Why wasn't this year's third quarter the catastrophe it could have been?. Ron Brounes is a certified public accountant and president of Brounes & Associates, a financial education, communications and strategic planning firm based in Houston, Texas.

Historically the summer months are bad for equity markets. This year, while investors and traders alike were working on their tan lines in the Hamptons, numerous key developments occurred at home and abroad that undoubtedly impacted the global economy and the markets. 

Market matters

Market/Index
2005 Close
2nd Qtr Close
3rd Qtr Close
Qtr Change
YTD Change

DJ Industrial
10,717.50
11,150.22
11,679.07
4.74%
8.97%

Nasdaq
2,205.32
2,172.09
2,258.43
3.97%
2.41%

S&P 500
1,248.29
1,270.21
1,335.85
5.17%
7.01%

Russell 2000
673.22
724.62
725.59
0.13%
7.78%

Fed funds
4.25%
5.25%
5.25%
0 bps
100 bps

10-yr Treas. (yld.)
4.39%
5.14%
4.63%
-51 bps
24 bps

So let's take a closer look and attempt to analyze how (and why) the markets played out this summer.

Survey of discontent

Geopolitics.North Korea defied all international warnings and conducted a nuclear missiles test in July, alerting that world that the Axis of Evil is still very much in the picture. A war broke out along the Israeli-Lebanese border, further threatening peace in this crucial region. A terrorist plot was uncovered in Great Britain that would have resulted in significant deaths over international waters.

Energy. During July, oil prices set a record of $78.50 a barrel, with the average price of unleaded gasoline moving above $3 a gallon. Corrosion and poor maintenance forced BP to shut down a portion of its Prudhoe Bay, Alaska, oilfield and limit production during the hot summer months.

General. Laptop computers assembled with Sony batteries began to overheat and prompted a major product recall at Dell, Apple, and other large computer makers. The housing sector continued its freefall as builders and retailers began to suffer negative repercussions in their earnings outlooks (and stock prices). Amaranth, a hedge fund, lost its investors $6.5 billion after making a wrong guess about natural-gas prices.

Corporate. As Enron's former CEO Andrew Fastow and Worldcom's former CEO Bernard Ebbers began serving time behind bars, new reports of corporate malfeasance emerged at Hewlett-Packard and elsewhere.

Domestic politics. Heading into the midterm election season, Republican House member Mark Foley resigned in disgrace over "morals" issues. The fallout from this could affect the political climate for years to come.

Bright side

One look at these negative third-quarter headlines would have caused even the most optimistic analyst to predict the worst for the markets. However, a closer look inside the news uncovers some positive signs.

After peaking in July, oil and gas prices began plummeting as the devastating hurricane season that was predicted never materialized and the Organization of Petroleum Exporting Countries (OPEC) kept production at relatively high levels. Chevron announced a major discovery in deep-water test that could enhance domestic reserves.

The Federal Reserve ended (or, at least, paused) the recent round of interest rate hikes after 17 consecutive increases, resulting in a collective sigh of relief from economists, investors, business leaders and consumers alike.

Significant transactions were announced during the quarter (HCA, AMD, Kinder Morgan, for example) that would seem to reflect a mood of growing confidence among corporate managers.

Though fears persisted, inflation remained relatively subdued with excellent prospects for the future given the recent drop in energy prices. Consumers remained upbeat about the months ahead (and a strong holiday shopping season) as the halt to rate hikes and lower gas prices left them a few extra bucks in their pockets.

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Investors took their clues from this confidence and pushed the markets to much higher levels. With inflation seemingly under control (for now) and the domestic economy expanding at a "reasonable" pace (second-quarter gross domestic product grew 2.6%), traders overlooked the sluggish housing sector and the geopolitical concerns and set their sights on new market highs.

And equity markets rewarded investors with their best third-quarter performance in nine years. In fact, as September came to a close, the Dow Jones Industrial Average stood just below its all-time high set in January 2000 and the S&P closed barely off its five-and-a-half-year high.

Despite the Sony battery recall and the Hewlett-Packard board scandal, techs performed well as the Nasdaq Composite posted strong returns. Through the smaller-cap Russell 2000 was comparatively subdued in the quarter, it was up by about 8% year to date. Health care (up 9.6%) led all sectors in performance with telecommunications (up 9.2%), technology (up 8.2%), and financials (up 7.2%) each experiencing stellar quarters.

Among the "losers," the energy sector declined by 2.6% during the quarter period as oil prices plunged from almost $80 to below $60 a barrel. In fact, analysts at Merrill Lynch downgraded the energy sector during the quarter to "underweight" as a result of the decline in commodity prices.

Trend is friend

Likewise, fixed income markets moved higher in the third quarter as investors clearly rejoiced at the (perceived) end of the Fed's interest rate hikes. While some Fed officials continued to run their mouths every few days about runaway inflation, the Beige Book and Fed minutes seemed to indicate that rates will not be moving higher for the foreseeable future.

In fact, many economists expect the next Fed rate action to be a cut. During the quarter, the yield on the 10-year treasury fell by over 50 bps to its lowest level in seven months. (Don't forget, there is an inverse relationship between the prices and yields of fixed income securities, so a drop in yields is positive for bonds.) The Lehman Aggregate Bond Index, the investment-grade bond benchmark, climbed by almost 4% during the third quarter.

Looking ahead, a few several things warrant close monitoring. With oil plunging over the past few months, OPEC will eventually act to stabilize prices (and keep their profits intact). Geopolitical developments remain a concern as events in Iraq, North Korea, and Iran could change the global landscape overnight. The mid-term elections could result in a shift in party leadership; while Republicans have long been perceived as more market-friendly, those Clinton years actually put a few bucks in investors' pockets.

And remember: the "trend is your friend." If the major equity indexes can make new (recent) highs and hold those levels, expect more investment nay-sayers and fence-sitters to shift views and join the bullish party. But, as the third quarter just proved, better late than never. -FWR

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