Second Quarter 2006 Newsletter

Several factors—low interest rates being one of the biggest—have contributed to an increase in risk-taking in the financial markets. This has happened at a time when markets have seen few disturbances, so it is understandable that the market gyrations we’ve seen recently have created a lot of concern, even though these gyrations are not out of line by historical standards.

The Fed’s reaction to rising inflation seems to be the biggest concern. Aside from the direct damage of inflation, there is risk that the Fed will overshoot in trying to choke off inflation and that higher rates will push us into a recession.

There are several anti-inflationary forces at work, including the string of rate increases, so we aren’t overly concerned that we’ll see further big rises in inflation that would necessitate a lot of additional tightening.

The stock market is pricing in a lot of risk, and accordingly U.S. stocks are attractively valued—but not quite enough for us to take a tactical overweight. If we see additional declines, we are prepared to overweight stocks.

Quarterly Investment Commentary

The markets bounced around quite a bit 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 1.4%. 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 and emerging market short-term bonds (local currency) were flat, but commodity futures fared better, gaining roughly 6% over the three-month period.

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 in many cases their managers have been looking anywhere and everywhere for places to eke out some extra return. These funds often use leverage (meaning they invest borrowed money) and with the incredibly low interest rates we saw in 2003 and 2004 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 is very possible that commodity futures, and maybe even REITs and small-cap stocks, were a part of this strategy as well.

We 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). Our point here is not so much to dissect hedge funds’ impact on the markets, but rather to point out that a collection of factors have led 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 have 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.

What suddenly caused things to change? Investors’ biggest concern seems to be inflation. In particular, it is concern over what will eventually happen if inflation persists and the Federal Reserve Board keeps raising rates.

We Think 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 is 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. Without the tailwind of rising home prices or declining interest rates, homeowners are less likely to refinance or take out home equity, 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 recessionary, rather than inflationary. 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.).

Weighing all the evidence, we think it is unlikely that a broad, dramatic, and sustained rise in inflation is likely in the foreseeable future. Anything can happen in the short-term, but there are at least as many reasons to be concerned about a 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 and represent a fat pitch? The short answer is: Not quite. We look at valuations many different ways, but when we go through the math today, we don’t feel like stocks are cheap enough to compensate us for taking on the risk of an overweighting to equities. For us to take on that added risk, we want to feel highly confident that the market is being irrationally pessimistic, resulting in significantly above-average return potential over the next five years. From where we stand today (the S&P 500 is at 1250 as of this writing), we’d need to see a decline in the 5% to 10% range before feeling confident that an irrational level of pessimism was reflected in stock prices.

Having said that, we do believe that valuations are quite attractive and already discount much of the risk. If a negative scenario fails to materialize, or is less than investors expect, the market will likely have a nice run-up as investors price in the new information, leading to five-year average returns that are quite good.

If and when the time comes to overweight stocks, we must also decide where the money will come from. Because of the way our portfolios are positioned—including exposure to non-dollar fixed-income and commodity futures, the recessionary ballast provided by investment-grade bonds is lower than we would normally like to have. Convention would have us reduce our bond exposure when increasing equities, but this would further reduce our recessionary protection. Considering all of the options in a variety of scenarios, we would probably eliminate our commodity futures positions, since this asset class would be of little help in a recession, and our return outlook for the asset class is not as high today as it was when we first established our positions.

A Brief Recap of Other Asset Classes

Our 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 a very important role in protecting portfolios against losses during tough equity markets, especially in a recessionary or deflationary scenario. We continue to believe that emerging-markets short-term local-currency bonds will outperform domestic bonds over a multi-year time frame, in part due to their attractive yields, but more so because of the potential for currency appreciation; the current-account deficit remains a significant risk, and a decline in the dollar over time seems very likely.

In the equities arena, we 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 our view, but many of the managers we use have the flexibility to range beyond the confines of their “style box,” and we are more than happy to have them opportunistically buy stocks that are unconventional for their style. If a value manager wants to buy a “growth” stock and his rationale is consistent with his investment process, that is fine by us. We think flexibility and opportunism are valuable in the hands of disciplined, thoughtful investors. What we do not like to see are managers who buy particular stocks or industries simply because “that’s what’s working.” To us, that is just speculation and increases the likelihood of getting whipsawed.

Like equities, commodity futures 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, we think the odds are good that stocks will outperform commodity futures over the next several years, although this may not be the case versus bonds. This makes commodity futures somewhat less appealing from a tactical standpoint, but they continue to have to value as a portfolio diver-sifier.

Conclusion

Watching stocks go down is not fun, but we must confess that as valuations have become increasingly more appealing, we are feeling a growing sense of excitement that a good buying opportunity could be near. As long-term investors, we look for the silver lining in a down market: 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.

We thank you for your confidence and trust.

Best Regards,

Jon Houk, CFP