Market Reviews 2007

The market volatility that characterized the second half of 2007 continued through December, as US equity markets alternated between gains and losses week by week. The S&P 500 index ended December with a loss of –0.69%, bringing its total return for the fourth quarter to –3.33%. For all of 2007, the S&P 500 returned +5.50%. Losses related to the subprime mortgage business once again dominated the news, as large institutions continued to report large writedowns. Merrill Lynch and UBS also joined Citigroup in receiving capital investments from foreign sovereign wealth funds.

Stocks fell in all capitalization ranges, although the S&P Midcap 400 index fell just –0.19% for the month (it returned –2.72% for the fourth quarter and +7.98% for the full year), and the Small cap 600 returned –0.79% for the month, –6.45% for the quarter, and –0.29% for the full year. Growth stocks generally outperformed value stocks for the month, quarter, and year. The S&P 500 ended 2007 at a level of 1468.38. At December 31, 1999, it stood at 1469.25 — the index moved less than one point in eight years. [Index returns and levels: Standard & Poors]

Overseas stocks shared the weakness of the US market. In local currencies, the MSCI Barra EAFE international equity index returned –1.18% for December, –2.96% for the fourth quarter, and +3.54% for the full year. The US dollar recovered a bit of strength against major currencies during December, ending the month at 111.396 yen (compared to 111.148 at 11/30, 114.745 at 9/30, and 118.765 a year ago at 12/31/06); $1.460 against the euro (from $1.464 on 11/30, $1.427 on 9/30, and $1.315 on 12/31/06); and $1.985 against the pound Sterling (from $2.057 on 11/30, $2.045 on 9/30, and $1.960 on 12/31/06). As a result of the currency movements, EAFE returned –2.25% in US dollars for December, bringing the index’s return in dollars to –1.75% for the fourth quarter, and +11.17% for the full year. [Index returns: MSCI Barra; currency yields: Yahoo! Finance]

Bond yields jumped around quite a bit during December, but they ended the month not far from where they began it. At year-end, the ten-year US Treasury yielded 4.04%, compared to 3.97% at November 30. The two-year Treasury ended the year at a yield of 3.05%, compared to 3.04% at November 30. Although yields made only small moves in December, they fell sharply for both the quarter and the year. At September 30, the ten-year yielded 4.59%, and the two-year 3.97%. A year ago, December 31, 2006, the ten-year yield stood at 4.71%, and the two-year 4.82%. Bond market performance reflected these changes, as the Lehman US Aggregate Bond Index returned +0.28% for December, +3.00% for the quarter, and +6.96% for the full year. [Interest rates: US Treasury; index returns: Lehman Brothers]

The turmoil in the US and global credit markets continued to weigh on stocks in November. Stocks had held steady in October, but after a series of reports indicating that several large financial institutions still face substantial losses on mortgage-related instruments — and the resignation of the CEOs of Merrill Lynch and Citigroup — the stock market took another sharp turn downward. On top of everything else, the price of oil spiked up to within a whisker of $100 per barrel in the futures market, before ending the month at around $90. The S&P 500 lost -9% from October 31 to November 26, before turning back upward in the month’s last four days. The recovery apparently came as a response to accommodative comments from senior Federal Reserve officials, as well as an investment in Citigroup by the Abu Dhabi Investment Authority. The Fed comments and the Citi-Abu Dhabi deal seemed to indicate that the financial system would be able to raise sufficient, if not ample, capital to weather its mortgage-related losses. Even with the rally at the end of the month, the S&P 500 still lost -4.18% for November, the worst monthly return for US stocks since December 2002. Smaller stocks were even weaker than large stocks, with the S&P Midcap 400 index returning -5.04%, and the S&P Small Cap 600 returning -7.42%. Value underperformed growth among large and mid-cap stocks, but did slightly better among the small caps. [Index returns: Standard & Poors; oil price: various news reports]

International stock markets followed the same pattern as the US markets, with strikingly little regional variation. The MSCI Barra EAFE international equity index returned -4.11% in local currencies for the month. The weakness in the US dollar persisted, though other currencies also made relatively large moves against one another. As a result, the dollar picture ended mixed. The dollar weakened to 111.15 yen on 11/30 (from 115.31 yen at 10/31) and to $1.4637 against the euro (from $1.4503 at 10/31), but it strengthened a bit against the pound Sterling, ending the month at $2.0568 to the pound (from $2.0812 at 10/31). The net result was that EAFE returned -3.29% in US dollars. [Index returns: MSCI Barra; currency rates Yahoo! Finance]

As often happens in times of market turmoil, high-quality bonds performed strongly during November. The Lehman US Aggregate Bond Index returned +1.80% for November, as interest rates continued to fall. The yield on the two-year US Treasury note fell to 3.04% at November 30, from 3.94% a month earlier. The yield on the ten-year Treasury fell to 3.97%, from 4.48% at the end of October. The drop in rates represented both a flight to quality as many investors shifted to safer assets. The sharp drop in the two-year yield also probably reflected investor expectations for further cuts in short-term interest rates by the Federal Reserve. Late in the month Fed Chair Bernanke and Vice Chair Donald Kohn both signaled that the Fed would be “flexible” in its response to economic conditions, a word that most market observers took to point toward a likely rate cut when the Fed Open Market Committee meets on December 11. [Index returns: Lehman Brothers; interest rates: US Treasury]

The markets began October on a positive note, continuing the strong recovery that marked September’s movements. By mid-month, the major stock market indices had nearly regained the highs they had achieved in July before this summer’s downdraft. Quarterly earnings reports began to come out in mid-October, and some early ones drove markets lower for a bit. Stocks recovered again toward the end of the month, driven in part by a 0.25% drop in the Fed Funds target on October 31. For the full month of October, the S&P 500 index returned +1.59%. Mid-cap stocks were strong as well, with the S&P Mid-cap 400 returning +2.63%. The Small Cap 600 returned +1.86%. Growth indexes continued their recent strength, out-performing value at all capitalization ranges. [Index returns: Standard & Poors].

International stock markets also exhibited strength in October. The MSCI Barra EAFE international stock index returned +2.41% in local currencies. Low interest rates and credit concerns in the US continued to weigh on the US dollar, particularly relative to European currencies. The dollar weakened to $1.450 against the euro, from $1.427 on September 30. It also weakened to $2.081 against the pound Sterling, from $2.045 at the end of last month. The dollar performed better against the Japanese yen, rising to 115.314 from 114.745 at September 30. As a result of the currency movements, EAFE returned +3.93% in US dollars. [Index returns: MSCI Barra; currency exchange rates: Yahoo! Finance].

At its policy meeting on October 30-31, the Federal Open Market Committee decided to lower its target Fed Funds interest rate by 0.25%, to 4.50%. Even though Fed Funds is a short-term interest rate, other short-term rates barely moved. The yield on the two-year US Treasury note fell to 3.94% on October 31, from 3.97% at 9/30. The ten-year yield fell by a bit more, ending the month at 4.48%, down from 4.59% at 9/30. Thanks to the general fall in interest rates bonds had a strong month, with the Lehman US Aggregate Bond Index returning +1.63%. [Index returns: Lehman Brothers; Treasury yields: US Treasury]

The markets started the third quarter calmly moving higher after a solid recovery in June, but their tone changed quickly in mid-July, as the news emerged indicating widespread losses from exposure to sub-prime mortgage loans and related securities. A series of events over the next several weeks left credit markets in a fragile state, and equity markets responded with falling prices. From June 30 to August 15, the S&P 500 fell by –6.20%.

After a volatile August, September opened with market participants still uncertain about the depth of global credit worries tied to the unwinding of the sub-prime mortgage market. The news early in the month wasn’t encouraging. Images of blocks-long queues of depositors withdrawing their savings from Northern Rock, a UK bank, reinforced fears that global credit markets might seize up altogether, with unpredictably bad effects. A risky, but timely, move by the British Government effectively guaranteeing consumer deposits at Northern Rock and other British banks calmed savers there. Then on September 18, the Federal Open Market Committee reduced its target Fed Funds interest rate by 0.50% to 4.75%, and the stock market responded with a strong rally. The move brought the return on the S&P 500 to +2.03% for the quarter. It has returned +9.13% year to date. The market’s strength was narrow, though – mid- and small-capitalization stocks didn’t do nearly so well. The S&P Midcap 400 index returned –0.87% for the quarter, and the Small cap 600 returned –1.83% for the quarter. In addition, growth stocks performed substantially better than value stocks in all capitalization ranges. The S&P Citigroup Midcap Value index, for instance, returned –2.52% for the quarter, while its Midcap growth counterpart returned +0.76%. [Index returns: Standard & Poors]

Global stocks fell further than US stocks early in the quarter, but generally shared in September’s equity market strength. The MSCI Barra EAFE index returned –2.52% for the quarter, a recovery from a much weaker start. As many writers have noted, however, the Fed’s easing hit the US dollar, which dropped sharply against other major currencies. For the quarter, the dollar fell to 114.74 yen (from 123.14 on 6/30), and to $1.427 against the euro (from $1.354 on 6/30) and $2.045 against the pound Sterling (from $2.008 on 6/30). As a result, EAFE had a positive return, +2.18%, for the quarter. Year-to-date (9/30), EAFE has returned +13.15% in US dollars. [Index returns: MSCI Barra; Currency rates: Yahoo! Finance]

In spite of tightness in lower-quality credit markets, the Fed’s move also drove interest rates on short-term, high-quality debt lower. At quarter’s end, the yield on the 10-year US Treasury note stood at 4.59%, down substantially from its level of 5.03% at the end of June. The two-year yield fell to 3.97% at the end of September, from 4.87% at the end of June. With these drops in interest rates, the Lehman US Aggregate Bond index returned +2.05% for the quarter, and +3.84% year-to-date. [Index returns: Lehman Brothers; Treasury yields: US Treasury]

After a volatile August, September opened with market participants still uncertain about the depth of global credit worries tied to the unwinding of the sub-prime mortgage market. The news early in the month wasn’t encouraging. Images of blocks-long queues of depositors withdrawing their savings from Northern Rock, a UK bank, reinforced fears that global credit markets might seize up altogether, with unpredictably bad effects. A risky, but timely, move by the British Government effectively guaranteeing consumer deposits at Northern Rock and other British banks calmed savers there. Then on September 18, the Federal Open Market Committee reduced its target Fed Funds interest rate by 0.50% to 4.75%, and the stock market responded with a strong rally. The S&P 500 ended September with a total return of +3.74%, bringing the return for the quarter to +2.03%. It has returned +9.13% year to date. The market’s strength was narrow, though – mid- and small-capitalization stocks didn’t do nearly so well. The S&P Midcap 400 index returned +2.65% for September, and –0.87% for the quarter. The Small cap 600 returned +1.49% for the month, and –1.83% for the quarter. In addition, growth stocks performed substantially better than value stocks in all capitalization ranges. The S&P Citigroup Midcap Value index, for instance, returned –2.52% for the quarter, while its Midcap growth counterpart returned +0.76%. [Index returns: Standard & Poors]

Global stocks generally shared in September’s equity market strength, with the MSCI Barra EAFE index returning +2.24% in local currencies for the month, improving the quarterly return to –2.52% from a much weaker start. As many writers have noted, however, the Fed’s easing hit the US dollar, which dropped sharply against other major currencies. For the month, the dollar fell to 114.74 yen (from 115.81 on 8/31), and to $1.416 against the euro (from $1.362 on 8/31) and $2.045 against the pound Sterling (from $2.017 on 8/31). As a result, EAFE returned +5.35% in US dollars, and had a positive return, +2.18%, for the quarter. Year-to-date (9/30), EAFE has returned +13.15% in US dollars. [Index returns: MSCI Barra; Currency rates: Yahoo! Finance]

In spite of tightness in lower-quality credit markets, the Fed’s move also drove interest rates on short-term, high-quality debt lower. At month’s end, the yield on the 10-year US Treasury note stood at 4.59%, not much changed from its 8/31 level of 4.54%, but down substantially from its level of 5.03% at the end of June. The two-year yield fell to 3.97% at the end of September, from 4.15% at the end of August and 4.87% at the end of June. With these drops in interest rates, the Lehman US Aggregate Bond index returned +0.76% for September, bringing its return to +2.05% for the quarter, and +3.84% year-to-date. [Index returns: Lehman Brothers; Treasury yields: US Treasury]

This August gave us an unusually large amount of financial news, most of it concerning the sharp contraction in liquidity surrounding the trouble in the market for sub-prime mortgage loans and their related securities. The overall effect of the news was to increase uncertainty among market participants, and increased uncertainty often plays out in the form of market volatility. US equity markets were certainly volatile during August. The S&P 500 index dropped by more than –2% on four different days (8/3, 8/9, 8/15, and 8/28), and rose by more than +2% on 8/6 and 8/17. The index fell by more than –6% between August 8 and August 15. Yet in the end, the index posted a gain for the month, returning +1.50%. The mid-cap 400 index gained a bit less, returning +0.92%, and the small-cap 600 index performed better, returning +1.87%. Growth stocks performed better than value stocks in all capitalization ranges. (Index returns, including daily figures: Standard & Poors)

After several months of performing in lockstep with US markets, international equity markets diverged in August, with the MSCI Barra EAFE index returning –1.45% in local currencies. The US dollar declined sharply against the Japanese yen, easing to 115.81 yen from its 7/31 level of 118.81, but the US currency strengthened a bit against its European counterparts. The dollar strengthened to $1.3624 against the euro (from $1.3691 on 7/31) and to $2.0165 against the British pound (from $2.0346 on 7/31). On balance the currency movements hurt US investors in overseas assets, and EAFE’s return in US dollars was –1.56% for the month. (Index returns, MSCI Barra; currency rates, Yahoo! Finance)

While trouble in the credit markets attracted attention all month, high-quality fixed income instruments, especially Treasury securities, attracted investors. As a result, yields on US Treasury notes fell sharply. The yield on the 2-year Treasury note fell to 4.15% on 8/31 (from 4.56% on 7/31), and the ten-year yield fell to 4.54%, from 4.78% on July 31. As a result of this rally in Treasuries, the Lehman US Aggregate Bond index returned a strong +1.23% for August. (Index returns, Lehman Brothers; Bond yields, US Treasury)

After a long, quiet stretch, volatility has returned to the US equity market, with sharp swings occurring on every time scale — daily, weekly, monthly, and quarterly. The US market finished June with a solid recovery after a rough first half of that month, and the same recovery carried over into the first few days of July. But the market came under pressure after about July 9, and spent the last three weeks of the month in a steady slide. For the full month, the S&P 500 index lost -3.10% (that’s a total return). Smaller stocks performed even worse, as the Midcap 400 returned -4.38%, and the Small Cap 600 returned -5.11%. The market downdraft hit value stocks harder than growth stocks at every capitalization range; the S&P/Citigroup 500 Value index lost -3.93%, while its Growth counterpart lost -2.22%. A couple of factors contributed to the market’s weakness. One was the price of oil, which ended the month at a record level in excess of $78 per barrel. The greater drag came, however, from a general, downward repricing of risky assets in response to several well-publicized problems in the debt markets. The highest-profile problems hit certain hedge funds that held leveraged portfolios of speculative securities made up of sub-prime consumer loans, but in fact the trouble affected all risky assets. For the most part, the riskier the asset, the greater the damage. (Stock index returns: Standard & Poors; oil price from news reports)

Global equity markets moved down in tandem with the US market. In local currencies, the MSCI Barra EAFE international equity index returned -3.25% for the month. The dollar also weakened against other currencies, though, softening the international equity loss for US investors. The dollar eased to 118.807 yen (from 123.128 on 6/30), to $1.369 against the euro (from $1.3535 on 6/30), and to $2.035 against the pound Sterling (from $2.008 on 6/30). As a result of the currency movements, the EAFE index’s loss was just -1.47% in US dollars. (Index returns: MSCI Barra. Currency rates: Yahoo! Finance)

As investors shied away from risky assets during July, higher-quality assets like US Treasury securities enjoyed price increases. This flight to quality drove yields on US Treasuries down by 20-30 basis points all along the yield curve. The yield on the 10-year Treasury fell to 4.78% from its June 30 level of 5.03%. The two-year yield also fell, ending the month at 4.56%, down from 4.87% a month earlier. As a result of this rally in bonds, the Lehman US Aggregate bond index returned +0.83% for the month. (Index returns: Lehman Brothers. Treasury yields: US Treasury)

After a seesaw first quarter with a strong ending, US equity markets marched higher in April and May. On May 30, the S&P 500 closed at a record high, finally regaining the level of the previous record, on March 24, 2000. A brief spike in interest rates, along with an increasing awareness of investment risks associated with funding sub-prime mortgage loans, arrested the rally in early June, and while the market recovered somewhat toward the end of the month, the S&P’s return for June was negative. On balance, though, the second quarter was strong, and the S&P 500 returned +6.28%. For the first half of 2007, the index returned +6.96%. While the market’s strength was broad-based, large stocks performed better than mid- and small-capitalization issues, and growth out-performed value. For the quarter, the S&P Mid-cap 400 returned +5.84%, and the Small Cap 600 returned +5.18%.

Interest rates fluctuated significantly during the quarter, ending well off their highest levels of the quarter, but still significantly higher than three months earlier. The yield on the 10-year US Treasury note rose to 5.03% at June 30 (it had reached 5.26% on June 12), up from 4.65% on March 31. The two-year yield also rose, although not so sharply. It ended the quarter at 4.87%, having been at 4.58% on March 31. The yield curve is still fairly flat, but the difference in yield between tens and twos is now 0.16%, more than it has been since the curve flattened dramatically, and then inverted slightly, at the end of 2005. With the general increase in rates, bonds had a weak quarter, with the Lehman US Aggregate Bond index returning –0.52%.

International equities shared the broad strength of US stocks. Measured in local currencies, the MSCI Barra EAFE international equity index (with dividends, net of local taxes) returned +5.92%. The US dollar strengthened somewhat against the Japanese yen, rising to 123.17 from 117.675 yen at March 31. In contrast, the dollar lost ground relative to European currencies. It fell against the euro ($1.3543 to the euro on 6/30 from $1.3355 to the euro on 3/31) and the pound Sterling ($2.0094 to the pound on 6/30 from 1.9677 to the pound). Sterling had not been above $2 since 1981. With these and other currency movements, EAFE in US dollars returned +6.40% for the quarter.

Interest rates took center stage during June, as yields on the 10-year US Treasury note jumped from 4.90% on May 31 to as high as 5.26% on June 12, before easing back to 5.03% at the end of the month. Apparently in reaction, but in any case at the same time, US equity markets pulled back from their recent strength. The S&P 500 index fell by around -2.4% between May 31 and June 12, before recovering a bit during the second half of the month. For the full month, the S&P 500 fell by -1.66%. Even so, its return for the full quarter was +6.28%. The Midcap 400 index returned -2.18% (+5.84% for the quarter), and the Small Cap 600 -1.64% (+5.18% for the quarter). Growth stocks performed better than value in all capitalization ranges for the month and for the quarter. (Stock index returns: Standard & Poors; 10-year yield: US Treasury)

International equity markets were also a bit soft, but not so soft as the US market. In local currencies, the MSCI Barra EAFE international equity index returned -0.26% for the month, bringing the quarter’s return to +5.92%. The US dollar continued to trade mixed against other major currencies. The dollar strengthened against the Japanese yen, rising to 123.17 on June 30 (from 121.73 on May 31 and 117.81 on March 31). It eased a bit against the euro and the pound Sterling. It moved to $1.3543 against the euro (from $1.3454 on 5/31 and $1.3355 on 3/31), and $2.0094 against Sterling (from $1.9794 on 5/31 and $1.9677 on 3/31). The net result of all the movements was to bring the US dollar return on EAFE to +0.12% for the month, and +6.40% for the quarter. (International equity index returns: MSCI Barra; currency exchange rates: Yahoo! Finance)

Not only did the yield on the 10-year Treasury note rise, but the overall shape of the yield curve also changed significantly during the month. The ten-year yield rose to 5.03% from 4.90% on May 31 and 4.65% on March 31. The yield on the two-year Treasury, on the other hand, fell to 4.87% on June 30, from 4.92% on May 31 (it was 4.58% on March 31). So on June 30, the ten-year yielded 0.16% more than the two-year, a change from May 31, when the two figures were just about the same (the two-year was actually 0.02% higher). The yield curve still isn’t exactly steep, but after its pivot this month its shape is now closer to normal than it has been for about the last eighteen months. Overall, the Lehman US Aggregate Bond Index lost ground, returning -0.30% for the month and -0.52% for the quarter. Longer-term bonds are generally more sensitive to interest rate changes than shorter-term bonds, so the rise in the ten-year yield outweighed the decline in the two-year yield in terms of the performance of the bond index. (Treasury note yields: US Treasury. Bond index returns: Lehman Brothers)

Equity markets continued to perform strongly during May, turning in nearly uninterrupted gains for the month, only pausing as if for breath here and there. The S&P 500 index returned +3.49% for the month, bringing its year-to-date total to +8.76%. The strength has accompanied reasonably stable, but not especially strong, economic data, and seems in some measure to reflect a high level of merger and leveraged buyout activity in the market. In any case, the S&P 500 ended the month at 1530.62, a record close. Mid- and small-cap stocks performed even more strongly, with the S&P Midcap 400 returning +5.01%, and the Small Cap 600 returning +4.60%. Value outperformed growth by a bit in the large cap arena, but growth did somewhat better among mid- and small-caps. (Returns and levels: Standard and Poors)

Once again, international equity markets participated in the general strength, with the MSCI Barra EAFE international equity index returning +3.20% in local currencies. This month, however, the US dollar reversed course and rose against the yen, euro, and pound Sterling. The strength of the dollar trimmed international equity returns for US investors, and EAFE returned +1.76% in US dollars (+10.62% year-to-date). The dollar rose to 121.729 yen from 119.56, and strengthened to $1.3454 against the euro (from $1.3652) and to $1.9794 against the pound (from $1.9992). (Index returns: MSCI Barra; currency rates: Yahoo! Finance)

Interest rates rose markedly, by around +0.30% across the yield curve, during May. Specifically, the yield on the ten-year US Treasury note ended the month at 4.90% (up from 4.63% at the end of April), while the two-year yield rose to 4.92% (from 4.60%) and the five-year yield rose to 4.86% (from 4.51%). Bond prices move inversely to interest rates, and as a result the Lehman US Aggregate Bond index returned -0.76% for the month, bringing its year-to-date figure down to +1.27%. (Index returns: Lehman Brothers; Treasury yields, US Dept of the Treasury)

After a sharp recovery at the end of March, markets continued to move upward during April. You may have seen or heard headlines about the progress of the Dow Jones Industrial Average, now above 13,000 for the first time. In fact, the market as a whole moved steadily higher throughout the month, giving back a bit on April 30. The S&P 500 index returned +4.43%, an excellent figure for a single month. In fact, large stocks led the advance, so while mid- and small-capitalization stocks also had nice returns, they did less well. The S&P Midcap 400 index returned +3.04% for April, and the Small Cap 600 index returned +2.23%. Growth stocks out-performed value stocks in all capitalization ranges. (Index returns: Standard & Poors)

International equity markets also advanced. The MSCI Barra EAFE international equity index returned +2.90% in local currencies. The US dollar was mixed against its overseas counterparts, advancing against the Japanese yen but declining further against the Euro and pound Sterling. The dollar ended April at 119.56 yen, $1.3652 against the Euro, and $1.9992 against Sterling. At the end of March, the dollar stood at 117.81 yen, $1.3355 against the Euro, and $1.9677 against the pound. (Index returns: MSCI Barra. Currency rates: Yahoo! Finance)

Interest rates fluctuated during the month, rising at first and then falling back near the levels at which they started. The yield on the 10-year US Treasury note ended April at 4.63% (from 4.65% on March 31), while the two-year ended at 4.60% (from 4.58% on March 31). The Lehman US Aggregate Bond Index returned +0.54% for the quarter. (Index return: Lehman Brothers. Treasury yields: US Treasury)

For the first several weeks of 2007, equity markets appeared set to continue the strength with which they ended 2006. On February 27, however, after a –9% overnight drop in the stock market in China, US markets fell by around –3.5%, wiping out the early-year gains. For the next six weeks or so, market talk revolved around overextended markets in China; the yen carry trade (a popular, leveraged investment position involving borrowing at low rates in Japanese yen and investing at higher rates in other currencies); and the parlous state of sub-prime lenders in the US. The drop called attention, in other words, to a number of markets in which investors were suddenly a bit extra nervous about the risks they had taken in pursuit of returns. The jitters persisted until March 21, when the Fed Open Market Committee announced its decision to keep its Fed Funds interest rate target unchanged. The announcement contained language that market participants generally regarded as reassuring on both inflation and economic growth, and the market found some welcome stability. After all the talk and all the action, the S&P finished the first quarter with a return of just +0.64%. Mid- and small-capitalization stocks were stronger. For the quarter the S&P Midcap 400 index returned +5.80%, and the Small Cap 600 index returned +1.68%. The mid-cap range appears to be the favorite fishing grounds of private equity investors, which perhaps accounts for their strength. [Index returns: Standard & Poors]

As often happens in times of equity market distress, the bond market rallied strongly (interest rates fell) in February, but that rally was really just a break in an otherwise steady upward creep in rates. Overall for the quarter, the yield on the 10-year US Treasury note fell just a bit, ending March 31 at 4.65%, compared to 4.71% on December 31. The two-year yield fell more convincingly, however, ending March at 4.58%, down from 4.82% at the end of 2006. Because the two-year yield fell so much further than the ten-year, that part of the curve is no longer inverted — tens now yield more than twos. Mostly because of February, bonds had a good quarter, with the Lehman US Aggregate Bond index returning +1.50%. [Index returns: Lehman Brothers; interest rates: US Treasury]

International equities were broadly stronger than US stocks. Measured in local currencies, the MSCI Barra EAFE international equity index (with dividends, net of local taxes) returned +4.15%. The US dollar weakened somewhat against the Japanese yen, falling to 117.675 yen at March 31, from its 12/31/06 level of 118.95. The dollar also slipped a bit against European currencies. It fell against the euro ($1.3355 to the euro on 3/31 from $1.320 at 12/31) and the pound Sterling ($1.9677 to the pound on 3/31 from $1.959 on 12/31). With these and other currency movements, EAFE in US dollars returned +4.08% for the quarter. [Index returns: MSCI Barra; currency rates: Yahoo! Finance]

After equity markets took a bit of a heart-in-the-throat dip toward the end of February, they began March on an uncertain footing, with participants looking to news about the sub-prime mortgage market, corporate earnings, Fed policy — just about anything, really, that could give the market a sense of direction. In this environment, the market began the month by drifting lower. It finally received a welcome lift on March 21, when the Fed Open Market Committee (FOMC) released its statement announcing its expected decision to keep the Fed Funds target at 5-1/4%. Investors found the language conciliatory enough on inflation and reassuring enough on economic growth that the S&P 500 index jumped 1.7% that day. The market received subsequent comments by Fed Chair Ben Bernanke as a bit less hopeful, and so gave back some of that gain. At the end of this volatile month, the S&P 500 had gained +1.12%, restoring the index to the positive column for the year, with a tepid year-to-date return of +0.64%. Mid- and small-capitalization stocks performed better, with the S&P Mid-cap 400 returning +1.35% for the month and +5.80% year-to-date, largely on the strength of leveraged buyout (now called private equity) activity, and the Small-cap 600 returning +1.68% for the month and +3.61% year-to-date. (Source of stock market returns: Standard & Poors)

International stocks continued to show strength. The MSCI Barra EAFE international equity index returned +2.05% in local currencies, bringing its return to +4.15% for the quarter. The US dollar slipped a bit against major currencies, falling to 117.675 yen from 118.120 on 2/28 (and 118.95 on 12/31/06); to $1.3355 against the euro from +1.3215 on 2/28 ($1.320 on 12/31/06); and $1.9677 against the pound Sterling from $1.9592 on 2/28 ($1.959 on 12/31/06). As a result, the EAFE index returned +2.55% in US dollars, for a year-to-date figure of +4.08%. (EAFE returns: MSCI Barra; currency exchange rates: Yahoo! Finance)

With the FOMC holding interest rates steady but commenting on prospects for both inflation and economic growth, the bond market reacted in a fashion unusual for recent months. Short-term rates fell, and long-term rates rose. This movement undid the slight inversion in the US Treasury yield curve we have seen for the past several months. The yield on the two-year US Treasury note fell to 4.58% from 4.65% (2/28). It’s down from 4.82% on 12/31/06. The five-year yield held about steady (4.54% 3/31, from 4.52% 2/28 and 4.70% on 12/31/06), while the ten-year yield rose to 4.65% from its 2/28 level of 4.56% (it stood at 4.71% on 12/31/06). With yields on the long end of the curve rising, price changes in the Lehman US Aggregate Bond index just offset coupon income, and that index return for March was 0.00%. The index is up +1.50% year to date. (Treasury yields: US Treasury; bond index returns: Lehman Brothers)

Going into the last week of February, equity markets appeared headed for a modest continuation of the strength they had displayed in the latter part of January. But on Tuesday, February 27, markets around the world fell sharply. The consensus view is that the spark for the downward pressure was a one-day drop of -9% or so in Chinese equity markets, which certainly appeared to propagate through markets around the world for the rest of the day. (By an accident of history and geography, the placement of the International Dateline means that any given market day begins in Asia and Australia, moves on to Europe and the UK, and ends in the US. Not long after the New York market closes, Tokyo opens again — for the following day.) In addition, the Japanese yen rallied sharply on Tuesday, rippling through markets in an indirect fashion. The issue here is what you may have read about as the “yen carry trade.” The idea is that interest rates in Japan have been so persistently low (much lower even than in the US) that many traders have sought to profit by borrowing cheaply in yen and investing in assets denominated in other currencies, including the US dollar. Repaying the yen they’ve borrowed becomes more expensive when the yen rallies, so the carry trade becomes less attractive. As a result, it appears that many traders that had been engaged in the yen carry may have sold US dollar assets on Tuesday in an effort to unwind part of their exposure to a rising yen. Also on Tuesday, former Fed Chair Alan Greenspan suggested in a speech that he sees a reasonable chance of a mild recession in the US in the not-too-distant future. The markets, already disposed to fall after the downward move in China, may have taken a further signal from Mr. Greenspan’s remarks. In the end, the Dow Jones Industrial Average fell by -416 points on Tuesday. The Dow, NASDAQ, and S&P 500 indices all fell around -3.5% that day. 416 points is a satisfyingly large number if you’re a headline writer, and a one-day move of -3.5% is enough to make anyone in the markets take notice. But the markets stabilized nicely the next day. The S&P 500 finished the month with a loss of -1.96%. For the first two months of the year, the S&P 500 is off by -0.47%. During February, value stocks performed somewhat better than growth stocks except in the small-cap range, and both mid- and small-cap stocks did better than large ones. The S&P Midcap 400 index returned +0.73% (+4.39% year to date), and the Small Cap 600 index returned -0.54% (+1.51% year to date). (Source for index returns: Standard & Poors)

International stocks followed the same general pattern as US stocks, and the MSCI Barra EAFE international equity index returned -0.52% in local currencies. But currency movements, particularly in the yen, boosted returns for US dollar investors, and EAFE returned +0.81% in US dollars. The dollar slid against the yen, falling to 118.55 yen from its 1/31 level of 120.71. It also fell against the Euro, with that currency commanding $1.323 on 2/28, against $1.3028 on 1/31. The dollar was about flat against the pound Sterling, firming to $1.9638 (2/28) from $1.9647 (1/31) against that currency. (Source for index returns: MSCI Barra. For currency rates: Yahoo! Finance)

As often happens when nervousness pervades equity markets around the world, US Treasuries had a good day on Tuesday, and the US bond markets showed strength for the month. On February 27 the yield on the 10-year Treasury fell from 4.63% to 4.50% as Treasuries caught a flight-to-quality bid (remember that the sharp drop in yield corresponds to a sharp rise in prices — right around +1% on the 10-year Treasury on 2/27). The Lehman US Aggregate Bond index returned +1.54% for February (+1.50% year to date). For the full month, the yield on the 10-year Treasury fell to 4.56% on 2/28 from 4.83% on 1/31. The yield on the two-year Treasury fell to 4.65% from a 1/31 level of 4.94%. (Source for interest rates: US Treasury. For index returns: Lehman Brothers)

The markets began 2007 slowly, moving sluggishly around a narrow range until the very end of the month. Through January 29, the S&P 500 index moved up just +0.26% on mixed economic news and fairly good, but not great, corporate earnings reports. Market participants also seemed skittish ahead of the Federal Open Market Committee meeting on January 30-31. As anticipated, the FOMC once again kept its target Fed Funds rate unchanged at 5.25%, but the Committee’s statement announcing the decision was surprisingly conciliatory, both in terms of prospects for economic growth and for inflation. Markets reacted well to the statement, boosting valuations in the last two days of the month, and the S&P 500 ended January with a gain of +1.51%. Mid- and small-capitalization stocks performed even better; the S&P Midcap 400 index returned +3.63%, and the Small cap 600 returned +2.06%. The value-growth picture was mixed: Among large caps, value out-performed growth, but mid-cap growth performed better than mid-cap value, while small cap growth and value were about equal. (Source of returns data: Standard & Poors)

International equities also continued their string of gains. The MSCI Barra EAFE international equity index returned +1.85% in local currencies. As market opinion has shifted toward the view that the Fed will remain firm on interest rates for a while, the US dollar has gained some strength, especially against the yen, which seems likely to continue in a low interest rate environment for some time. The dollar strengthened to 120.71 yen (from 118.95 at 12/31/06). It also strengthened to $1.3028 against the euro (from $1.320), but it eased just a bit against the pound Sterling, to $1.9647 (from $1.959). Because of the currency movements, the EAFE index returned just +0.68% in US dollars. (Source of EAFE returns: MSCI Barra. Source of currency rates: Yahoo! Finance)

The accumulation of economic news led to a general increase in interest rates during the month. Treasury yields rose by about +0.12% over the entire yield curve. The two-year Treasury yield rose to 4.94% (from 4.82% 12/31/06), and the ten-year yield rose to 4.83% (from 4.71% 12/31/06). The rising rates lowered bond prices, and the Lehman US Aggregate bond index returned -0.04% for the month of January. (Source of Treasury yields: US Treasury. Source of bond index return: Lehman Brothers)