Quarterly Recap - 2011 Third Quarter

“Uncertainty driven volatility” was among the third quarter’s most cited market descriptors as global equities delivered one of their worst quarterly performances on record. The S&P 500 experienced no less than 19 sessions of 2% or more daily market moves during the third quarter compared to just one such occasion in each of the first and second quarters. Indeed, the U.S. broad market index saw eleven trading days of 2% to 3% plus or minus moves, two days of 3% to 4% moves, five days of 4% to 5% moves and one day with over a 6.6% decline. This as the CBOE VIX Volatility Index more than tripled within the quarter from a July 1st low of 15.8 to an August 8th high of 48.0 and ending the quarter at 42.9. What drove investors to such extreme divergence?

The quarter was marked by a sharp degradation in business and consumer confidence as Wall Street reacted to domestic challenges ranging from fires, floods, hurricanes and earthquakes to man-made disasters in Washington and Continental Europe. The U.S. narrowly avoided a Treasury default with a last minute debt ceiling increase and was hurt by the unprecedented loss of the pristine AAA credit rating by S&P. Additional uncertainties resulted from persistently high U.S. joblessness, the near stall out of global economic growth and the still-uncertain fate of the European debt crisis. Uncertainty fears drove investors to “de-risk” out of equities into traditional safer havens in Treasuries and precious metals. On the other hand, resultant low valuations at perceived bargain basement discounts provided the impetus to put the equity “risk-on” back into play.

From a 1,353 July 7th high through an August 8th 1,119 low, the S&P 500 saw a third quarter peak-to-trough loss of 17.3%, narrowly avoiding a formal -20% bear market designation. The third quarter’s August 8th low brought its year-to-date peak-to-trough loss to 17.9%, just 2.1% away from bear market status. The quarter ended on a down note with a 2.5% final day loss to 1,131, which extended the period’s overall negative return to 13.9%. It was the S&P 500’s worst quarterly performance since the fourth quarter of 2008. The index has fallen for five straight quarters, the longest losing streak since March 2008.

Among the ten major U.S. industry groups, only Utilities displayed positive quarterly performance, albeit just a +1.6% total return. Defensive sectors widely outpaced Cyclicals with Utilities, Consumer Staples and Healthcare delivering positive year-to-date returns of 10.7%, 3.4% and 2.5% respectively. Materials, a Cyclical industry, was the worst performing sector on the quarter, losing 24.5% on the global economic slowdown. A large number of ratings downgrades on leading U.S. banks helped make Financials the second worst performing sector for the quarter (-22.8%) and overall worst laggard on a year-to-date basis (-25.2%).

Outside the U.S., developed markets experienced even more dire results. Europe’s deepening sovereign debt crisis and China’s accelerating inflation to a three-year high contributed to 18.9% negative return on the quarter for the MSCI EAFE Index (Europe, Australia and Far East regions). With the euro currency at decade lows against the yen, eurozone leaders voted in a second bailout aid package to Greece and now debate plans to backstop financial contagion spreading to other troubled EU peripheral members, including Spain and Italy. Plans for a controlled Greek default are also being discussed. Emerging equity markets couldn’t escape the massive overhang, generating negative returns of 22.5% for the third quarter.

Safer-haven fixed income markets were again the quarter’s winning asset class over equities, but they too experienced intense volatility in both price and yield. Investors typically exit or trim positions in downgraded bonds, but not so regarding U.S. sovereign debt. Overall global market fears coupled with the QE2 stimulus expiration at the end of June and the Federal Reserve’s September 21st Operation Twist monetary policy announcement all served as catalysts to attract global investors to U.S. debt. Re-proving itself as the world’s reserve debt, the ensuing price rally inversely drove U.S. Treasury yields down to their lowest levels on record. The 10-year Treasury yielded a historic low of 1.7% on September 22nd before ending the quarter at 1.9%. The overall bond market, as measured by the Barclays US Aggregate Bond Index, generated a positive third quarter return of 3.8%.

Municipal Bonds extended positive performance for a third straight quarter. As measured by the Barclays Municipal Bond Index, this tax-favored asset class returned 3.8% in the third quarter. Municipal bond industry activity was marked by heightened levels of bond calls, asset class shifts to higher-yielding securities, and concerns over potential tax deductibility limits placed on the wealthy. High Yield Bonds ended a multi-quarter positive performance trend, ending the third quarter with a negative return of 6.1%, as measured by the Barclays US Corporate High Yield Index.

This information is compiled by Cetera Financial Group. No independent analysis has been performed and the material should not be construed as investment advice. Investment decisions should not be based on this material since the information contained here is a singular update, and prudent investment decisions require the analysis of a much broader collection of facts and context. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. All economic and performance information is historical and not indicative of future results. The market indices discussed are unmanaged. Investors cannot directly invest in unmanaged indices. Please consult your financial advisor for more information.

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