Fourth Quarter 2006 Newsletter

It was an eventful year in 2006, with energy prices, the housing market, and Fed policy all impacting the investment landscape. Early in the year investors feared rising rates but once the Fed ended its string of rate hikes, the market climbed steadily higher.

Most asset classes had good returns for the year, with REITs and foreign stocks doing especially well, and domestic equities returning in the middle teens.

Despite rising stock prices, equity valuations remain attractive – thanks to strong earnings, suggesting either that stocks are undervalued or that the market is discounting a material slowdown in the economy.

After seven consecutive years of beating their benchmarks, our US stocks lagged in 2006. This stemmed from the synchronized and material underperformance of several of our managers (our asset allocation was neutral) but we are not concerned, as our focus is on the long term.

Quarterly Investment Commentary

Most equity asset classes did well in 2006, with smaller-caps once again leading large-caps for the year, continuing their run of outperformance that began in 1999-2000. The small-cap Russell 2000 index was up 18.2%, while the large-cap S&P 500 was up 15.6%. The value indexes vastly outperformed their growth counterparts across all market caps. As a group, the broad universe of diversified equity fund managers underperformed their benchmarks, with value managers having a particularly tough year. Despite a multi-year run of great returns and uncompelling valuations, REITs surged by 35.1% in 2006 as investors continued to pile into the asset class. While a rational case can be made that REITs are not severely overvalued, it is hard to imagine them performing as well as the broader equity market in coming years given current valuation levels.

On the fixed-income side, domestic high-quality, intermediate-term bonds had a respectable year, with the Lehman Aggregate gaining 4.3%. Foreign bonds were aided by a currency tailwind, lifting developed markets foreign bonds to a 6.1% gain, while developing local markets bonds (in which we have a tactical position) gained 12.3%.

A broad observation about returns in 2006 is that riskier asset classes generally did best. With a gain of almost 27%, foreign stocks did very well, but the riskier emerging-markets asset class gained close to 30%. Back home, the high-yield bond benchmark was up about 11.6%, while the riskiest bonds in the high-yield universe—those rated CCC and below—gained about 19%. And as noted, smaller-caps once again outpaced larger-caps.

Investors’ willingness to take on risk implies a lower risk premium. Interestingly, though, valuations for the S&P 500 reflect a different story: Our 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). We don’t know who will turn out to be 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.

Following seven straight calendar years of outperformance, our US stocks had a disappointing year in 2006. Our Fixed Income had significant outperformance and our International stock is performing in line with its benchmark. See the “Performance Discussion” section below for more, but in short we are not concerned, as we don’t expect to beat our benchmarks every calendar year since our focus is on long-term outperformance.

Investment Review

Recapping 2006, it was an eventful and at times tumultuous year. The ongoing difficulties in Iraq and the related shift in power in Washington D.C. were two big stories, but not as interesting from an investment standpoint as the stories on oil prices, the housing market, and Fed policy.

After beginning the year around $60 per barrel, oil peaked near $80 per barrel and fostered the belief among some industry watchers that higher oil prices would continue indefinitely (pundits were talking about $100 per barrel oil). Many of the managers and strategists we follow believed that oil prices would come down, which turned out to be true, and oil ended the year at roughly the same place at which it began. As of this writing (January 17th) oil prices have fallen another 15%.

The big question on the housing market was when or if the housing bubble would burst, and what would the fallout be. While some regions were hit hard, a 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. We are glad we stuck to our guns on that, since a defensive posture would have caused us to miss out on a portion of the very good stock market returns for the year. As of this writing, the housing market has already cooled off considerably, but it’s still too soon to say how much further it might have to go.

Fed policy was a big driver of the markets in 2006. Early in the year, investors were growing concerned about an interest-rate overshoot causing a recession. By summer, the Fed had hiked rates by another 125 basis points, and stocks suffered. Once the Fed 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 possibility of a recession that would lead the Fed to begin cutting rates again. This illustrates the fickle nature of short-term sentiment. In less than six months, the market went from concerns about rising rates damaging 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, underlying fundamentals seldom change that quickly. We think the message is that objective analysis that focuses on the long-term is an advantage. Being in “reactive mode” is an almost sure-fire way to get whipsawed, since the market reflects investors’ sentiments instantaneously. But short-term investor sentiment rarely impacts long-term fundamentals.

Equity Market Outlook

With the S&P 500 putting up good numbers in 2006, and some market indexes reaching record levels, stocks may “seem” like they should be getting expensive. In truth though, 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, our valuation model showed the S&P 500 as being approximately 18% undervalued (our model showed the market at a 15% discount to fair value at this time last year). It is worth remembering that the new highs reached by some indexes are only now eclipsing levels that were first seen nearly seven years ago.

Where does this all leave us? 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 are coming off of a spectacular period of earnings growth, and things are likely to cool off. But at current valuation levels a pretty big margin of safety is already baked into the market.

While our overall equity exposure in our portfolios is at a neutral weighting, this does not mean we are not seeing some opportunities within that universe. For example, the extended period of small-cap outperformance created a valuation disparity relative to large-caps, which caused us to shift some money from small-caps to large-caps earlier this year. Looking overseas, valuations of foreign stocks are roughly in line with their historical average relative to the U.S. Our portfolios remain at a slight weight to foreign stocks and as always, we prefer to let the geographical allocation be determined on a stock-by-stock basis by our managers.

Bonds and Bond-Replacements

With the Lehman Aggregate Bond Index yielding better than 5%, intermediate-term investment-grade bonds are likely to generate returns in the 4% to 6% range on average over the next five years. The beauty of bonds is that their returns are based on straightforward math. For example, we know that if interest rates go from 5% to 3%, a bond yielding 5% with a 4.3 year duration will return 5.7% annualized over a five-year period. Individual calendar years can be higher or lower, depending on the pattern and timing of rate changes, but on average we expect bond returns going forward to be generally in line with their long-term historical average.

We expect the commodity futures asset class to be volatile, and it lived up to expectations in 2006, with big quarterly swings in returns. As of early January, we are reevaluating our tactical rationale for owning this asset class because the DJ-AIG commodity futures index now appears to be in significant “contango” as a result of the index’s annual rebalancing at the beginning of the year. Contango exists when spot prices are lower than futures prices, and this results in a negative “roll return,” which creates a headwind for overall commodity futures returns. We still believe the return prospects for commodity futures are better than bonds but not as good as equities over the next three to five years. For this reason our small commodity futures positions are taken from our bond exposure.

We own small tactical positions in emerging-market short-term bonds in our balanced portfolios. In addition to the overall decline in the dollar that we think is likely over coming years, we favor emerging-market short-term local-currency bonds because they have higher yields than U.S. bonds of similar maturity, and are further helped by improving fundamentals in many emerging-market countries. In a dollar-crash scenario, emerging markets could face pressure as a result of their strong ties to the dollar and a broad move away from riskier economies. Developed-market foreign bonds would probably do better in that environment, but are considerably less attractive in a base-case scenario (which we think is far more likely) because of their lower nominal yields, the fact that most developed-market currencies, with the exception of the yen, have already had big moves versus the dollar, and that some countries with which our largest trade imbalances exist (such as China and Mexico) are not represented at all in developed-market foreign bond fund portfolios.

Performance Discussion

2006 is the first calendar year in a more than eight-year stretch that our US Stock funds/managers have underperformed our benchmarks. The primary reason for our recent underperformance is that several of our managers have been simultaneously lagging their benchmarks by large amounts. As a reminder, we seek to add value both through asset allocation and manager selection. With few compelling tactical-allocation opportunities, our relative performance is more dependent on manager selection, and we know this is more variable over shorter spans.

As always, we are in regular contact with all of the managers we use in our portfolios, and we are careful to understand what is driving performance. If any developments, performance or otherwise, impact our original basis for confidence in the manager, we will act accordingly. That is not the case now however, and we remain highly confident in our managers. We will say that our poor relative showing in 2006 warrants the same caveat we’ve given frequently during our many-year stretch of benchmark-beating performance, which is that it is not realistic to expect a manager to beat a benchmark each and every calendar year. In order to outperform in the long term, a manager has to have the conviction to look different from the benchmark, and this will inevitably result in periods of underperformance. We don’t know if our performance will be better than our benchmarks in 2007, since our investment discipline is not based on predicting shorter time periods (which we think is not possible). But we are confident that over longer time periods our managers and our portfolios on the whole will beat their benchmarks.

In Summary

At current valuation levels, we think return prospects for our portfolios over the next five years are reasonably good right now under the scenarios we consider most likely—in a range from mid- to high-single-digits for our most conservative portfolios to perhaps low double digits for our all-equity portfolios. We cannot predict the timing of those returns, except that it is highly unlikely that they will be smooth from year to year. We are confident, however, that by remaining aware of overall portfolio-level risk and setting allocations accordingly, taking tactical allocations only when highly compelling opportunities are presented to us, and using managers we believe to be highly skilled, we can earn above-average long-term returns while keeping our shorter-term downside risk within our loss thresholds.

We wish everyone a prosperous 2007. As always, we appreciate your confidence and trust.

Best Regards,

Jon Houk, CFP®