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Quarterly Newsletter July 2006

Quarterly Newsletter | July 2006                                             Belmont Financial


The markets experienced the 1st correction (5-10% from the peak) in 3 years during the second quarter, with the S&P 500 reaching a year-to-date high in early May before sliding sharply, then recovering at the end of June to finish the quarter down 2%. The small-cap Russell 2000 Index dropped 5%, while foreign stocks managed a slight gain for the quarter. Value stocks continued their dominance over growth stocks in the second quarter. Domestic investment-grade bonds were flat. Is a change underway? Are large companies about to take the lead from the small companies? Perhaps, but it will take another quarter or two to determine market leadership. As is typical in a downturn, the funds with the largest recent gains, i.e. small caps, gave back the most. Over the past 26 quarters, covering almost 7 years, the large cap S&P 500 bested the Russell 2000 ten times or 38%. And yet, this was clearly a period of small cap dominance. Eventually, I’m sure we will have to realign our portfolios toward large caps and our unique investment methodology will signal when. My monthly analysis of over 50 world-wide asset classes will keep us aligned with the best performers by incrementally shifting to market leadership as it is confirmed over several months.


As distressing as corrections are, they are hitched to good performance like a horse and carriage. The past several weeks have certainly been a wake-up call to many investors. For a few years now, investors seem to have taken comfort in a number of things: the fundamentals looked good in most parts of the world; we’d gone more than three years without a market correction; and there was lots of money looking for a home. This money came from many sources, including hedge funds. These vehicles have grown in popularity and influence, and their managers have been looking anywhere and everywhere for places to eke out some extra return. These funds often use leverage, and with the incredibly low interest rates we’ve seen (especially in Japan where many hedge funds went to borrow) they could borrow very cheaply, then put that money to work anywhere it stood to gain more than the cost of borrowing. Corporate and high-yield bonds, as well as emerging markets securities, were likely big beneficiaries, and it’s very possible that commodity futures, and maybe even REITs and small-cap stocks were a part of this strategy as well.


I can’t say for certain how much of these asset classes’ behavior was due to hedge funds’ involvement, but we do know two things: 1) Most hedge fund managers’ fees create a very strong incentive for risk-taking, and 2) according to an article in The Economist magazine, hedge funds controlled more than $1 trillion in assets as of year-end 2004, and can account for more than half the daily volume on the New York Stock Exchange (and can have an equally large presence in every other financial market). A collection of factors has lead to an increase in risk-taking in the financial markets, and it has been a few years since something came along and rattled everyone’s nerves. So it is understandable that the market gyrations we’ve seen in the last month and a half may have caught people’s attention, even though these gyrations are not out of line by historical standards.


But what suddenly caused things to change? Why is the market less “steady” than it was? Of course, the market doesn’t have a mind of its own—it’s just the aggregate reflection of many individuals’ buying and selling decisions—but investors’ biggest concern seems to be inflation. And in particular, it is concern over what will eventually happen if inflation persists and the Federal Reserve Board keeps raising rates.


Why Should We Worry About Inflation?

Inflation has many negative effects, and can be very disruptive not only to consumers (by raising the cost of living), but to the financial system and the markets as well. But the bigger concern with inflation is that it increases the risk that central banks will overshoot in their desire to stamp it out with high interest rates, and that those high rates will tilt us into recession. The hope among investors has been that the Fed will stop soon and that the economy will slow just enough to bring inflation back to the Fed’s targeted range while leaving it healthy enough for decent earnings growth. As economic growth has continued to surprise on the upside—and the Fed has continued to raise rates—the risk of an overshoot (and the ensuing recession) has increased. This concern has probably been exacerbated by the fact that central banks have become less transparent about their future plans (probably because they are less certain themselves).


What are the odds that continued inflation will lead the Fed to tighten to the point that the economy ultimately tips back into recession? I believe that the longer-term inflation picture is not troubling. Given the sizeable rate increases that have already occurred, and signs that the economy is slowing somewhat, my guess is that further rate increases will be limited and a near-term recession isn’t very likely. The risk is still there, but even if it materialized, we have the benefit of going into that scenario with stocks already at attractive valuations, so a cyclical bear market shouldn’t be severe, and this would actually set stocks up for nice returns later.


The Odds Favor a Benign Inflation Environment

There is a potentially large laundry list of counter-inflationary forces at work right now, and among the biggest of them is globalization. Not long ago, the outsourcing of jobs was the big headline, and while the media has chosen to focus on other things now, we still live in a very competitive world where 1) cheap labor is readily available in most industries, and 2) it’s hard to raise prices when the competition is so stiff. If jobs go overseas, domestic consumers’ aggregate wages may temporarily decline; and even if producer prices (e.g., oil) experience inflation, any company with overseas competition is going to have a hard time raising prices to offset its higher costs. Their profit margins may get squeezed, but unrestrained price pass-throughs to consumers would be difficult.


Along with globalization, technology has had a big impact on productivity. Globalization and technology work together, and their combined impact have played—and will continue to play—a big role in keeping inflation in check through increased productivity. The so-called “productivity miracle” is a big part of the reason why profit margins are high, even in the face of rising commodity prices and a lack of pricing power. This is a secular force that is likely to dominate a temporary cyclical rise in inflation.


Another force working against inflation—albeit a cyclical one—is a slowdown in the housing market. The counter-inflationary impact here could take many forms. A decrease in housing prices would likely have a negative wealth effect, causing consumers to cut back on spending. Similarly, without the tailwind of rising home prices or declining interest rates, homeowners are less likely to refinance or take out home equity, again leading to lower spending. The construction and financial services industries have grown tremendously in recent years in response to the booming housing market, and a slowdown could lead to layoffs; higher unemployment is usually considered deflationary. Also, with fewer families rushing to buy homes, there’s less spending on all the goods that come along with a home purchase (furniture, appliances, etc.).

I believe that a broad, dramatic, and sustained rise in inflation is unlikely in the foreseeable future. And, there are at least as many reasons to be concerned about recession as there are reasons to be concerned about inflation.


Valuations Revisited

So if inflation is causing the market’s problems, but we don’t think those concerns are justified, does that mean stocks are undervalued? There are many ways to look at valuation. For example, Jeremy Siegel, renowned Princeton economics professor, shows the market being from 8 to 32% undervalued. Another observer I respect shows the market 17% undervalued. There are many legitimate risks out there right now but, current prices are already discounting many of the risks. I do believe that valuations are quite attractive.


A Brief Recap of Other Asset Classes

My views on the other major asset classes have not changed much, in spite of the big moves some of them have experienced lately. Investment-grade bonds have performed poorly for several quarters running, which should come as no surprise given the Fed’s persistent interest-rate hikes. Inflation has been on the rise as well, meaning that real interest rates are still somewhat low. The real question is what inflation will do going forward, and in spite of all the negative media attention, the bond markets are only implying long-term inflation of 2.7%. In this context, investment-grade bonds are probably in a fair-value range, and continue to play an important role in protecting portfolios against losses during tough equity markets, especially in a recessionary or deflationary scenario. Foreign bonds are useful because of the potential for dollar depreciation; the current-account deficit remains a significant risk, and a decline in the dollar over time seems very likely.


In the equities arena, I continue to view large-caps as being attractively valued versus small-caps, even after the big drop in small-caps in May. Growth stocks also look pretty good relative to value stocks, but again, the data is not strong or consistent enough right now to warrant a deliberate move at the portfolio level. Foreign stocks have had a significant run-up relative to domestic stocks, and are presently in a fair-value range. The aggregate-level data doesn’t support asset-class shifts in my view. I think flexibility and opportunism are valuable in the hands of disciplined, thoughtful investors.

Like equities, commodities have also been on a wild ride from the competing influences of rising commodity prices and fears over a Fed-induced recession. Futures prices are generally above spot prices, which may suggest somewhat limited return potential going forward, and the return prospects for stocks and bonds have been getting higher at the same time. Right now, I think the odds are good that stocks will outperform commodities over the next several years, although this may not be the case versus bonds.



Corrections are distressing, but compelling valuations provide a floor. As long-term investors, we look for the silver lining: The potential for better-than-average returns in the future. By objectively looking at the data and considering what it implies in the real world, we can begin to differentiate between a serious long-term threat to investors and the short-term noise that causes many market participants to react based on emotion or fear. In recent years, the fundamentals have been generally good or improving in most parts of the world, so there has been little in the way of market-rattling fear and a notable dearth of attractively priced asset classes. But if investors around the globe do act based on irrational fear, bringing markets lower in the shorter term as they demand a greater premium for taking on risk, we will welcome the opportunities it creates for longer-term investors like us.

Thank you 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 with questions or comments or to change your investment objectives.

I look forward to seeing you during our periodic review meetings.

Mike Durant, CFP, July 2006                                   617-489-0040