Thomas J. Steffanci, Ph.D., Announces Investment Opinion: Financial Market Third Quarter Review and Outlook.

CLAREMONT, Calif. -- Stocks registered respectable gains during the third quarter despite rising interest rates, surging commodity prices, destructive hurricanes and airline bankruptcies. The S&P 500 gained 3.6%, the Dow advanced 3.4% and the Nasdaq rose 4.8%. Natural resource stocks, utilities and technology shares led the way; healthcare shares performed better than the stock market averages. However, financial and real estate sector stocks fared poorly, as both short-term and long-term interest rates rose during the quarter.

According to Morningstar, growth funds did better than value-oriented funds, continuing a second quarter trend, and small companies did better than large companies, continuing their multi-year trend. Also, growth stocks are finally getting investors' attention, thanks to better returns in some technology stocks, communications shares and healthcare. The best performing equity fund category, mid-cap growth, returned 6.3% in the third quarter. By contrast, mid-cap value funds gained 4.1%.

With interest rates and inflation expectations rising, bonds did not fare well during the third quarter. The broadest measure of the taxable bond market, the Lehman Aggregate Bond Index, posted a negative 0.8% return. Long-term government and corporate bonds suffered losses of 2.7%, municipal bond returns were unchanged during the quarter and floating rate bonds, whose yields adjust as short-term interest rates change, returned 1.2% besting the returns on 3-month Treasury bills and CDs.

So, what's ahead? For starters, recall that the broad stock market indexes such as the S&P 500, the Nasdaq and the Dow Jones Industrial Average have only gained about 5% in price since early 2004, whereas corporate earnings have increased by 60%. During that time, 10-year bond yields have averaged 4.2% (near present levels), the economy has grown by 3.8% and inflation (excluding food and energy) has risen between 1 1/2% and 2 1/2% annually.

Then why haven't stocks done better? Well, stocks surged by 30% on average in 2003, anticipating big corporate profit gains over the ensuing eighteen months. Also, bond yields stayed around 4%, posing no threat to stocks.

The relevance? Stocks have already discounted the unfolding slower pace of economic growth. Financial stocks have underperformed the general market since early 2004 anticipating lower lending margins and rising interest rates. P/E ratios are down to levels not seen in years on the broad stock market averages.

Stock action since early 2004 can explain why the equity indexes haven't declined with slowing profit growth, the surge in oil prices and the devastation of two hurricanes. While the force and timing of the latter two events could not have been foreseen, their effects reinforce the markets' continuing expectation of much slower growth ahead.

As the Fed chases its tail by tightening monetary policy and trying to slay an oil-induced inflation scare, the market is biding its time for the next Fed blink when they (along with $3 gasoline) are in danger of tipping the economy over. The sharp decline in economic growth "surprising" us in the coming months will be the catalyst for Greenie to redeem himself before he rides off into the sunset (hopefully) in February. But long before it is apparent to the wizards on Wall Street that the Fed doesn't want to be a slave to the mistakes of its past, stock prices will have already risen in anticipation of lower interest rates and a re-acceleration of economic growth.

One caution in all this is the cyclical bull market that began in late 2002 is long in the tooth. It is three years old now, the average length of past upswings, so, historically, we're on borrowed time. The telltale signs: The number of upward-moving stocks is diminishing, as evidenced with financial and retail stocks. Real Estate and housing stocks are also losing strength.

But the last several months of a cyclical advance can be rewarding for market sectors that normally shine at the end of an upswing. Usually capital goods and commodity stocks hit their stride at that time as do selected technology sectors. Consistent with our view that commodity-linked investments will win over the next several years, energy, industrial commodities and precious metals could experience outsized gains. However, due to the narrowing of market breadth underway, investing in broadly diversified index funds could penalize returns.

It is too early to turn bearish on stocks in general. Economic and inflation releases will get more "worrisome" and the media may harrumph all about oil prices, deficits and falling consumer sentiment. But from the market's perspective, it will mostly be yesterday's news. While surprises can and do occur, producing violent swings in market prices, market up moves of consequence occur when current conditions look the bleakest and the chirping consensus says head for the hills.

-- Thomas J. Steffanci, Ph.D., Sr. Managing Director, Glencrest Investment Advisors, Inc.