By Martin E. Landry, CFA, CFP®, CIMA® Senior Investment Analyst

After being modestly in positive territory for the quarter-to-date entering September, equities were suddenly confronted by an unrelenting gauntlet of negative developments, which were stunning in their size and pace and had profound implications for the capital markets. The government put Fannie Mae and Freddie Mac into conservatorship. The contours of Wall Street were re-shaped dramatically in a matter of days, with stand-alone investment banking business models crumbling amidst Lehman Brothers Holdings’ bankruptcy filing, Bank of America’s acquisition of Merrill Lynch, and Goldman Sachs and Morgan Stanley becoming commercial banks and raising capital with the help of Warren Buffett and Mitsubishi UFJ, respectively. American International Group (“AIG”) teetered on the brink of collapse before the Treasury intervened. The saga of Washington Mutual, a Seattle-based savings and loan hard-hit by sub-prime lending, ended abruptly as a result of its seizure by the government (its deposits were quickly purchased by JPMorgan Chase); thereby becoming the largest U.S. bank failure ever.

In this environment, equity market performance has been shaped and defined by periods of shock due to particular crisis events followed by hope that policymaker responses will bring the crisis to an eventual end. With that as a financial backdrop, stock market weakness was widespread and deep. For the third quarter, the broad U.S. equity market as measured by the Russell 3000® Index fell -8.73%, while the large-cap oriented S&P 500® Index plunged -8.37%. Hindered by a rising dollar, U.S. investors suffered a worse fate with their stake in international stocks. The MSCI All Country World ex-U.S. Index (Net), representing both developed and emerging international markets, slumped
-21.91% for the quarter.

An enormous amount of market capitalization and style differentiation characterized the quarter as a whole, although much of that separation occurred in September, which was an especially tumultuous month. Small capitalization equities were decisively the “place to be” for the entire quarter, topping their large capitalization counterparts by more than 8% (based on the Russell 2000® and Russell 1000® Index performance). Small-cap value (Russell 2000® Value Index) actually delivered positive performance – rising 4.96% during the quarter - buoyed primarily by revived stock price performance of regional banks and diversified financial services companies in the index. Within the U.S. large capitalization arena, value topped growth for the overall period, although style leadership fluctuated earlier in the quarter prior to value gaining the upper hand in September as financials performed relatively well and technology-related stock prices weakened considerably. The Russell 1000® Value Index and Russell 1000® Growth Index had total quarterly returns of -6.11% and -12.33%, respectively.

Concerned that the financial crisis will inevitably translate into economic downturn, materials, energy, and industrials led the market lower. By contrast, as might be expected, the relative safety of consumer staples and healthcare led these sectors to significantly outperform in the quarter. Amidst mounting evidence that a global economic slowdown was underway – particularly in regions such as Europe, Latin America, and parts of Asia – commodity prices slumped in response. The CRB Commodity Price Index (an arithmetic average of a wide array of commodity futures prices) fell about -30% during the quarter. Enormous volatility characterized the oil markets. After peaking in mid-July at nearly $150/barrel, oil prices dipped to just under $100 at quarter-end.

Compared with much of the rest of the world, however, the U.S. was a relative oasis. The MSCI EAFE Index (Net) and MSCI Emerging Markets Index, two well-known indicators of the performance of foreign stocks in developed and emerging markets, skidded -20.56% and -26.95%, respectively, in the quarter. From a regional perspective, returns were relatively tight, with the both the UK and Europe declining about -21%. Within Europe, market returns varied somewhat based on local issues. For example, Ireland (-42.2%) suffered the wrath of its own imploding housing market while Norway (-40.7%) stumbled due to its relatively high energy and materials exposure. Japan fared better than most major markets (only down -17.7%), primarily because of a stronger yen. However, the U.S. dollar surged over 10% against the euro.

After a rough second quarter, investments in public real estate companies, including REITS, provided a rare bright spot for the third quarter. The Dow Jones Wilshire Real Estate Securities Index rose 4.51%. This index remains down about -13% over the last twelve months.

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