will say no to scams, rip-offs, fraud, hypocrisy, ego, excess, and just about anything that doesn;t sound right. People now firmly believe the emperor has no clothes. Living beyond your means, seeking to get ahead at all costs, focusing on short term results, trying to one up your neighbor, breaking the rules, call it what you will, but the end does not justify the means.

There will be a period of soul searching, looking inward, at ourselves, asking tough questions about what we want and why we want it. Previous generations this past century, facing the harsh realities of two world wars, a great depression, and countless obstacles and difficulties, became stronger, more determined, ethical, family-oriented, honorable, and better equipped to deal with adversity. What has the last 25 years brought to America? A soft underbelly, that's what I call it. But things have changed, haven't they? We have been forced to our knees. We are ready for a better day. We yearn for the "good ol days," don't we? They are fast approaching. The relentless and punishing reality of market forces, combined with political ineptitude, has forced our hand. We should be grateful.

We can re-boot America. We have flushed much out of the system in the past few weeks. There may be a little more to go. But the slate is almost clean. We will set a new direction for healthy living, healthy investing, saving as opposed to spending, right versus wrong. We will be accountable, respectable, modest, humble, and even-keeled. We can work as a coherent society, together, without hypocrisy, because, as we have stared into the abyss, we don't like what we see. I am optimistic about the future; it is something to look eagerly forward to.

The Quarter in Review

The third quarter was rough, and the fourth quarter was even worse in its first few weeks. In fact, 2008 is shaping up to be the stock market's worst calendar year in decades. Anyone who has kept his percentage loss to single digits can claim victory in this environment, while those who achieved break-even are on top the world.

In the 3rd quarter the investment landscape changed dramatically: Fannie Mae (FNM) and Freddie Mac (FRE) were placed under government conservatorship, Lehman Brothers (LEH) collapsed in bankruptcy, and Merrill Lynch (MER) seems to have avoided a similar fate only by agreeing to be acquired by Bank of America (BAC). Insurance giant American International Group (AIG) was essentially nationalized, with the government now holding an implicit 80% ownership stake. Large banks like Washington Mutual (WM) and Wachovia (WB) teetered on the edge of failure, with WM being taken over by FDIC while WB was forced to sell itself to the highest bidder. A major money market fund "broke the buck", and others would have done so without government assistance.

With that as background, consider the raw numbers. In the third quarter, the S&P 500 lost -8.4% and the Nasdaq Composite was off -8.6%. The Dow Jones Industrial Average did better with only a -3.7% loss. Small caps also performed relatively well; the Russell 2000 Index turned in a -1.1% change for the quarter. These differences between supposedly "broad" indexes were largely a function of sector weightings, as we will discuss below.

To get a closer look at sector trends, let's look at the SPDR Select Sector ETFs. These funds break the S&P 500 stocks into the nine broad sectors. Here are the results for 3rd quarter 2008, in descending order from best to worst. (All these returns include dividends).

Because the S&P 500 is capitalization-weighted, each sector does not have the same impact on broad market performance. Nonetheless, these returns may surprise some people. The bulk of the quarter's loss came from the Energy and Technology sectors, and to a lesser degree from Utilities. Basic Materials had a large loss, but it is only a small part of the S&P 500.

Meanwhile the Financials – which we now know were destined to collapse after the quarter ended – actually had only a fractional loss in the third quarter. The Dow is heavily weighted toward financial and consumer stocks, and it has no exposure to utilities or transports. That allowed it to outperform the broader benchmarks in the 3rd quarter.

In the 4th quarter, markets will be preoccupied by the success or failure of government efforts to rescue the financial sector from its own folly and by the rapidly growing threat of a severe recession. Stocks seem likely to remain in a bear market for the foreseeable future, but there may still be opportunities to find growth in defensive sectors. We are working hard to find such opportunities.