International stocks led way during difficult period in '05.

As our nation's economy roars into 2006, resiliency is the current pervading economic theme. Most would agree that the third quarter proved to be a dramatic period on a number of fronts. The Federal Reserve continued to raise interest rates to battle inflation. Energy prices continued to surge.

Adding to this volatile mix, an unprecedented two hurricanes slammed the Gulf Coastal region creating significant damage. This damage was inflicted in both tragic human terms as well as economic impact. The Gulf region is, of course, home to a large portion of domestic energy production and refining capacity. As a result, the energy markets went on a wild post hurricane ride. Prices for crude oil, natural gas and gasoline all surged due to post-hurricane supply disruptions.

However, even against the backdrop of these tragic and unsettling events the strength of the U.S. and world economies was evident. As information began to be available as to the scale and impact of these events, investors grew more confident in the economy's ability to withstand them. U.S. stocks turned in solid gains during that period. The Dow Jones Industrial Average rose 3.4% for the third quarter. The broader S&P 500 Index increased 3.6%. Smaller companies did even better. The Russell 2500 Index, a measure of these small and mid-sized companies sailed to a 4.9% gain. The energy sector was certainly the standout. The energy sector performance was bolstered by these higher prices and rose 18.3% for the quarter.

International stocks were in a similar position. Rising energy prices were affecting overseas markets as well. Despite many predictions for a "falling dollar" the greenback actually rose significantly against the European currency. This represented a significant headwind for foreign equities. Like the U.S. markets, foreign markets rose in spite of the challenges. The MSCI EAFE. an index of foreign developed markets in Europe and Japan rose 10.4%. The Japanese market led the way. The Japanese economy, long mired in recession, was revived by election results that may hold hope for economic reform. The Japanese Nikkei 225 ran up over 15% on the quarter on these hopes.

Emerging markets

The highlight of the quarter could arguably be the emerging markets stocks. Despite many of the same concerns that plagued domestic and international equities, investors chose to look on the bright side. The Emerging Markets Index soared 18.1% for the quarter with notable strength in both Asia and Latin America. Emerging markets stocks, buoyed by optimism over China and globalization, are up 39.6% per year over the last three years. While prospects for growth on these markets are strong, this level of out-performance is certainly dramatic and is not likely to continue indefinitely.

Acting under pressure to contain inflation caused by rising energy prices and foreign demand the Fed continued to push short-term rates higher. Bond prices briefly rallied toward the middle of the quarter. Some expected that the Fed policy makers could slow or even halt the rise in short-term rates due to the impact of Katrina and Rita. These hopes were dashed as the Federal Reserve raised the discount rate for the eleventh time in September.

Bond prices eroded but losses were well contained. For the quarter, the longer maturity bond index fell 2.6%. The long bond index is still up 2.9% for the year to date. There were losses for the quarter for most segments of the fixed-income markets. The Lehman Aggregate, a broad measure of bond credits and maturities, edged down 0.7%. Treasury Inflation Protected Securities (TIPs) were unchanged for the quarter. Of all of the bond indexes only the high-yield index managed a modest gain of 0.9%.

The effect of the storms on future bond prices and economic growth is uncertain. As we have already seen, the disruptions can cause immediate supply imbalances that lead to inflation. It is also likely that there will be a decline in growth due to the idling of parts of the economy. These phenomena will likely prove temporary. As supply disruptions are cleared and the massive rebuilding begins economic forces should begin to normalize.

Richard Rojeck, CFP is Managing Director, Southern California region with Sagemark Consulting, a financial planning and investment advisory firm. He can be reached at [phone]