4th Quarter 2007 Review

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.