FOURTH QUARTER 2005

US markets were weak at the start of the quarter, and again at its end. At one point (October 20), the S&P 500 index had fallen -4%, largely due to a tepid start to the earnings season and an increase in oil prices. Oil prices eventually eased, and earnings reports turned out a bit better than many had anticipated. The market recovered nicely, the S&P ending October down just –1.67%, and advancing +3.79% in November. December started out with more of the same, but a brief, slight inversion of the yield curve raised fears of a possible recession, and the hoped-for year-end rally became a year-end fizzle. December was flat (+0.03%), and the S&P returned +2.09% for the quarter. For the full year, the index’s total return was a tepid +4.91%. Smaller stocks did better, with the S&P 600 Small Cap index returning +7.67% for the year, but the big winner were the mid-caps — the S&P 400 Midcap index returned +12.54%. (Index returns: Standard & Poors)

International equities continued to perform strongly. The US dollar also strengthened further, but the market performance was strong enough to give US investors good returns in international equities. The MSCI EAFE international equity index (with dividends, net of local taxes) returned +7.11% for the quarter in local currencies and +4.08% in US dollars. For the full year, EAFE returned +29.00% in local currencies and +13.54% in US dollars. During the year the dollar strengthened by roughly 15% against other major currencies. It rose from 102.41 to 117.94 yen, from $1.357 to $1.184 against the euro, and from $1.919 to $1.702 against the pound Sterling. (Index returns: MSCI. Currency rates: Yahoo! Finance)

The dollar’s continued upward drift mostly reflected a similar upward drift in short-term US interest rates. Long-term rates were steady for the quarter. As a result, the Lehman US Aggregate Bond index returned +0.59% for the quarter. For the year, the index returned +2.43%. During the course of the year, of course, the Federal Reserve raised its target Fed Funds rate (an overnight interbank lending rate) by 25 basis points at each of its eight meetings, a total increase from 2.25% to 4.25%. Short-term Treasury yields followed suit; the yield on a 3-month Treasury bill had been 2.22% at 12/31/04, and ended 2005 at 4.08%. The yield on the 2-year US Treasury note rose from 3.08% to 4.41%, but the 10-year yield only increased from 4.24% to 4.39%. The sharp increase in short rates, coupled with the small rise in longer rates, resulted in a nearly complete flattening of the yield curve, with shorter- and longer-term yields nearly equal. The two-year yield is actually slightly higher (12/31/05) than the 10-year yield, giving rise to excessive comment on the inversion of the yield curve. An inverted yield curve (short rates higher than long ones) is sometimes a precursor of recession, but this curve is nearly flat, not meaningfully inverted. (Index returns: Lehman Bros. Treasury yields: US Treasury).

US markets started the quarter strongly, with the S&P 500 index returning +3.72% for July. Solid corporate earnings and indications of good economic growth gave the market a solid upward push. In the first three weeks of August the markets gave back much of their gains, but they recovered somewhat at month’s end, closing with a small loss for the month. Problems associated with Hurricane Katrina gave traders hope that the Fed might pause in its program of raising interest rates, but the Fed raised its Fed Funds target rate on September 20 anyway. In spite of this headwind, and the additional drag of high prices for crude oil and refined fuels, the market picked up a bit of ground during the month. For the full quarter, the S&P 500 index returned +3.61%, bringing its return to +2.77% year to date. (Index returns: Standard & Poors)

International equities performed strongly. The US dollar also strengthened a bit, but the market performance was so solid that international equities still did well for US investors. The MSCI EAFE international equity index (with dividends, net of taxes) returned +11.45% for the quarter in local currencies and +10.38% in US dollars. Japan was particularly strong, returning +21.9% in yen and +19.2% in dollars. (Index returns: MSCI)

The dollar’s upward drift mostly reflected a similar upward drift in US interest rates. As a result, bonds were weak. The yield on the 10-year US Treasury note fell backed up from 3.94% at the end of June to 4.34% at the end of September. The whole bond market weakened, with the Lehman US Aggregate Bond index returning –0.68% for the quarter. (Index returns: Lehman Bros. Treasury yields: US Treasury)

US markets began the second quarter by continuing the negative performance of the first. They finally turned around in mid-April, climbing nicely until the very end of June, when interest rate uncertainty seemed to deflate the rally. The S&P 500 returned +1.37%% for the quarter, not quite enough to erase the first quarter’s losses. The index ended the first half with a year-to-date return of –0.81%. During June an increasing number of observers expressed a sense that the Federal Reserve’s string of interest rate increases (nine so far) might be coming to an end. But when the Fed announced its June 30 rate increase, its statement was nearly identical to previous ones. This suggested that rate increases may continue, and the market fell nearly –1% in the last 90 minutes of the quarter. (Index returns: Standard & Poors)

International equities performed strongly, but the US dollar strengthened even more. So while the MSCI EAFE international equity index (with dividends, net of taxes) returned +4.55% for the quarter in local currencies, it fell –1.01% in US dollars. The effect was strongest in the Eurozone (the twelve nations sharing the common European currency), where the MSCI equity index rose +5.73% in euros, but fell –1.51% in US dollars. The euro fell from around $1.28 in March to around $1.20 at the end of June. Analysts cited continuing interest rate increases in the US, better growth in the US market, and political uncertainty over the European constitution as the main reasons for the dollar’s strength. (Index returns: MSCI. Currency rates: Yahoo! Finance)

Bonds were strong. The yield on the 10-year US Treasury note fell from 4.50% at the end of March to 3.94% at the end of June. The whole bond market did well, with the Lehman US Aggregate Bond index returning +3.01% for the quarter. In spite of persistent rumors in May of bond-related troubles at some large hedge funds, and the downgrading of credits of General Motors and Ford, corporate and other risky debt also held up well. (Index returns: Lehman Bros. Treasury yields: US Treasury)

US markets turned in a choppy, and generally negative, performance for the first quarter. The S&P 500 returned -2.15% for the quarter, including a -1.77% return for March. Observers cite a number of factors in explaining the decline. The most important include a general settling back after a very strong (+9%) fourth quarter; a renewed runup in the price of oil; and a subtle but unmistakable shift in the tone of statements by the Federal Reserve, suggesting that the Fed may become more aggressive about increasing interest rates, thereby possibly slowing economic growth. (Index returns: Standard & Poors)

International equities started the quarter strongly, but faded toward the end as the Fed’s comments led to a bit of a recovery of the US dollar after a long slide against other currencies. During March the dollar rallied from 105 yen to 107; from $1.32 per euro to $1.295, and from $1.92 per pound sterling to around $1.885. The MSCI EAFE international equity index returned -0.10% for the full quarter, including a fall of -2.51% for March. (Index returns: MSCI. Currency rates: Yahoo! Finance)

The Fed’s comments also affected the bond market. The yield on the 10-year US Treasury note, which had already risen from 4.24% (12/31/04) to 4.36% (2/28/05), rose further, ending March at 4.50%. As rates rose bonds fell, and the Lehman US Aggregate Bond Index returned -0.48% for the quarter, including -0.51% for March. (Index returns: Lehman Bros. Treasury yields: US Treasury)