Broker Check

Quarterly Newsletter Jan 2007

Quarterly Investment Commentary | January 2007                                   Belmont Financial

Our mutual funds and therefore our managed accounts had an outstanding quarter and year. Again, I attribute this to the asset class and mutual fund analysis at Belmont Financial. Every month we analyze over 50 world wide asset classes considering both return and relative risk. From this analysis we develop our tactical asset allocation, choosing several of the most attractive asset classes for maximum diversification. Then we select top performing funds in the most attractive asset classes, again considering risk and return. Fund management tenure and ethics are also factors. This analysis has led us to emphasize funds which invest in smaller companies and foreign companies. Confounding the pundits yet again, smaller-caps led large-caps, continuing their run of outperformance that began in 1999-2000. And value vastly outperformed growth across all market caps. On the fixed-income side, foreign bonds were aided by a currency tailwind and outperformed domestic bonds.

 A broad observation about returns in 2006 is that riskier asset classes generally did best: With the riskier small caps, foreign and domestic, leading the way. However, after seven years of ho-hum returns and many false starts, large companies are showing signs of life and narrowing the gap of underperformance relative to small companies, leading us to shift money toward large caps during the year. Investors’ willingness to take on risk implies a lower risk premium. Interestingly, though, valuations for the S&P 500 reflect a different story: Analysis suggests this index’s valuation is either too low or investors are pricing in an economic slowdown, which wouldn’t be good for risky assets. Meanwhile, real interest rates are very low, which usually means bond investors are worried about recession (suggesting risk aversion). This is all an interesting dynamic to observe, and we can’t always know who is right. Valuation analysis is complicated by the participation of foreign investors and hedge funds, which have their own agendas that may have little or nothing to do with the aforementioned observations—for example, interest rates might not be low because of recession fears, but rather because foreign investors currently prefer our bonds to their own, driving prices higher and yields lower.

Investment Review                                                                        
It was an eventful and at times tumultuous year in 2006. The ongoing difficulties in Iraq and the related shift in power in Washington D.C. were just two of the big headlines that most everyone watched with rapt attention. I too was interested in those events from a human-interest standpoint, although neither of them was especially significant from an investment standpoint. Our mission is to focus on factors that can be analyzed with confidence and that are likely to directly impact our investment portfolios, and politics and international affairs rarely meet those criteria. Below are some events we observed during the year and kept investors on edge.

Oil and Energy Prices

We saw record oil prices in 2006. Oil started off the year at around $60 per barrel, about $10 below its peak of the year prior, but still higher than what the markets had become accustomed to. As the months moved on, so too did oil prices, ultimately peaking near $80 per barrel, amid a widespread belief that this would either ignite inflation or cause the Fed to raise interest rates to a recession-inducing level. As is often the case, many assumed that this trend of higher oil prices would continue indefinitely (pundits were talking about the inevitability of $100 a barrel oil) although many of the managers and strategists I follow believed that oil prices would come down. The latter turned out to be true, and oil is back to roughly the same place at which it began 2006. I didn’t buy the secular arguments that ever-rising oil prices are inevitable, so from an investment standpoint I didn’t take any action in response to oil prices.

Housing Prices
When would the housing bubble burst? Would the inevitable crash be deep enough to cause a crippling recession, or even worse? Those were the questions on everyone’s minds at the beginning of 2006 amidst rising interest rates and a rapidly softening housing market. In fact, it was perhaps the most frequently asked questions I received throughout the year, as it was in 2005 as well. Focusing on disciplined, broader analysis suggested that while the risk of a housing decline was very high, the magnitude and spill-over into the broader economy was not sufficiently high to warrant a defensively oriented portfolio move. A defensive posture would have caused us to miss out on a portion of the very good stock market returns for the year. The housing market has already cooled off considerably. Forward looking indicators forecast a bottom this year, at least nationally. We need another month or two for confirmation, so stayed tuned.

Fed Policy     
When we started the year, the Fed Funds rate was 4% up from 1%, and investors were beginning to grow concerned about the possibility of an interest-rate overshoot causing a recession. By the time summer rolled around, the Fed had added another 1.25% to the Fed Funds target rate (now 5.25%), raising these fears even more, and the stock market started to feel the pinch. However, once the Fed finally announced that it was on hold for future hikes, the market spent the rest of the year bouncing higher. Today, there is growing talk of the economy cooling off, with some suggesting that a recession in 2007 has a real chance of materializing and that the Fed will begin cutting rates soon. This provides a nice illustration of the fickle nature of short-term sentiment. In less than six months, the market went from concerns about rising rates, which could be damaging to the economy, to relief that the rate hikes were over, to fears of a cyclical recession (which would lead to falling rates). In the real world, things seldom change that quickly. As it looks now, the Fed has engineered a soft landing (no recession) and that growth will pick up later in the year. 

What is the message in all of this? First, it pays to be disciplined and rely on objective analysis when making investment decisions, and ignore emotion. It can be difficult at times—and in fact is the most difficult at the times it’s most needed—but being rational and objective is a requirement to succeed at investing. The other message is that keeping a focus on the long term is a big advantage. Being in “reactive mode” is an almost sure-fire way to get whipsawed. The market reflects investors’ sentiments instantaneously. By the time any of us start worrying about oil prices, a housing collapse, or rising interest rates, it is highly likely that the market has already priced in those concerns. By reacting to our short-term concerns, we’re most likely going to be taking action to “protect” us from something that has already happened.

Equity Market Outlook
While the S&P 500 put up good numbers in 2006, the valuation picture has actually changed very little. This is because earnings have gone up along with stock prices, leaving the relationship between prices and earnings at about the same place. At year-end 2006, a valuation model showed the S&P 500 as being approximately 18% undervalued (the same model showed the market at a 15% discount to fair value at this time last year). Any valuation model is little more than a rough approximation of general valuation levels of stocks. Others models differ in the amount of undervaluation. This leaves us with a valuation backdrop that is modestly attractive.

Another cyclical variable I like to think about is recent stock market returns. While this is admittedly a backwards-looking variable, it helps contextualize where we are in relation to where we’ve been. As of year-end 2006, the trailing annualized returns for the S&P 500 were below average over the last 5 and 10 years, meaning that the bear market was so deep that it more than offset the run-up that preceded it. What does this suggest? The most obvious thing is that we’ve started to recover from the big bear market in the early part of the decade. All things being equal, a period of abnormally low returns is often followed by a period of better-than-average returns.

Much has also been made of the recent “new all-time high” for the Dow Jones Industrial Average, and that this suggests the market is overvalued. While I don’t believe that the Dow is a particularly representative benchmark, this nonetheless provides a good opportunity to think about what it means. True, the Dow is at a new all-time high. But the prior high occurred nearly seven years ago! To me, that’s hardly a sign of irrational exuberance. But what about the broader indexes that provide a more representative view of the overall market? The S&P 500 is the one I put the most weight on, and it is still more than 8% below its prior all-time high (reached on 3/24/00, almost seven years ago). And the NASDAQ is still an amazing 53% below its peak on 3/10/00. In fact the NASDAQ is at roughly the same place it was in January 1999, before the bulk of the bubble occurred. Not exactly a spectacular return from a group that includes many dynamic and innovative companies.

Where does this all leave us? First, it suggests little in the way of froth in large-cap stocks. Attractive valuations tell us the market is either cheap—meaning returns going forward are likely to be better than average—or that the market is discounting a meaningful decline in the fundamentals. We’ve seen signs of slowing earnings growth and a deceleration in the economy. Part of this is normal cyclical behavior, and some may be in response to the slowdown in the housing market, but in either case it is clear that we’re coming off of a spectacular period of earnings growth, and things are likely to cool off a bit. But a pretty big margin of safety is probably already baked into the market and the market still appears to be mildly undervalued.   There are opportunities within the equity universe. For example, the extended period of small-cap outperformance created a valuation disparity relative to large-caps. Another dynamic I’ve observed from many of the fund managers I listen to is that many high-quality companies—some of which were once the darlings of growth stock investors—are attractively valued. Looking overseas, valuations of foreign stocks are roughly in line with their historical average relative to the U.S. We have been overweight international funds for several years which helped offset dollar weakness. The dollar declined in 2006, most notably and significantly against the euro. Record-high trade deficits suggest that the dollar’s declines to date have been insufficient to correct the root of the imbalance, and that on a long-term basis, the dollar is likely to experience further declines.

In Summary
I think return prospects over the next five years are reasonably good under the scenarios I consider most likely—perhaps low double digits for equities. It is highly unlikely that they will be smooth from year to year. Geopolitics and terrorism are always concerns. With a world view and disciplined (not emotional) investment process, I believe we can add value over the averages, although there are no guarantees. This is a great time for tactical asset allocation.

With the new year upon us, take a look at your financial situation and risk tolerance and advise me of any changes.  As always, I appreciate your confidence and trust, and wish everyone a healthy and prosperous 2007.   A special thank you to clients who have referred friends or relatives to Belmont Financial.  I look forward to seeing you during our periodic review meetings.  Comments welcome!  

Mike Durant, CFP
®, January 2007   
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