To the surprise of many investors, global stock markets rallied powerfully during the 3rd quarter, and in the process offset the losses incurred in the first half of the year. The Standard & Poor’s 500 Index advanced 10.7% and the Dow Jones Industrials rose 10.4%. Even more impressive were the gains of 20.0% in the EEM Emerging Markets ETF (which includes China, India, and Brazil among others) and 18.1% in the EFA Developed Countries ETF (which includes Europe, Japan, and Australia among others, but excludes the U.S.). Most bond holders also enjoyed positive returns, as did investors in gold and many other commodities. Losses in the quarter were sustained by investors who were short these markets and currency traders who bet on further gains in the U.S. dollar and/or wagered against the euro.
At the beginning of the quarter, a pervasive gloom and doom had settled over the U.S. and international financial markets. The U.S. economy had hit a “soft patch,” and some highly publicized forecasters warned of a coming double-dip recession. Europe was racked with sovereign debt headaches that threatened another credit crisis and battered Euro Area financial markets. The leading emerging markets (China, India, and Brazil) grappled with inflation fears, which provoked some pundits to predict that initiatives taken by the governments and central banks to slow their overheating economies might overshoot and plunge their countries into recession. As risk aversion spread, the S&P 500 Index corrected -16% from April 23 through July 2, and some key international markets suffered even greater declines. By early July, an overwhelming majority of technical analysts in the U.S. and abroad predicted more losses to come.
The expected decline never occurred. Global stock markets rallied in July, when strong quarterly corporate profit reports once again exceeded estimates. A further batch of disappointing U.S. economic data in August, however, rekindled pessimism and reduced the advance. As September loomed, investors braced for more dismal economic news and were reminded by the financial media that September is historically the worst performing month for the U.S. stock market. One indication of the growing pessimism was that $16.53 billion flowed out of U.S. stock mutual funds in August, which came on top of a $10.45 billion net withdrawal in July (Investment Company Institute). Inflows into bond funds soared despite historically low yields. Bearish investors were emboldened: by the end of August, the New York Stock Exchange short interest (shares sold in expectation of profiting from future price declines) hit a 52 week high.
The September “stealth rally” was triggered by a surprisingly solid U.S. employment report released on September 3 and then supported by economic news that further discredited forecasts of a double-dip recession. An increase in corporate merger and acquisition activity was also encouraging. Adding to the optimism were favorable developments in Washington. Action in Congress to provide incentives for small business owners to hire workers and talk of an extension of the Bush tax cuts boosted the markets. The Federal Reserve also contributed by announcing its readiness to provide additional monetary stimulus in November. As the rally gathered steam with further gains each week, the pressure intensified on short sellers to limit their losses by buying into the market. The September rally was historic: the 8.8% jump in the S&P 500 Index marked the best performance of this often-dismal month since 1939.
The threat of a double dip recession combined with continued accommodation from the Federal Reserve to lower the yield (and raise the price) of bonds. The yield on the benchmark 10-year U.S. Treasury note fell to a near-record 2.51%, thereby continuing a decline dating back to April 5, when the yield peaked at 3.99%. This drop in yields took place even as the U.S. Treasury auctioned off a record $2.3 trillion of notes and bonds in the fiscal year ended September 30. Many companies took advantage of this opportunity to sell bonds at rock-bottom interest rates, and corporate debt was eagerly purchased by yield-hungry investors confronted with money-market funds yielding 0%. Most commodity investors prospered during the quarter. The CRB commodity price Index jumped 11% during the quarter, with spectacular surges in wheat (+30.4%), corn (+37.5%) and sugar (+48.6%). With much fanfare, gold topped $1300/oz. and closed September at $1307/oz. Notably lagging were energy prices: oil rose only 9% and natural gas fell -16.6%.
Currency fluctuations were surprising and significant. The U.S. dollar, which had risen 13.8% against a basket of currencies between January 1 and June 7, retreated 6.8% in the 3rd quarter. To the dismay of travelers planning trips to Europe, the euro ballooned 14.0% against the U.S. dollar following a 32.1% plunge from last November 25 through June 7. The continuing ascent of the Japanese yen, which rose a further 6.6% against the dollar, created consternation within the Japanese government and among investors in Japanese stocks. The government reacted by selling yen in the market in hopes of supporting exports and bolstering the slumping Japanese economy. Investors were disturbed: the meager 1.9% rise in the Tokyo Nikkei 225 stock market index during the quarter amounted to a miserable underperformance. Perhaps most noteworthy in the currency markets is what did not happen: the Chinese yuan inched up 1.3% against the dollar when many governments, especially the U.S., were demanding and expecting a sharp appreciation.