Broker Check

Quarterly Newsletter April 2006

Quarterly Newsletter | April 2006                                                                  Belmont Financial

US stock indexes posted solid quarterly gains with the S&P 500 scoring its best 1st quarter gain in 7 years. In spite of that high bar, our managed portfolios trounced this index once again. The secret to our success is working hard to implement our unique investment management methodology. My monthly analysis of the performance and risk of over 50 world-wide asset classes kept us mainly in foreign stocks and domestic mid- and small-caps. The long heralded shift to domestic large-caps was put on hold again as foreign and smaller companies stole the show; hence the benefit of incrementally shifting to market leadership as it is confirmed over several months. In the face of steadily rising interest rates, the Lehman Aggregate Bond Index struggled to stay in the black, and a tough month in March resulted in a quarterly loss. Rising interest rates, fear that the housing market may be starting to roll over, a growing trade deficit, volatile commodity prices, ongoing turmoil in the Middle East—all of these concerns have been on investors’ minds lately. Looking past short-term noise is important in making good investment decisions, but many of these issues are more than noise, and may impact our investment performance. An important piece of this puzzle is valuations, since valuations impact how well we might do in a more positive scenario and how much of a cushion we have against a more negative scenario.

US Equity Market Outlook                                                                                                                           It appears that risk levels are slightly above average, but that valuations appear to be reflecting at least some of that risk. Evaluating risk levels is difficult as the world almost always looks scary to varying degrees. An almost endless list of negatives (and positives) can come into consideration, and the goal is to make a realistic assessment that weighs optimism and pessimism fairly.  Here are some of the specific issues I believe are worth thinking about in the context of the U.S. stock market. The factor which elicits the most debate is market valuation because valuation work involves a lot of judgment calls. Should we use reported earnings or operating earnings? Current numbers or forward-looking estimates? Where are we in the earnings cycle? Should we rely on absolute valuations or use numbers relative to interest rates? The list of considerations is extensive, and the results can be wildly different depending on the choices we make. For example Jeremy Siegel, renowned Princeton economics professor, shows the market being 13 to over 30% undervalued. Another service I respect shows the market 15% undervalued. On balance, even when factoring in some negative earnings and macro-economic scenarios, I think valuations are somewhere between reasonable and attractive.

There are other non-valuation-specific reasons to be optimistic: Trailing long-term stock market returns have been below average and over the long term I think the odds favor sub-par performance to be followed by average or better-than-average performance. Turning to economic fundamentals, the overall health of corporate America appears to be quite good, earnings have been on a tear, profit margins are high, and core inflation is restrained (oil prices have pushed up reported inflation, but not to outrageous levels). All these variables—as well as others—contribute to my belief that US equities are modestly attractive.

The current-account deficit, the impact of a slowdown in housing prices, and other macro-level risks could all create scenarios where earnings could decline (e.g., a weakening dollar could depress demand for Treasuries by overseas investors, leading to recession-inducing interest-rate increases; flat or declining housing prices could cause a negative wealth effect, hurting consumer spending, etc.). Earnings growth is still quite good at the moment, but profit margins are near all-time highs, which leaves little room for improvement, and earnings are way above trend, which in the past has been followed by earnings corrections.

Turning to the length of the current economic expansion, our economy has been growing for a little over four and a half years, which equates to an average post-World War II expansion. The last expansion (defined as the period between recessions) lasted almost 10 years, so it’s possible that things could continue to be good for a while, but the odds are that we’ll have another recession sometime in the next several years; the team at PIMCO has suggested the possibility that this could happen as early as 2007, as the full impact of the Federal Reserve’s interest rate hikes are felt throughout the economic system. But I am not a market timer—as tempting as it can be at times, in the end it increases the odds of being wrong—but the probability is that a recession is statistically likely to occur somewhere within a three to five year horizon.

The current-account deficit recently hit an all-time record of 7% of GDP. The U.S. continues to import far more than we export, and while there is some debate about the calculations used in measuring this statistic, the trend is clearly getting worse rather than better, and is unlikely to last indefinitely. One way—and probably the most likely way—this will be rectified is through a decline in the value of the dollar relative to the currencies of our biggest trading partners, and if such a decline occurred quickly and in a “disorderly” manner, it could cause foreign investors to lose confidence in U.S.-based stocks and bonds, and our markets could decline.                                                                                                              The absence of pessimism is another consideration. Typically, when we see undervaluation, it’s associated with a market decline, negative sentiment (e.g., bearish stories in the media, big outflows from mutual funds), and underperformance of riskier assets like small-caps and emerging markets and widening yield spreads on corporate and high-yield bonds relative to Treasuries. Right now, we’re not seeing many of these things. (However, this doesn’t suggest that stocks are in risky territory—in my view the level of optimism associated with overvaluation isn’t present.)                                                                                                                                                           As is often the case, we face a balancing act of pros and cons, and there is plenty of uncertainty as to what lies down the road. When we weigh good valuations based on current fundamentals against the probabilities and magnitude of future risks, we are net overall slightly positive on the US Equity Market.                                                                               Among the sub-sectors of the U.S. market, large-cap and growth stock valuations are favorable versus small-caps and value stocks, respectively, but we have not seen this reflected in recent relative performance, which we require to adjust our allocation. In looking at foreign stocks, there are some similarities and some differences in our analysis of the fundamentals relative to domestic stocks, but a big part of my thinking with this asset class is influenced by valuations relative to the U.S. market. Right now, developed foreign markets appear to be within a broadly defined fair-value range.

Investment-Grade Bonds                                                                                                                    Intermediate-term bond prices have finally started reflecting the Fed’s tighter interest rate policy, and the yield-to-maturity of the Lehman Aggregate Bond Index stood at 5.3% as of this writing. With yields at this level, it’s likely that bond returns will both beat inflation and equal their historical long-term average performance. Returns can and will be higher and lower over shorter time periods (anything less than three to five years), but on balance the prospects for bonds are better than they were a year ago, and they’re probably within a fair-value range. In addition to an improved outlook in a steady-state scenario, bonds could generate fairly attractive returns should a recession (or worse) come about—conceivably even double-digit gains over a 12-month timeframe—and this would provide an important counter-balance to the equity market for conservative investors.

Final Thoughts                                                                                                                                                   The good news is that right now, equity valuations are somewhere between average and good, which gives me some confidence that returns on average over the next several years are likely to be at least decent (high single digits). Rising interest rates have brought investment-grade bonds back into fair-value territory, so their future contribution to our more conservative portfolios should be better than it has been over the last year. We have our money invested in the best asset classes and the best funds, and believe we can add significant value over their benchmarks. These are all good things to focus on while we patiently wait for the next compelling opportunity to come along.

Fixing Fidelity: Ho-Hum Returns Trigger Shakeup at Fund Icon:                                         “Why don’t you use Fidelity funds”? Living in the shadow of Fidelity, a name synonymous with mutual funds and omnipresent in retirement plans, it’s understandable why clients ask this question. The subtitle of this paragraph came from a recent article in the Wall Street Journal. About a year ago, Chairman Ned Johnson combed through Fidelity’s fund-performance numbers and didn’t like what he saw: After a generation of beating the competition, some Fidelity’s flagship stock funds were among the dogs. Magellan, once an icon of success was being beaten by 80% of similar funds. This triggered one of the most significant shifts in Fidelity’s 60 year history. Management identified the following problems: Fidelity’s research and stock picking group had become a dinosaur. Two issues kept popping up. The firm had long used its clout to gather intelligence from companies, but new regulations (Reg. FD, Fair Disclosure) prohibited selected disclosure.  Now professional career research analysts are required, and, at Fidelity, research analyst was not a career position, but rather a stepping stone to running funds. In addition, the analyst’s pay was determined by the fund managers so many analysts were preoccupied with marketing themselves. The solution: Mr. Johnson reassigned his daughter and presumed heir apparent, Abigail, to a job outside the mutual fund operation; added two dozen career stock analyst positions and installed a new compensation system to better reward beating the market. Has it worked? Well not yet. Fidelity’s large stock funds are lagging behind roughly 2/3 of their peers. It remains to be seen if the real problem is that Fidelity is simply too big to consistently provide market-beating returns. At 3 times its size a decade ago (when I used Fidelity’s funds), it needs to hold significantly more stocks to fill its portfolios.   

Thank you again for your continued trust and confidence and a special thank you to clients who have referred family and friends to Belmont Financial. Please contact me if you have any questions or comments.                                                      I look forward to seeing you during our periodic review meetings.                                                                                                                                                                                             Mike Durant, CFP, April 2006                                  617-489- 0040