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).