Economic and Market Commentary Period ending September 30, 2006

The third quarter started off with financial markets near their 2006 lows. During the quarter several factors turned the markets around.  The two most important themes for the quarter were lower oil prices and reduced inflation fears.  Strong economic growth in the first quarter gave way to slower economic growth in the second quarter (an annualized rate of 5.6% for the first quarter versus an annualized rate of 2.6% for the second quarter[1].  Meanwhile lower commodity prices, particularly oil prices[2]. further reduced concerns about inflation.  The Federal Reserve added to the positive environment by not raising short-term interest rates during the quarter, their first pause in two years of steady rate increases.

The stock market rally saw a shift in leadership, as the emphasis shifted away from smaller companies toward larger capitalization blue chip companies.  Gains were seen in real estate investment trusts, utilities, telecommunication and financial sectors.  Concerns over slower economic growth resulted in falling commodity prices, which left oil and natural resource companies with losses for the quarter.[3]

Declining interest rates and continued corporate earnings gains, although slower than in past quarters, had a positive impact on both the stock and bond markets.  For the quarter, with long-term interest rates declining and long-term bond prices rising, all of the bond funds (Dimensional One-Year Fixed Income, Dimensional Two-Year Global Fixed Income and Dimensional Intermediate Government) produced positive returns for the quarter.  The Dimensional Real Estate fund was the clear leader for the quarter, while among the US stock funds, Dimensional US Large Company saw the largest gain.   Dimensional U.S. Large Cap Value was underweight in some of the best performing sectors including Utilities and Financials and underperformed its benchmark this quarter, as did the Dimensional US Small Cap Value fund, although both are leading their respective benchmarks year-to-date. In addition, US Small Cap Value has significant exposure to micro-cap stocks, which was the worst performing capitalization segment this quarter. 

A similar picture emerged in the international funds, with Dimensional International Value outperforming the Dimensional International Small Cap Value fund for the quarter and as a consequence for the year-to-date as well.  Dimensional Emerging Markets Value fund nearly equaled the International Value return for the quarter.  With the third quarter gains, all of the Elliott Cove Portfolios have nice gains year-to-date and the Moderate, Aggressive and All Equity Portfolios have beaten the S&P 500 Index year-to-date. 

The third quarter quick positive turnaround just serves to emphasize the point that it is important to remember that the Elliott Cove Portfolios have been developed for long term investing and short-term market timing can result in missed opportunities.  Within any market cycle there will inevitably be periods of volatility and negative returns as the market reacts to short-term negative economic news.  Longer term, the strength of the financial markets depends on the strength of the economy and currently, the economy, while showing signs of slowing, is still growing at a comfortable pace.