Third Quarter 2006 Newsletter

Despite rising stock prices, valuations remain attractive thanks to a decent earnings environment.

Why do stocks measure as being cheap right now? Investors seem to believe that a significant economic downturn is likely enough that they are pricing stocks based on a potentially big decline in earnings.

In our view, broad risk levels are higher than average right now, and we are no different from the rest of the market in that these risks impact our enthusiasm for stocks. But good valuations provide a cushion.

Over the last year we reduced the smaller-cap exposure in our portfolios and moved the proceeds into larger-caps. Smaller-cap valuations are near the high end of their historical range relative to larger-caps, and cyclical considerations also favor a lower smaller-cap weighting. We will continue to reduce small-cap exposure in the months to come.

In addition to the underweighting to smaller-caps, we continue to own tactical positions in International bonds and commodity futures.

 

Quarterly Investment Commentary

Returns were generally good in the third quarter. Some stock indexes are finally reaching record levels first touched over six years ago (though the NASDAQ remains far below its peak). The larger-cap S&P 500 index ended up 5.6% for the quarter. Small caps were nearly flat, gaining 0.4%. Value outpaced growth across all market caps. Domestic investment-grade bonds and international stocks were each up about 4%, while short-term local currency emerging-markets bonds gained almost 3%. Commodity futures had the worst quarter by far, losing 6.5%. Our portfolios trail their benchmarks year to date, but continue to outperform over longer time periods.

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. From its most recent bottom in mid-July, the S&P 500 is up almost 9%. Normally a rising stock market makes stocks more expensive, but earnings have also been positive over this stretch, which has kept valuations from changing as much as one might think. Our valuation model estimates that the S&P 500 is roughly 20% below fair value. Several other approaches we look at tell a similar story, and even the more conservative of these valuation methods suggest the market is at worst in a fair-value range.

Why do stocks measure as being cheap right now? Investors seem to believe that a significant economic downturn is likely enough that they are pricing stocks based on a potentially big decline in earnings. There are many factors that could contribute to declining earnings going forward—a housing-induced recession, under-funded employee liabilities such as pensions and health insurance, and even a simple reversion to normal profit margins—but it is really only a perfect storm that would cause earnings to drop so much that it would justify current valuations.

Among other equity asset classes, foreign stock valuations are in line with their historical average relative to the U.S., and we remain at slightly over weight. Among domestic equities, growth stocks look cheap relative to value stocks on a statistical basis, an opinion which has also been voiced by many of the managers we respect. In both cases, we are comfortable letting our managers make the decision as to which specific stocks represent the best investment opportunities in those areas. The one equity area that we find sufficiently compelling to take a tactical weighting is in the valuation relationship between larger-caps and smaller-caps.

Explanation of Our Smaller-Cap Reduction over the Last Year

The chart below shows the historical relationship between large-cap and small-cap P/E ratios. A ratio of ratios may be difficult to get one’s arms around, but it is worth understanding. A P/E ratio on its own tells us how much it costs to buy a dollar of earnings: a higher P/E ratio means you are paying a higher price for that dollar, and a lower P/E ratio means you are paying a lower price. This chart is nothing more than a way of comparing the “costliness” of large-caps and small-caps to one another based on their P/Es. As an example, if a dollar of earnings from the average large-cap company costs $18 (which is a P/E of 18x) and a dollar of earnings from the average small-cap company costs $20 (a P/E of 20x), then the “ratio of ratios” would show that large-caps cost 90% of what small caps cost (18 divided by 20 is 0.9). Right now, this data shows that small-caps are expensive relative to large-caps. In fact, they are nearly as expensive as they’ve ever been, an observation supported by other data sources as well.

We also believe that cyclical considerations favor a lower small-cap weighting. We are well into the economic cycle, and small-caps’ best periods of relative performance typically come early in the cycle. Combined with the valuation backdrop, we think the odds are very good that large-caps will beat small-caps on average over the next five years.

We want to emphasize that our basis for underweighting smaller caps is relative. Larger-caps are not necessarily a compelling absolute return opportunity on their own, but smaller-caps are clearly less attractive than larger-caps, and as such we want to shift our asset allocation accordingly. Our overall equity exposure remains unchanged. We also caution that there is no way to know for sure how long it will take for this move to pay off. Our confidence is based on a longer time frame, one that could be as long as five years, but it is impossible to successfully predict the short term.

The Economy and Bonds

Thanks to slowing earnings, dropping oil prices and a deteriorating real estate market, the Federal Reserve has finally put on hold what has turned out to be one of the sharpest cycles of rate increases on record. Economic forecasting is extremely difficult, but it’s pretty clear that the risk of recession is greater today than in recent years. For us, that means we need to manage our portfolios with an eye towards this risk, as well as others. High-quality bonds are generally the best-performing asset class during recessions, and as such we believe bonds still have an important role to play in balanced portfolios (bonds help mute the volatility of equities in other scenarios as well). The bottom line is that we do not need to be able to forecast the economy with precision in order to make sound portfolio decisions.

We also own International bonds as a tactical hedge against a dollar decline. At almost 6% of GDP, the U.S. current account deficit remains near its worst level in history. Foreigners’ demand for our financial assets has, to some degree, offset our demand for their goods and services, and that has mitigated the dollar’s decline over the last several years. The dollar did decline a significant amount between 2002 and 2004 against a basket of major currencies, so a partial correction of this imbalance has started, but the dollar has declined far less relative to “other important trading partners,” a group defined by the Fed that includes China, Mexico, and much of Latin American and Asian emerging markets. The fact that the current-account deficit, which is mostly driven by our trade deficit, remains at an all-time high is further validation that the dollar’s declines thus far have been insufficient to correct this imbalance. To us, this suggests that on a long-term basis, the dollar is likely to experience further declines. This is the most important argument underlying our position in International Bonds.

In our balanced portfolios, we continue to own small positions in commodity futures. At present, we believe the return prospects for commodity futures are not as good as equities, but are better than bonds (and they provide a valuable diversification benefit when mixed with stocks and bonds). As a result, our small positions in this asset class are coming out of our bond exposure.

Conclusion

We are pleased that there are tactical opportunities in International bonds, commodity futures, and larger-caps versus smaller-caps in our portfolios. We are confident these moves will modestly improve our return prospects while helping mitigate certain risks over coming years. That said, there are still no compelling, purely return-based opportunities at this time. The fact that several of our managers have trailed their benchmarks at the same time hasn’t helped, and as a result our performance has lagged this year after a long stretch of outperformance. The shorter-term underperformance of our managers does not impact our confidence in their ability to beat their benchmarks over the long term. Over the years, we have often observed and commented that even top managers occasionally have lengthy and sometimes significant stretches of underperformance. The managers we use are chosen based on extensive due diligence, and we follow up with them frequently. As long as our original thesis remains intact, and there are no material issues that impact our confidence in their investment edge, we know that underperformance is not by itself a reason to make a change. Even the greatest managers will at times test their investors’ patience, but as in all investing, patience and discipline are keys. At the asset class level, we will remain patient as well, and when the inevitable mispricing provides us with a compelling return opportunity, we will be ready to take advantage of it. We thank you for your confidence and trust.

Best Regards,

Jon Houk, CFP®