By any reasonable measure, the past three months have been among the gloomiest fiscal quarters on record for the investment markets. The debt ceiling debate, constant dithering in Europe over whether or not Eurozone members should be allowed to default on their sovereign debt, partisan bickering, the downgrade of U.S. government debt, continued unemployment and a general unsettled feeling about the economic recovery have all combined to put investors in a pessimistic mood. When people are pessimistic about the future, they sell--as they did, steadily and persistently, through what will be remembered as the gloomy summer of 2011.
It is hard to remember now that in the first quarter, just a few months ago, the markets were flirting with a full recovery from the 2008 debacle, or that before this quarter started the markets were in positive territory overall for 2011.
 
The Wilshire 5000 index, which most closely reflects the total U.S. stock inventory, dropped a remarkable 12.85% of its total value for the quarter. This wiped out the gains of the previous two quarters; the index is now down 7.54% for the year. The more widely-followed S&P 500 index of the largest companies domiciled in the U.S. was down 13.87% for the quarter, giving it a loss of 8.68% so far this year.  The Russell 2000 small cap index fell 21.87% in the third quarter, placing it down 17.02% for the year.
 
Internationally, the results were much the same--only more so. The EAFE index, which represents large cap stocks across the developed world, plunged 19.60% for the quarter, and is down 17.18% for the year. Europe as a whole was down 23.00% for the quarter; the Far East dropped 9.64%, and the EAFE emerging markets index of developing nations fell 22.88%.
 
Investors with a portion of their portfolio allocated to bonds experienced the benefits of diversification with the Barclays Aggregate Bond Index up about 4% during the quarter.

What does all this mean to you?
 
It is usually more difficult to read the minds of the investing public than the cable financial programs and financial press makes it appear; the headlines one day will say that stocks fell after the Fed issued a warning about the economy, and the next day we will learn that stocks rose because the Fed was so worried about the economy that it might lower interest rates.

However, this summer there was a certain clarity about the cause of the malaise; the S&P 500 was routed to the tune of a 2.2% one-day loss on August 2, right after Congress finally agreed to a messy compromise on the debt ceiling. It was clear that many people were questioning whether our lawmakers have a clear grasp of the financial and economic challenges facing a nation that is still climbing out of the worst recession since the second world war. When they look overseas, they see that European governments are, if possible, even less functional in their approach to repairing the global economy. On August 4, the S&P 500 fell 4.3%; it fell 5.6% on August 6 and another 4.4% on August 8--and those four days represented nearly all of the damage for the quarter.
 
September, of course, was worse, and the handwriting was on the wall when the S&P 500 experienced its worst first week start in its five-decade history. (Yes, that includes the Fall of 2008.) A brief five-day rally gave us a 4% bump in value, but the end of the month was dismal, with a 2.9% drop on September 21, followed by a 3.2% fall the next trading day. Altogether, the index was down 6% for the month.
 
Is gloom and doom the real story about the economy, or is it a reflection of unfounded fear? The NumberNomics economic web site notes that the U.S. GDP (the broadest measure of economic activity) actually grew 2.3% for the past three months, a much faster growth rate that the anemic first quarter (0.4%) and only slightly-more-promising second quarter (1.3%). Do those numbers look like they are moving the economy toward a double-dip recession, as many investors seem to fear?
 
Another fear is that the Eurozone will collapse under the weight of Greek debt. But there is good news on that front as well; the German parliament voted on September 29 to support the expansion of the European Financial Stability Facility by a surprising 315-85 margin. Germany is the 10th--and most important--of the Eurozone members to ratify the bailout agreement
 
Meanwhile, supply shortages of oil have eased from the start of the year, causing oil prices to drop. Consumers have paid down enormous amounts of debt over the past three years, bringing them in line with where the consumer debt burden has been for the past 30 years. Corporate profits and cash levels remain at record high levels, and there are signs that the unemployment problem is starting to ease--although it will be years before we seen unemployment fall to levels seen in the early part of this century.
 
With all this good news hiding behind headlines about U.S. and European sovereign debt levels, it is hard to predict that the market rally of the past week and a half will continue. But it is also difficult to bet against it.  The wisest heads in the investment game tend to see the optimistic side of the situation when the markets are most gloomy, and see the dark clouds gathering when everyone else is enjoying a strong runup in stocks.

Despite what you hear on the cable financial news channels, nobody really knows how long stocks will remain on sale or how long it will take for the global economy to finally sort itself out. We DO know, from past experience, that eventually the economy recovers from even the most severe shocks, and (again, eventually) the markets return to health. History tells us that a recovery is inevitable, and it seems to be visibly underway somewhere behind the hubbub of the negative press, partisan bickering and occasional market panics.

When investors figure that out, there will be another bull run and (this we can predict with confidence), people in that happy time will forget all over again that stocks can go down as well as up. That's when you'll hear our lonely voices talking about the downside risks.