Once again, it was a disappointing quarter for U.S. stocks, as a spring rally fueled by investors' optimism that the worst of the financial crisis was over gave way to concerns about inflation, soaring oil prices and renewed fears about the ongoing credit crunch.
The Dow Jones industrial average, hurt by recent analyst downgrades of key companies such as General Motors and Citigroup, was down 7.4 percent for the quarter, after skirting bear market territory late last month. For the year, the Dow is off 14.4 percent, due in part to a first quarter in which the stock market had its worst performance in six years. The Standard & Poor's 500- stock index ended the quarter down 3.2 percent and is off 12.8 percent in the first six months of the year. The tech-heavy Nasdaq composite index was up 0.6 percent for the quarter but is down 13.6 percent for the year. Mutual funds that invest in stocks recovered slightly, ending the quarter up 0.13 percent. But the year-to-date picture is much bleaker, with diversified U.S. stock funds off 10.1 percent.
"The first half of the quarter . . . [was] fairly optimistic. It looked like the economy was firming up a bit and consumers were coming back," said Christopher Low, chief economist at FTN Financial. "Now, we've ended the quarter with a fairly tremendous burst of pessimism."
With oil prices escalating, home values dropping, foreclosures rising, and major financial institutions continuing to take write-downs, it is unclear when a wave of optimism will once again be warranted. "Certainly not in the third quarter, and not anytime soon," said Charles McMillion, president and chief economist of MBG Information Services, a District-based business forecasting firm.
There were few safe havens last quarter. From large-cap funds that invest in big companies to international stock funds, which have been touted in recent years as safer bets, most mutual fund categories have been in the red, if not for the quarter then for the year.
Since January, the hardest-hit funds have been financials, telecoms, real estate and consumer services. The best-performing ones have been commodities and natural resources.
Looking ahead, analysts said that would likely remain the case, at least through the next quarter. Some analysts said commodities have become too speculative and would not be able to sustain such returns. Others say commodities, gold, biotechnology, metals, mining, and oil are still the way to go, while financials and real estate are not.
"All of those stand the best chance of upside," said Mike Tarsala, managing analyst at Thomson Financial's Squawk Box, which provides market analysis. "They're all giving us the strongest trends."
In the second quarter, small-cap funds were slightly better off than large-cap funds, reversing results from the previous quarter. While shares of small companies tend to outperform their larger peers when the economy is headed toward recovery, analysts said it was unclear whether this trend would continue in the months ahead.
"I don't know why small caps are doing well. I would be reluctant to hop on them," said Mark A. Coffelt, president and chief investment officer of Empiric Funds.
Tom Winmill, manager of the Midas Fund, a gold mutual fund, also said large-cap funds were still more stable. "With the freeze on credit, it's harder for smaller companies to raise debt financing than it is for larger companies," he said. Coffelt said he would use new money coming into his fund to buy oil and commodity-related stocks when prices dip and keep the rest in cash.
"The only thing working in the stock market is anything related to commodities and oil -- and that is it," Coffelt said. "Tech's not working. It's very difficult to make money on industrials. Nothing in consumer discretionary is working. Nothing in financial stocks is working -- that's a complete disaster area. Every once in a while, people say, 'We've hit the bottom,' and they go in, and stocks go up a lot. But . . . I think the unwinding has a long ways to go because housing prices have not stabilized, and I'm not sure the banks have taken all the write-downs they need to take."
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So uncertainty lingers.
The Federal Reserve, which had tried to massage the economy into recovery with multiple interest-rate reductions, is now turning its attention to concerns about inflation.
Consumer behavior is also proving worrisome. Consumers fuel two-thirds of the U.S. economy but are beginning to retrench as the value of their homes falls and they have less access to credit. It's no wonder: A recent government report found that the prices Americans pay for a broad range of goods and services are up 4.2 percent over the past year. And the precarious job market is not helping.
Investors will get a clearer idea of how companies are faring in this environment as earnings reports trickle out this month. But already, there are signs of trouble at major institutions.
Lehman Brothers' shares were hammered as investors questioned the health of its balance sheet and feared another run-on-the-bank situation similar to the one that brought Bear Stearns to near collapse that required a federal bailout.
In the past several weeks, credit-rating firms downgraded Lehman and other Wall Street banks. Wall Street analysts further slashed these companies' already lowered earnings expectations. On top of that, Moody's downgraded the credit ratings of the two top bond insurers, raising the prospect of additional losses at financial institutions.
"Ultimately, our economy is built on credit, and I don't think six months was nearly enough time to fix the credit crisis and the banking system," said FTN Financial's Low, who said housing prices will stabilize and banks will have reported out their losses by year's end, setting up the economy for the path to growth in 2009.
Indeed, the past three months proved that more time is needed to work through the economy's troubles.
The quarter opened with the Dow jumping nearly 400 points in a single day as investors cheered a capital infusion at Lehman and decided billion-dollar write-downs at UBS and Deutsche Bank meant large financial institutions were finally 'fessing up to the losses they needed to take. Financials and broader markets then rallied despite abysmal quarterly results at such giants as Merrill Lynch and Citigroup.
Relative calm took hold in financial markets, with a range of markets for debt functioning better, thanks in part to the Fed's moves to restore confidence in the system. U.S. stocks recovered enough to climb close to their 2008 highs in early May. As some favorable data on consumers and retail came in, analysts began talking about avoiding a recession, which had seemed all but inevitable a few months before. But the relief proved short-lived as oil prices rose relentlessly, bringing inflation worries to the fore. High energy prices battered company shares, most notably airlines'. Then major investment banks reported abysmal earnings.
As at any time -- tumultuous or not -- market experts advise: Think long-term. "Let the logic take over instead of the emotional," said Christopher Burdick, director of economic analysis at Charles Schwab. "What we've seen in the past is it's so difficult to try to time the market. You have to be right twice, once when you sell and once when you buy."
Even with all the dark signals, not everyone is gloomy. Tarsala of Thomson Financial's Squawk Box sees evidence of an impending recovery for the U.S. market. He points to the Nasdaq and the Russell 2000 index, which measures small-cap companies. Both were up for the quarter, and neither has financials or home builders.
"To me, it's pointing to the fact that things outside of financials and home builders, they're bad but they're not terrible," he said. "This adds to our conviction that we are due for a bounce soon."
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