MARKET OVERVIEW

Stocks advanced in August amid light summer trading. The S&P 500 rose 1.4%, its third monthly gain since cresting at an all-time high last October. Falling energy prices, upwardly revised economic growth and hopes for a bottom in the housing bust lifted investor confidence.

The price of crude oil closed on August 29 at $115.46/barrel, down nearly 7% for the month and more than 20% below July’s record high. Cheaper energy should have the dual benefit of bolstering consumer confidence and dampening headline inflation. Meanwhile, the battered U.S. housing market showed signs of life. In July, existing and new home sales rose 3.1% and 2.4%, respectively, according to the National Association of Realtors and the U.S. Commerce Department. Also according to the Commerce Department, the U.S. economy grew faster than originally believed during the second quarter, expanding at a 3.3% annual pace rather than the initially reported 1.9%.

The Federal Open Market Committee assembled on August 5 and left lending rates at 2.00%. It was the second consecutive meeting ending without a change to the fed funds rate. Minutes from the meeting revealed a fusion of concerns over financial system frailties and inflation. Bankers agreed their next move would likely be a rate hike, but didn’t provide a timeframe.

Corporate earnings remain anemic. Thomson Reuters reports S&P 500 profits fell more than 22% during the second quarter of 2008. This marks a full year of falling profits, the longest such stretch since the technology bubble burst at the turn of the century. Financial firms produced the worst results, with profits sinking 93%. In dollar terms, that equates to $61.1 billion earned in 2Q07 and $4.0 billion earned in 2Q08. Profits among energy, consumer staples and technology companies grew, up 18%, 15%, and 14%, respectively, last quarter.

EQUITY UPDATE

STYLE AND MARKET CAPITALIZATION

Small-cap stocks chalked up a fourth consecutive month of outperformance versus mid- and large-cap stocks last month, the longest winning streak for the asset class since a six-month stretch shuddered to a close in August 2003. As measured by the Russell 2000 Index, small-cap firms have advanced five of the past six months, even as credit and consumer woes weigh on the broader economy. From a style standpoint, value outperformed growth a second month in August, the longest winning streak for value in sixteen months.

S&P 500 SECTORS AND INDUSTRIES

Wall Street’s August advance was paced by a 7.2% rally in the consumer discretionary sector, the category’s biggest gain in nearly five years. Retailing shares saw the best results, as investors bet falling energy prices would allow Americans to spend more money on other items. Shares in J.C. Penney, Dillard’s and Lowe’s spiked. Other corners of the market retrenched, led by losses among materials, utilities, financial and energy companies.

INTERNATIONAL EQUITY

Investors in foreign shares lost money a third month in August, matching their longest losing streak in more than five years. However, the retreat was more a matter of an appreciating U.S. dollar than falling stock prices, at least in Europe. The greenback bounced off a record low versus the euro in July, with a near 6% rally in August. Gains for the greenback equate to currency losses for U.S.-based investors in foreign stocks. Measured in local terms, European equities advanced last month. Currency effects had less of an impact in Asia, where stocks lost ground in both U.S. and local terms.

PERSPECTIVE

By Horacio A. Valeiras

THE SUMMER OF THE MARKET’S DISCONTENT

What a summer we have had. European markets bottomed mid-July and bounced, but we are now retesting those lows. Asia is plumbing new depths. With non-U.S. markets down 20-50%+ this year, what should we expect?

We still believe that the U.S. dollar has bottomed and has started a multi-year rise. Capital flows into non-U.S. markets have begun to show outflows after many years of inflows, as demonstrated by the most recent AMG data. Relative valuations of non-U.S. developed and emerging markets remain at historically high levels. Economic activity in Europe, Japan and Asia has been slowing sharply. As consumer staples analyst Greg Ise indicates in his article in this edition of At the Margin, European consumer sentiment is at a five-year low. Interest rates are still too high in Europe and the European Central Bank (ECB) shows no sign of caring about economic growth (which makes sense given their mandate to contain inflation). Because of these trends, the decline in corporate profits that started in the United States at the beginning of 2007 is emerging in other parts of the world.

We don’t see any of this changing until the ECB, Bank of England and all the other central banks realize that inflation will probably not be an issue twelve months from now and begin to reduce interest rates and normalize their yield curves. The banking system is as much in tatters outside the U.S. as it is here; the U.S. authorities have responded, the rest of the world has not. They better start doing so soon.