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All's Well That Ends Well October 1, 2007 By Mat Johnson "Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised." — Warren Buffett Last week stocks moved slightly higher, stringing together three straight weeks of gains. Despite the volatility seen through this past quarter the third quarter ended with solid gains. Last week the DJIA added 0.5%, while the S&P 500 rose 0.1% and the NASDAQ Composite Index advanced 1.1%. The small cap Russell 2000 declined -0.9%. For the third quarter, the DJIA gained 3.6%. The S&P 500 posted a 1.6% gain and NASDAQ jumped 3.8%. Small cap stocks however, posted a loss, with the Russell 2000 falling -3.4%. What is notable is that through the halfway point in the quarter, the major market indices had given up their year-to-date gains, though with the Fed’s dramatic lowering of the discount rate, all of the major indices have risen sharply through the quarter’s end. While the Fed will likely be given credit for fostering a rebound in equities, the closer reality is that the Fed's role was chiefly to restore investor confidence in an otherwise fundamentally sound economy. Thus far the financial sector has born the brunt of credit market concerns, with there being little fallout notable in other segments of the markets. Given the S&P 500’s higher financial sector representation, this largely explains this index’s relative underperformance this past quarter. In other words, the “fallout” has thus far been contained. With companies nearing the reporting season for third quarter earnings, the focus of many investors will likely be in assessing whether this past quarter’s financial market turmoil has affected other sectors of the economy, most notably amongst retailers. In advance of earnings being released, this week will see the latest report of manufacturing sector conditions as well as September job creation. This latter report will be more closely watched than usual given the surprise decline seen in August. Importantly, there is growing support that the August decline may have been a seasonal aberration, with an upward revision possible for August and a larger than recently seen figure being reported for September. Should this stronger scenario play out, this could likely introduce a new round of volatility into the capital markets; given that the Fed’s recent rate cutting was done on the premise of forestalling future economic weakness. While this past quarter's gains are indeed welcome given the volatility experienced, volatility could very well be here to stay a while longer. This week could shape up to be a game changer should the economic data be consistently strong, causing investors to reemphasize the underlying fundamentals reported in the upcoming earnings season, as opposed to hopes of future Fed rate cuts.

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