Smart401k Blog

Value funds have not had nearly the year so far that growth funds have, though with a gain of 7% large cap growth has been able to outpace both small and mid-cap value funds. Since many of the traditional defensive stocks fall in the large cap value category, the market volatility and the threat of recession has helped buoy this group.

With continued high oil prices, it’s not surprising that the oil majors in the group such as ExxonMobil, Chevron, and ConocoPhillips have bolstered the year-to-date performance of the large cap value funds. These stocks are up 23%, 30%, and 24%, respectively. Companies related to oil production such as Halliburton have also had a strong year so far.

Though technology names typically make less of a showing in value funds than growth funds, large cap value has seen some spillover from the strength in technology this year. Year to date IBM and AT&T are both up 22%, while Texas Instruments has gained 28%.

On the downside, large cap value funds do have significant exposure to the weakness that has hit the financial sector due to the housing and credit market problems. American International Group, JPMorgan, and Bank of America are all down single digits for the year, and Citigroup has lost 13%.

By: Matt Koppenheffer for Smart401k.com

Having already discussed what the Federal Reserve and Federal Open Markets Committee (FOMC) are and what they do, let’s take a look back at what the FOMC did this week and what it means for the financial markets.

The Federal Reserve’s Take

In short, the FOMC decided to cut its Federal Funds Rate target 50 basis points (0.5%) from 5.25% to 4.75%. Not only is it significant that the FOMC cut rates, but the size of the cut is also meaningful. But first, let’s take the FOMC’s statement in parts (the text of the FOMC’s statement will appear in italics).

Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.

If you’re anything like me, when you start feeling sick, you don’t wait for a full-blown flu to set in before you start guzzling water and upping your vitamin C intake. In other words, you try to head off the sickness before things get too bad.

This is exactly what the FOMC has said here. Economic growth was still OK through the beginning of the year, but they saw the potential of tight credit markets (a fever) to intensify the housing correction (bad chest congestion). They hope that a rate cut (a lozenge) will help ease the situation enough that the housing correction can take place without causing a recession.

Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

As I discussed in the overview of the FOMC, when the FOMC lowers its targeted Federal Funds Rate, it buys government securities in the open market to pump more money into the system. A potential side effect of this action is an increase in inflation, as measured by indexes of consumer and business prices that the Fed watches. Here, the FOMC is asserting that so far this year inflation has been kept under control, and so there is not an imminent worry of prices getting out of control.

Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

The final paragraph of the release more or less reiterates what the FOMC’s stance is and underscores the fact that it is ready to do more should the situation continue to deteriorate.

The Market’s Take

Though there was a reasonable-sized minority of market participants that were expecting a 50 basis point rate cut, the majority of the market was taken by surprise. Some people were expecting the Fed to continue to hold rates steady at 5.25%, while many others saw a 25 basis point cut — the typical “moderate” move for the Fed — as the most likely move.

The larger than expected rate cut was very well received by the market, as measured by the one day rise of nearly 3% in the S&P 500 index, and similar gains in the Nasdaq and the Dow. The reason for the jubilant reaction is that many believe the lower rates will do exactly what the FOMC said in its statement and ward off further economic disturbances. Some may even see this as a near-term solution to the trouble in the housing market.

But the rate cut was not without controversy. While many saw good logic in the Fed’s move, many others believed that the decision to cut rates created a “moral hazard” and would encourage speculators to take increasingly larger risks with the thought that the Fed would bail them out if things went poorly. On the extreme side of this argument are those that believe if anything the FOMC should have raised its target rate to further shake out the speculators.

The Long Term Investor

As a long term investor, the rate cut may be interesting to follow, but it should not have a major impact on your continued, steady investing. The last time the FOMC went from raising rates to cutting them was in 2001 when the Internet bubble was bursting. However, this does not necessarily mean that the markets are headed for a major tumble similar to then — in the mid and late 90’s the Fed also cut rates a few times, and that was in the middle of one of the greatest bull markets one could hope to see.

The worst case scenario for the long term investor would be for the Fed to take an extreme tactic of either cutting rates to the point where inflation became a major problem, or raising rates to the point where deflation actually became a risk. The ideal for us is for the Fed to take a cautious and measured approach to the situation that will steady the economy while keeping it on a sustainable long term growth path.

One of the top business headlines from the Associated Press at the end of the day on Friday read “Stocks Flat Ahead of Fed Meeting.” If you read any business news coverage over the past week, you may have noticed that many headlines were some variation on the theme of the approaching Federal Reserve meeting. Based on the amount of attention that the Fed gets in the news it’s obviously important, but let’s take a step back for a minute and take a look at what exactly the Fed does and why it’s important.

The Federal Reserve was established in 1913 to direct US monetary policy and helps keep the economy stable and running like a well oiled machine. Monetary policy refers specifically to the amount of money in the economy, and is important because the amount of the money available has a major impact on the interest rates that lenders charge.

Low interest rates tend to encourage borrowing and stimulate economic activity. While this is often a positive, low interest rates can also stimulate activity above the economy’s capacity and drive inflation. Inflation is a whole topic in and of itself, but when it is high and unpredictable it can have destabilizing effect on the economy and discourage economic growth.

So the challenge for the Fed is to adjust the US money supply so that the economy expands smoothly and at the same time maintains a low and stable rate of inflation. To do this, the Fed has three tools at its disposal: the discount rate, reserve requirements, and open market operations. Each of these tools allows the Fed to either increase or decrease the supply of money.

The most widely used and best known of these tools, open market operations, is controlled by the Federal Reserve entity known as the Federal Open Market Committee (FOMC). The FOMC has the ability to either buy government securities to increase the money supply or sell securities to decrease the money supply. The current policy of the FOMC is to set a target for the Federal Funds Rate and then buy and sell securities to try to pinpoint that rate.

Which brings us back to the news headlines and the importance of the upcoming Federal Reserve meeting. Typically, these stories refer to a meeting of the FOMC (there are eight at least eight FOMC meetings per year). At the FOMC’s meetings, the members, led by the Chairman of the Federal Reserve, discuss current economic conditions and decide whether there should be a change in the Federal Funds Rate target.

The current Federal Funds Rate target is 5.25% and it has been there since the FOMC’s meeting in July of 2006. The next Fed meeting is scheduled for tomorrow, and the turmoil that’s sprouted from the housing and credit markets have many expecting that the Fed will cut rates by a quarter or half percentage point to try to relieve some of the pressure.

Interpretations of what a rate cut would mean varies. Some believe that a rate cut would go a long way to help prevent the situation in the credit markets from escalating further and view a potential rate cut as a positive development. Others, though, focus on the fact that a rate cut — particularly one of a half percentage point — suggests that the Fed sees the problems as major threats to economic growth.

Of course, following tomorrow’s meeting we’ll have much more to analyze. So stay tuned for a look back at what the Fed had to say and what it means for the stock market.

For anybody that’s been following the financial news recently, you’ve likely noticed the upheaval in the real estate sector. We wanted to take the opportunity to explain how the downturn in the real estate sector may have affected your retirement plan and the market as a whole.

The real estate sector turmoil stems in large part from mortgage loans made during the market boom of the past few years. It turns out that some mortgage products that seemed to offer greater flexibility and accessibility offer little more than poor underwriting. Hot areas of the country where real estate seemed as if it couldn’t go down are now mired in a swamp of standing inventory of unsold homes.

The way that all of this finds its way into the stock market is apparent in some respects and less so in others. The most obvious effect is on the homebuilders who until recently couldn’t put roofs over buyers’ heads quickly enough to satisfy demand. Now, many builders are sitting on large levels of unsold inventory and in a number of cases are curtailing further development. In addition, the buyers (such as commercial banks and insurance companies) of the loans used to finance the real estate boom have had to decrease the value of loans on their books due to the rise in foreclosures and defaults.

Looking out a bit further, the real estate problems have the potential to fan out into other sectors via consumers that find themselves much more reluctant to spend money as freely as they have during the past several years. The perception of wealth created through a rising real estate market, as well as the actual cash that homeowners took out through home equity loans, helped grease the wheels of consumer spending. In simple terms, when people feel that they are wealthier, they tend to spend more.

The decline in real estate values has the potential to reverse this effect. As people feel the value of their house declining and are less able to finance spending through home equity withdrawals, they may be less likely to spend as much as they have over the past few years.

As a major component of overall spending in the US economy, a decline in consumer spending can have a significant impact on the economy. Over the coming months, economists, investors, and policy makers alike will be closely watching for signs of expanding economic weakness created by the problems in the housing market. As new data comes out for these groups to evaluate, it is very likely that the market will continue to see high levels of volatility.

The economy and stock market are highly complex mechanisms though. Similar to a biological organism, these systems have many interacting, moving parts that can and do rapidly change course and create outcomes that the consensus didn’t expect.  For instance, in the late spring of last year the market hit a rough patch and fell nearly 8% by mid-June. At the time, many said that it was time for the market to “correct” after the gains of the preceding years. But instead of continuing downward, the market regained its footing in late July and proceeded to run up 25% over the next year. Investors that hit the panic button prematurely missed some great gains. This example certainly isn’t to suggest that investors should expect another 25% between now and this time next year. Rather, it’s a good illustration of the fickle nature of short term forecasts for where the market is going.

In a bigger picture view of the situation, what’s going on is fairly typical of the cyclical nature of the markets. From time to time over-excitement in one area ends up sewing the seeds for a future correction. Corrections tend to begin with the industry that was experiencing the excitement, but eventually ripple out to the rest of the economy and can affect many different industries.

The silver lining to any kind of market correction, large or small, is that they can be very beneficial to some investors. Specifically, investors that have a long term perspective and intelligently allocate their assets can be in a position to take advantage of the market’s pessimism and reap the rewards when the correction is over.

Drilling down a bit further, here’s a look at how some of the recent market action has impacted small cap growth funds.

Asset Class Focus: Small Cap Growth In these turbulent times growth funds in general have been holding up better than most and small cap growth has not been an exception. Prior to Friday’s sell-off, Morningstar reported that total returns at its small cap growth tracking index were 9.8% for 2007 versus 5.6% for the S&P 500 index.

As many of the financial institutions and major builders that have been dead center in this tumultuous market are too large for most small cap growth funds, this category has managed to miss a lot of the resulting declines. This isn’t to say that they’ve dodged the bullet completely, though. Smaller financial institutions like investment banks Jefferies Group and Thomas Weisel Partners have been caught in the same crosshairs as larger banks like Goldman Sachs and are down 8% and 35%, respectively, since the beginning of the year. Property manager CB Richard Ellis has also had a tough run and is off 24% since early January.

Meanwhile, both the consumer goods and technology sectors have positively impacted the performance of many small cap growth funds. Crocs, the largest component of Morningstar’s small cap growth index, has been on an absolute tear, posting a gain of 164% year-to-date. That familiar name-your-own-price travel website, Priceline.com, has similarly bolstered small cap growth performance by jumping 77% so far this year. Dick’s Sporting Goods, O2Micro, and Foundry Networks have likewise driven the performance of some of the top small cap growth funds.

By Scott Revare

I ran into some very interesting facts regarding past market pullbacks that I thought would provide a good investing perspetive for our customers.  Most of these facts were pointed out by Paul Lim in a recent NY Times article. First, we should define the two terms typically used when the market drops significantly - bear market and market correction.  A bear market is defined as a drop in the overall market of 20% or more.  (note:  the overall market is usually measured by the S&P 500 - made up of 500 widely held US Company stocks).  A market correction is a market drop of between 10% and 20%.  Sometimes the industry fudges a little and starts talking correction once we hit a 7% or 8% drop, but the point is, that its a fairly significant drop from a market high.  Here are a few facts for you on bear markets and corrections (brought to you by S&P):Bear Market Facts:

• Number of bear markets since 1928 (80 years):  23
• Number of bear markets since 1946 (62 years): 10
• Statistics for the last 10 bear markets:
  • Average market drop:  more than 33%
  • Average number of days to drop that amount: 490 - (15 months)
  • Average number of days for the market to recover back to the previous market high:  669 (22 months)

Market Corrections:

• Number of corrections since 1928: 87 - or more than 1 per year on average
• Number of corrections since 1946: 16 - or about 1 every 3 1/2 or 4 years
• Statistics for the last 16 corrections:
  • Average market drop:  15%
  • Average number of days to drop that amount: 148 - (less than 5 months)
  • Average number of days for the market to recover back to the previous market high: 111 (less than 4 months)

In looking at these numbers, we can draw a few conclusions:

1.  The market has recovered from all drops, but it recovers from corrections more rapidly than bear markets. Historically, the average time from the start of a correction to full recovery is typically less than 9 months.  But recently, it seems that recoveries from corrections are even quicker.  Paul Lim points out that there were three corrections in row in the late 90’s (97, 98, 99) in which the average recovery was only 51 days.  Our two last “mini” (6-8%) corrections of late spring 2006 and in February of this year had recovery times of just 1-2 months.

If we put the market recovery times in the perspective of our retirement accounts, and think (average) worst case in a bear market situation - the average time from the start of a drop to market recovery is a little over 3 years.  Which means that it pays for us to position our planning outlook to make sure we have 3 years to let our investments recover from a potential market drop.  If you can’t afford to wait 3 years, your risk tolerance (and hence your Smart401k allocation) should be more conservative.

2.  Market drops are more likely corrections than bear markets.  Since 1946, official rcorrections (10-19% drops in the S&P 500) have outnumbered bear markets 16 to 10.  When we factor in “mini” corrections(5-10%), that ratio is significantly higher.

3.  Believe it or not, last quarter’s drop was not ever quite enough to be awarded the official label of “market correction.”  Just using market closing values as the offical measure, the market has at most been down 9.4% (July-19th to August 15th).  If we count intraday pricing, the difference has hit 12% - but that doesn’t count in the official measurement.