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Quarterly Newsletter October 2006

Quarterly Newsletter | October 2006

Returns were generally good in the third quarter for most asset classes. Some stock indexes are finally reaching record levels first touched over six years ago (though the NASDAQ remains far below its peak). Large caps topped small caps and value outpaced growth across all market caps. Other asset classes were also positive for the quarter. Contrast this with last quarterís newsletter which heralded the 1st correction in 3 yrs. Commodities faired the worst by far, losing 6.5%.

Review of Equity Valuations                                                                                                                                                    With oil prices dropping and the Fed finally pausing after a lengthy string of rate hikes, the markets have had a nice run in the past few months. Normally a rising stock market makes stocks more expensive, but earnings (helped by a reduction in the supply of stock) have also been positive over this stretch. Investors who buy a share of stock are really buying a share of a companyís future earnings, and rising earnings have kept the valuation picture from changing as much as one might think. One valuation model estimates that the S&P 500 is a little more than 20% below fair value. The Fedís often-cited modelówhich compares the consensus 12-month forward operating earnings estimate for the S&P to the current 10-year Treasury yieldósuggests undervaluation of more than 30%. The degree of undervaluation varies quite a bit from one method to another, but even the more conservative of these valuation methods suggest the market is at worst in a fair-value range.

Why do stocks appear cheap right now? The stock market (or more accurately, the collective opinion it represents) seems to believe that a significant economic downturn is likely enough that it is pricing stocks based on a potentially big decline in earnings. How big? Average earnings would have to decline by a historically large amount in order to validate current stock prices. Specifically, average earnings would need to drop by almost 25% to show stocks as being fairly valued; since 1950, there have only been one or two instances where earnings moved that much from peak to trough. Over rolling five-year periods, it has also been very unusual for nominal earnings to show average declines of more than a couple percent per year annualized. There are many factors that could contribute to declining earnings óa housing-induced recession, underfunded employee liabilities such as pensions and health insurance, and even a simple reversion to normal profit marginsóbut itís really only a perfect storm that would cause earnings to drop so much and/or over so prolonged a period that it would justify current valuations.

The stock market is not always right (we are reminded of the quip about the market having predicted nine of the last five recessions) and if it is wrong then stocks really are undervalued. But, in my view, broad risk levels are higher than average right now, and these risks impact the enthusiasm for stocks. In addition to the above-mentioned factors, there remain problems associated with our trade and federal budget deficits, the looming threats of Social Security and Medicare liabilities, high levels of consumer debt, the growingóand potentially largeóamount of unregulated private lending and derivative use that has evolved along with the growth of hedge funds and other similar entities, and the continuing risk of an economically damaging terrorist attack. These bigger-picture risks are on top of normal cyclical risk; with the economy slowing and the housing market deteriorating rapidly, recession risk has risen. These risks are material enough to account for the undervaluation.

On the positive side, it is entirely possible that the U.S. economy will have a soft landing and continue to expand for several years; and a big valuation cushion reduces our downside risk (most bear markets, for example, start from a point of high or excessive valuation). As long as stock prices are factoring in a higher risk premium, stocks will continue to look undervalued relative to valuation comparisons over the past 25 years. However, if investorsí risk perceptions improve, the resulting higher valuations would drive a return spike (all other things being equal).

Among other equity asset classes, foreign stock valuations are in line with their historical average relative to the U.S., Among domestic equities, growth stocks look slightly cheap relative to value stocks on a statistical basis, an opinion which has also been voiced by many of the managers I respect. The one equity area where I do find a compelling tactical opportunity is in the valuation relationship between larger-caps and smaller-caps.

Large Caps: Have They Finally Arrived?                                                                                                                       Recently my monthly analysis of over 50 world-wide asset classes for risk and return has revealed an awakening in large caps.  There is no question: small-cap valuations are at or near the high end of their historical range relative to large-caps. Cyclical considerations favor a lower small-cap weighting. Weíre well into the economic cycle, and small-capsí best periods of relative performance typically come early in the cycle. Since 1950, periods of small-cap outperformance have lasted an average of 70 months. The current cycle has been going for 87 months (as of June 2006), so weíre well beyond the average, although still well short of the run that small-caps had in the 1970s and early 80s, which lasted roughly 120 months (10 years). Neither of these observations alone would cause us to make a move, but when combined with the valuation backdrop, I think the odds are very good that large-caps will beat small-caps on average over the next five years. Based on S&P 500 valuation work, I think that on average over the next several years, assuming no recession, larger-caps could generate decent returnsóperhaps even in the low teensówhich implies that smaller-caps would probably still put up positive numbers.                                                  History is full of examples where an asset class stayed overvalued for years at a time, then took years to return to a normal valuation level. While we can use history as a guide in forming our expectations, there is no way to know for sure how long it will take. Smaller-caps could already be on their way down, or they could continue to outperform larger-caps for a few more years (if the current economic expansion continues for several more years, which is a real possibility. My monthly in-depth study of asset classes will signal when leadership has shifted to large caps.  

The Economy and Bonds                                                                                                                                                             The Federal Reserve has finally put on hold the string of interest rate hikes that began more than two years ago. Over this time period, the Federal Funds rate climbed from 1% to 5.25%, making it one of the sharpest tightening cycles on record. Decelerating earnings growth, a slowdown in the housing market, and a drop in oil prices, among many other factors, all undoubtedly contributed to the Fedís decision to hold off on further hikes. Among the sources we look at, there is a growing consensus that the economy is slowing down, but there remains a wide range of opinions as to what happens next.

Some bears argue that the decline in housing prices will have a material effect on the economy: a negative wealth effect will cause consumers to cut back on spending, and the construction and financial industries that experienced job growth during the housing boom will turn the other way as that boom reverses. Combined, they argue, these factors will result in a meaningful recession.

The bulls, meanwhile, argue that corporate America is in great shape, and that even if housing takes a nosedive, the data do not support a meaningful contagion effect throughout the broad economy. The fact that there is disagreement even within particular firmsóincluding PIMCO and FPAís fixed-income teamóreinforces my belief that economic forecasting is a notoriously tricky process.

Where does that leave us? In short, I agree that the risk of recession is greater today than in recent years. This view is bolstered by the fact that the current economic expansion has lasted 60 months, compared to a post-war average of 55 months. Of course, this is just an average, and there have been expansionsósuch as the one throughout most of the 1990sóthat lasted roughly nine years. I believe itís largely impossible to predict with consistent accuracy when a recession will occur, but the longer we go without one, the closer we are to the next one. The bottom line is that we donít need to be able to forecast the economy with precision in order to make sound portfolio decisions.

Commodity Collapse                                                                                                                                                                     The last several months have been a reminder that commodities are a volatile asset class. Given that spot oil prices have declined from a peak of almost $80 per barrel earlier this year to around $60 as of this writing, and that natural-gas prices have plummeted approximately 70% in 2006, itís not at all surprising that natural resource funds have declined as well. As you know, we avoid most sector funds because of this volatility.                                           Many people invest in sector funds after a big run up only to experience the correction.

The Perils of Emotional Investing                                                                                                                                          ìWe have met the enemy and he is us.î This familiar saying applies to individual investors too. The Dalbar report Quantitative Analysis of Investor Behavior shows that the average stock mutual fund returned 12.4% annually from 1984 to 2004. And yet, the average investor, investing in those same funds earned 3.7% per year. How can that be? Only by piling in at market tops and panicking at market bottoms can one do so poorly. ìInvestment return is far more dependant on investor behavior than fund performance.î Successful investing requires discipline, which implies the absence of emotion. At Belmont Financial, we remain fully invested in the best world-wide asset classes and the best funds, considering risk and return. The portfolio management process is well researched and is not based on emotions.  The world almost always looks scary to varying degrees and the best time to invest is frequently when things are the bleakest.

Conclusion                                                                                                                                                                                        The good news continues to be that equity valuations are somewhere between average and compelling, which give me some confidence that returns on average are likely to be decent (around 10%) or better. Now that the Fed has paused and energy prices have fallen, it is more likely we can avoid a recession. The real estate correction has yet to play out completely and remains a risk. With a world view and a disciplined (not emotional) investment process, I believe we can add value over the averages. We are keeping a close eye on the monthly analysis of over 50 world-wide asset classes to confirm the long awaited shift to large caps. This is a great time for tactical asset allocation. 

Thank you again for your continued trust and confidence and special thanks 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, October 2006                      617 489 0870