Oppenheimer Capital 3Q07 Market Review

Heightened turmoil in the housing and credit markets during the third quarter rattled equities, but stocks bounced back in mid-September when the Fed cut its target overnight lending rate by 50 basis points to 4.75%. The broad U.S. market, measured by the S&P 500 Index, ultimately gained 2.0%. Economic growth reaccelerated in the second quarter and appears to have remained strong in the third. It has been sustained by a continued strong consumer, but we expect consumer weakness and a slower economy over the next four quarters.

Eight sectors advanced during the third quarter with energy continuing to lead the broad gains. The sector continues to benefit from solid demand globally and the market’s lagging response to energy prices and profitability that are higher on a secular basis. Technology and industrial stocks also outperformed, benefiting from strong capital spending and global economic strength. Consumer discretionary stocks declined in response to growing market concerns about a consumer pullback as the economy slows. Financials also fell, pressured by credit concerns and a liquidity crisis.

Year-to-date, energy and materials have led all sectors. Telecoms, industrials and technology companies also have considerably outperformed the broad index, which was restrained by weakness in consumer discretionary stocks and financials.

Large-caps advanced during the third quarter while mid-and small-caps declined. The 2.0% return for large-cap stocks (S&P 500 Index) outperformed mid-caps' -0.4% (Russell Midcap Index) and small-caps' -3.1% (Russell 2000 Index) returns. Year-to-date, mid-caps and large-caps have performed in line, returning 9.5% and 9.1% respectively. These returns top small-caps' 3.2% gain through nine months. Also during the quarter, growth stocks widened their margin of outperformance over value issues. Growth stocks returned 4.2% (Russell 1000 Growth Index) during the third quarter while value stocks declined, returning -0.2% (Russell 1000 Value Index). Year-to-date, growth stocks have returned 12.7% versus value stocks' 6.0% climb.

Treasuries posted their highest quarterly return in five years as the yield curve continued to show signs of normalizing and short-term yields plunged. The 3-month U.S. Treasury-bill fell to 3.82% from 4.82% in June, while the 30-year Treasury-bond dropped to 4.83% from 5.12% in June. The 2-year Treasury-note declined to 3.97% by quarter-end (versus 4.87% in June) and the 10-year T-note fell to 4.59% (versus 5.03% in June). Oil prices continued rising during the third quarter to $82 per barrel, up from $70 a quarter ago and $61 at the beginning of the year.

Data as of September 30, 2007. Data source: FactSet

Economy
GDP growth during the second quarter reaccelerated to a 3.8% annualized pace, up considerably from the 0.7% first-quarter rate. Non-residential construction was strong and a weaker dollar boosted exports. However, lurking amid the aforementioned strength was the continued housing slump, which has weighed on economic growth for the trailing six quarters and may continue doing so–perhaps more dramatically–in the coming quarters.

The lagging effect of 17 consecutive interest rate hikes continued to depress increases in consumer prices. Most inflation metrics are now around or below the Fed’s target 2.0% threshold. Core-CPI, which excludes volatile food and energy prices, rose at a 2.1% annualized pace in August as home starts and consumer prices dropped. Headline inflation for all items declined to a 2.0% year-over-year clip as food prices rose and auto prices fell.

Earnings
Corporate earnings were stronger than expected during the second quarter, growing at a 9.0% year-over-year rate and topping earlier estimates of 4.4% annualized growth. We believe that third-quarter earnings will continue to exceed expectations, due in part to a continued strong consumer. However, earnings growth during the fourth quarter and first half of 2008 are likely to weaken.

As measured by the S&P 500 Index, the stock market is currently trading at 15 times projected 2008 operating earnings. We view the market as being modestly undervalued, given the now brighter prospect for low inflation and low interest rates.

Outlook
A liquidity crisis coupled with ongoing concerns in the housing and credit markets rattled investors during the third quarter and threatened to slow the economy significantly or push it into a recession during the next four quarters. The Federal Reserve reacted to reduce the odds of a severe economic slowdown and inject liquidity into the system, providing easier access to credit. Housing starts and prices continue to plunge, and in the coming quarters we expect to see the spillover effects into housing employment and consumer spending, both of which are likely to weaken. Despite apparent strong economic growth during the third quarter, we expect GDP growth to slow during the fourth quarter and into the first half of 2008 as housing begins to wear on the economy more dramatically.

While the odds of a recession have increased further, we continue to believe that the most likely scenario is a mid-cycle slowdown. A strong global economy continues to mitigate the drag from housing, and the sharp dollar depreciation has sparked higher exports and fewer imports. Other factors such as inflation, which seems to have come under control as a result of 17 consecutive Fed rate hikes, and crude oil, whose higher prices likely represent a permanent structural change that has been largely absorbed by the economy, do not pose significant threats to economic growth at present.

Liquidity crises are historically short-lived and we expect the current environment to normalize by the end of October. It could be a few years before the housing market rebounds, but we do expect it to trough during the first half of 2008. Our biggest risk at present is housing wearing on economic growth worse than we expected and having a prolonged negative impact on employment and consumer behavior. We have been encouraged, however, by the Fed’s actions thus far and do expect further rate cuts through mid-2008 as housing slows the economy. Although the ramifications of these factors include the potential for a sideways market in the coming quarters, our research indicates potential for substantial equity returns once the economy has slowed and it becomes clear to the market that a recession is no longer required.