Broker Check

Quarterly Newsletter July 2007

Monthly Investment Commentary | July 2007                                             Belmont Financial, LLC

After an uninspired 1st quarter, stocks around the world recovered in the second quarter. Domestically, bigger was better, with larger companies delivering the highest returns, followed by mid-caps and then small-caps. Though small-caps did well in the first quarter, they now lag large-caps over the past year—though all market-cap segments have performed well in absolute terms. It was also a good quarter for growth stocks. Fueled by the second quarter’s returns, growth indexes have now out-returned value indexes for the year to date in all market-cap segments. International stocks had another strong quarter and out-returned the U.S. market again. The U.S. bond market was slightly negative for the quarter and only slightly positive for the year. REITs suffered a correction since peaking in early February.

Market Update  In every economic cycle there are points where the indicators are particularly confusing. During these times investors who try to read the economic tea leaves can be easily whipsawed. So far, 2007 seems like one of those times.

  • Early in the year investors worried that troubles in the housing market might lead to a recession. As economic activity weakened, interest rates dropped and stocks lost about 5% of their value—bottoming in early March.
  • Shortly thereafter, concerns about recession dissipated and optimism returned. Investors began to believe in a not-too-hot and not-too-cold Goldilocks economy, and the buy-out boom added to the bullish mood. The stock market took off from early March into early June. At the end of this run the S&P 500 finally surpassed its previous high—set over seven years ago in March 2000.
  • Early in June, investors began to fear inflation and further interest rate increases. The strength in the global economy, the need to rebuild inventories, and declining productivity began to dash investor hopes of a Fed interest rate cut later in the year, despite the weakness in the U.S. housing market. The bond market sold off, with the 10-year Treasury yield hitting levels not seen for over five years. Stocks followed suit in early June with a drop of about 3% over three days.
  • But then, the market briefly righted itself, helped by better (lower) than expected core inflation numbers.
  • As the quarter closed, the stock market dropped back near its low for the month as mixed signals on the economy, credit market fears, and concern that the buy-out tail wind might slow, collectively seemed to leave investors generally confused and increasingly cautious.

We’ve never believed that we could add value using an investment strategy that relied on accurate forecasts of the economy over the near term. In fact, I believe it’s a particularly difficult area to master, which is perhaps why Laurence Peter (The Peter Principle) once said that “an economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today.” The risk of feeling like a dog chasing its tail, by reacting as economic data shifts from week to week or month to month, is exacerbated by the intense coverage of the financial media and the comments on the part of professionals in the media. Recently, after a particularly bad day in the market, an investment advisor was quoted in the Wall Street Journal as saying that he had sold all the stocks in his personal account and gone completely to cash for the first time in 20 years. It is remarkable that he apparently is sure that this market environment is (by inference) even riskier than “the bubble” which, earlier this decade, led to the worst bear market since the 1930s. This is the kind of foolish comment and thinking that probably spooks some investors.

Tactical Asset Allocation Adds Value: Every month we analyze over 50 world-wide asset classesconsidering both risk and return. This analysis has led us to sell our REIT fund and move towards funds which invest in larger and more growth oriented companies. By the way, our REIT fund is still a top performer in an unattractive category. Foreign stocks are still attractive. Coupled with the real possibility of slower U.S. growth because of moderating consumption, the dynamics seem to be in place for further declines in the U.S. dollar relative to currencies of many developing markets over the next few years.

Large-Cap Domestic Stocks: From November 1999 through February of this year, a sizable performance discrepancy leaves large-cap stocks bargain-priced compared to stocks of smaller companies. Moreover, stocks of larger companies tend to do better when the dollar is weak (their foreign earnings are worth more converted back to dollars and U.S. exports become more competitive), which is partly why mega-cap stocks are now experiencing stronger earnings growth than smaller companies. They also tend to perform much better than small-caps late in the economic cycle. We may or may not be late in this cycle but we are clearly past the early stage. Domestic large-caps are reasonably valued and therefore attractive.                                                                                                While the stock market looks reasonably valued or even undervalued based on earnings and current interest rates, if profit margins were to move back to “normal” levels wouldn’t the overall stock market then be overvalued? It does appear that profit margins are likely to decline in coming years:

  • Labor costs are a big part of the equation. They have been the biggest driver of increasing margins. The massive growth in the global labor market from China, Eastern Europe, and other parts of the developing world, along with technology-based productivity increases have made it difficult for labor to grab as big a piece of the economic pie. However, labor’s lack of leverage may stop deteriorating and gradually reverse, increasing labor costs and putting some pressure on margins. But a big jump in labor costs doesn’t seem likely in the foreseeable future.
  • Depreciation expense, also a big factor, will increase given the pick-up in capital investment recently.
  • Interest expense is beginning to increase because of new borrowing and rising rates.

So, some margin pressure seems likely as the drivers of widening margins lose their momentum. However, it is not clear that margins will suffer a huge decline. Top-line growth has been healthy, and given a very strong global economy, revenue growth could stay reasonably strong. And though productivity is slowing and labor costs may not be as much of a positive, there is still an abundant supply of labor around the world and will be for years to come. China still has a long way to go in its transformation from an agrarian to an industrial economy. So, while we expect profit margins to decline and earnings growth to slow, we are not assuming that the slowdown will be alarming unless there is a recession. In which case, stocks would almost certainly be hit. In my view, a sharp decline in earnings is possible but not the most likely scenario. And, if we look out over five years, current valuations seem to suggest that it is reasonably likely that stocks will do better than bonds, even in a fairly bearish earnings environment. This isn’t all that surprising—since 1960 profits have had nine down cycles and stocks rose in five of them as P/E ratios rose. Addressing the general question of the outlook for stocks, there are several other bullish factors. One is the huge volume of money raised by private leveraged buy-out funds. According to investment firm Bridgewater, there is $300 billion of capital committed to these funds that is yet to be deployed. With the typical levels of leverage (i.e., debt) employed by buyout funds, this could result in almost $3 trillion of buying power. Over the last few years buyouts as well as corporate share repurchases have removed a sizable amount of stock from the market—about $1 trillion (net of new and secondary issues) since mid-2004. Though some of that stock may come back into the market as private equity firms exit their investments by taking their privatized holdings public, this trend of sizable amounts of stock disappearing through privatization seems likely to continue for a while and is a bullish factor. The lack of bargains does not mean that markets are overpriced. This is not like the late 1990s when large swaths of the global equity markets were massively overvalued. Today, many things are fairly valued. It’s not exciting but it doesn’t suggest that we should be defensive.

A second factor that is hard to quantify is the growth in sovereign wealth funds. These are state-run investment funds that invest a portion of a country’s currency reserves. Those countries with excess reserves to invest in this way include China and other developing countries with positive trade balances, as well as many of the oil exporting countries. According to a recent article in Barron’s, these funds may have as much as $2.5 trillion and are growing rapidly. Their objective is generally to capture higher returns than those offered by government securities (such as U.S. Treasury bonds), which means investing in areas like private and public equities and real estate. China’s recent $3 billion investment in the private equity firm Blackstone Group is an example of this.

Perhaps the biggest risk to longer-term stock returns is inflation and interest rates. The rapid growth in the developing world has caused demand for basic commodities to spike in a big way and is one source of potential inflation. At some point supply is likely to catch up with demand but that point may still be a ways off. However, there is a growing consensus among some of the sharpest fixed-income managers that inflation from a variety of sources is working its way back into the system and that it is likely to move higher in the next cycle (though no one I know of is predicting double-digit 1970s-style inflation). Over the shorter-term, I wouldn’t be surprised to see some news—economic, financial, geopolitical, a hedge fund or derivative-related blow-up—over the next year that spooks investors and triggers a quick stock market correction. A 10% decline would not be surprising given the performance run since February of 2003 (the S&P 500 has almost doubled). If it does happen, the downturn is likely to be a short-lived correction rather than the start of a bear market, unless we are heading to a recession, which is possible but seems unlikely given current global economic strength.

Bonds and Portfolio Stabilizers:  Every so often it’s useful to rethink our portfolio management methods. In many cases, the use of bonds is not for income but rather to limit losses in a correction or stabilize the portfolio. The relative unattractiveness of bonds over the past few years, i.e. low yields, has prompted me to search for alternatives to use in addition to bonds. Analysis of the Morningstar database, uncovers several asset classes which exhibit low volatility i.e. standard deviation, as well as attractive returns. Allocation Mutual Fundsare funds which enable the manager to use a variety of asset classes, foreign or domestic, including various types of bonds, cash and low risk stocks (dividend paying). The best of these funds offer attractive risk profiles, often comparable to bonds or slightly more volatile. In any case the returns are higher than bonds and therefore these funds have an attractive risk/return profile. For example, I’ve been using First Eagle Global, a World Allocation Fund, for many clients as a Portfolio Stabilizer, and I continue to research other funds for this purpose.                                                                                                                           Thank you for your continued trust and confidence and please contact me to schedule your periodic review or if you have comments or if your financial situation has changed.

Mike Durant, CFP, July 2007     617 489 0070