Commonwealth Financial Network

Abridged February 2010 Market Recap

A lackluster start to 2010

Little has inspired investors in 2010, as reflected in the major U.S. market indices.

·         The S&P 500 Index gained 2.85 percent in February but is down 0.95 percent for the year.

·         The Dow Jones Industrial Average (DJIA) was essentially flat in February and is lower year-to-date, down 0.47 percent.

·         Stocks were buoyed in February by strong merger and acquisition activities.

Overseas equities continued to face headwinds.

·         The MSCI EAFE Index fell 0.68 percent in February and is down 5.05 percent year-to-date.

·         European equities have been hurt by:

o       Troubles in Greece and concern about its potential for debt default

o       The strengthening U.S. dollar

The fixed income spectrum highlights the benefits of diversification.

·         The Barclays Capital Aggregate Bond Index added to gains, up 0.37 percent in February and 1.91 percent for the year.

·         Money flowed into bond funds, as investors shunned the stock market.

·         Yields for the average corporate bond held, at 4.60 percent by month-end, while high-yield bonds yielded around 9 percent at the end of February.

The Federal Reserve raises the discount rate

On February 18, the Federal Reserve (the Fed) made a surprise announcement, increasing the discount rate 0.25 percent to 0.75 percent.

·         After initial fluctuations, bond and equity markets stabilized. In fact, yield on the 10-year Treasury dropped 20 basis points during the rest of the month.

·         Equities changed little on the next day’s trade, due to comments from the Fed, which asserted that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

Two critical points:

·         The discount rate is a last-resort measure for banks to obtain capital, while the federal funds rate is used to benchmark lending. Before the crisis, the discount rate was 1-percent higher than the federal funds rate, and the Fed lowered it to provide emergency funding to banks.

·         The Fed has returned borrowing conditions to overnight status from the 28-day condition it had applied during the crisis.

o       It did this to encourage banks to seek funding from private sources rather than from the government in the hope of spurring additional lending opportunities.

·         The Fed also closed several extraordinary credit programs in February; again, the market seemed to accept this, as the Fed had previously warned that it planned to remove some stimulative programs.

Historical Changes in Interest Rates

Will bank lending increase?

·         Observers are skeptical that banks will seek outside capital and incur credit risk after having access to guaranteed government funding.

o       There has been rhetoric in Washington that the government will limit the ability of banks to foreclose on delinquent loans.

o       This could add to reluctance among banks to lend.

·         The critical factors to remember: There will be no change to the federal funds rate for the foreseeable future and the target rate of 0 percent to 0.25 percent has been a significant factor in stemming economic decline.

A mixed bag of economic data

·         Gross domestic product (GDP) was revised upward, to 5.90 percent in the fourth quarter, from the preliminary release of 5.70 percent.

o       Some investors are looking for follow-up, claiming most gains resulted from government stimulus and from companies rebuilding depleted inventories.

·         The January jobs report showed a loss of 20,000 jobs, after the economy had added 150,000 new jobs in December.

o       The market managed to see past the figures.

·         The third important component of this recovery is housing.

o       January data showed new home sales slipping to 309,000, from 348,000 in December, and prices edging lower as well.

o       The impact of the tax credits appears to be waning and for now buyers are staying on the sidelines.

o       The markets were also resilient to the mixed housing data released in February.

Keep an eye on volatility

Looking ahead, we should note inconsistencies in recent readings of market volatility.

·         The VIX, a measure of volatility for the S&P 500, is back down to recent lows, hovering around 19 percent at this writing.

·         Other data indicates that there could be more market volatility than forecast by the VIX.

o       In February, we saw 8 days with moves greater than 100 points—or approximately 1 percent for the DJIA.

o       We saw only 6 days of 100-point moves in January, and, for the second half of 2009, we averaged only 4.3 days of 100-point moves per month.

Some see this as the calm before the storm; others look at the market’s resiliency and its ability to hold up in the face of mixed economic news. But a well-diversified portfolio still proves to be the best strategy to add value for investors in the current market.

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. All indices are unmanaged and investors cannot invest directly into an index. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio. Diversification does not ensure against market risk.

Authored by Simon Heslop, CFA^®, director of asset management, at Commonwealth Financial Network.

© 2010 Commonwealth Financial Network^®