2nd QUARTER 2006 MARKET COMMENTARY & OUTLOOK
JULY, 2006
During the first four months of this year, equity prices rose on strong earnings gains, encouraging outlooks from company managements and an orderly but rising interest rate environment. A tight employment market, continued rate increases by the Federal Reserve (Fed) and rising commodity prices did not seem to be of great concern to the markets. By early May, news headlines were focused on the Dow’s flirtation with its all time high first reached in January of 2000. The expectation was that the Fed was close to the end of its string of 16 consecutive rate increases.
How quickly market perceptions can change….
In early May new Federal Reserve Chairman Bernanke signaled that the economic data being released indicated a strong economy and that the Fed would continue to be vigilant (code for continuing to raise rates). This statement surprised the markets. From our perspective, the overriding theme driving the volatility and direction of the equity markets since that point in time has been uncertainty: uncertainty about future Fed rate increases hurting the economy; uncertainty about inflation; and perhaps most importantly, uncertainty about if the economy will overheat or if the Fed will be able to control the economy through monetary policy (rate actions). While we have no crystal ball to predict the future, we are a little bit more comfortable with the economic environment than we sense the markets are.
Our comfort comes from some of the underpinnings we see. First, while the pace of earnings growth may have peaked, earnings for companies still look to be solid through year end. Second, yields on longer bonds (10-year bonds) have already moved substantially, to 5.14% from 4.40% at year end. We do not expect that there will be much upside to yields over the next several months. Third, while job growth has been solid and unemployment remains relatively low, higher gas prices appear here to stay which is forcing changes in consumer behavior. Given that the consumer represents two-thirds of the U.S. economy, we expect to see increased evidence that consumer spending is slowing which should result in less need for further rate increases by the Fed. The rally in the equity market at the time of the Fed rate increase and commentary in the last few trading days of June would lead us to believe that investors are starting to feel less uncertainty and believe that the economy will not overheat or spin out of control.
As we look to the remainder of the year, we expect to see continued evidence that Fed rate increases have had the desired impact of slowing down the economy as the combination of higher energy prices and higher interest rates continues to ripple through the system. We also suspect markets will remain volatile in the near term as new issues of uncertainty rise to the surface. At the time of this writing, the news that North Korea has just test launched seven missiles is unsettling to all, including investors. We expect investors and the markets will also be faced with additional uncertainty as we move into election season. Because of the possibility of a change of control in both houses of Congress, as well as several state houses and leadership positions across the country, we expect the focus on the elections and election issues will increase uncertainty as the issues are debated by candidates and discussed in the press. If there is a sense that one or both houses of Congress will actually change parties it will create uncertainty and likely unsettle markets until the eve of the elections, when typically the picture becomes clearer. (Please note – we are not attempting to make any political statements but rather trying to provide you with our interpretation of the market’s behavior. For political views one must join our weekly staff lunches where, from time to time, such views are “debated”….)
We believe the underpinnings of the economy remain strong. While the next few months in the market may prove to be more volatile than usual (wider swings both up and down) we view the upside of volatility as an excellent opportunity to be proactive in stock selection. We anticipate opportunities to reposition some portfolio holdings and sector weightings as we move through the third quarter.
In closing, we express our appreciation for your continued trust in our advice and our services. As always, please be sure to contact us or your portfolio manager with any questions you may have or any changes to your financial situation about which we should know.
Sincerely,
SPERO-SMITH INVESTMENT ADVISERS, INC.
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