4th QUARTER 2006 MARKET COMMENTARY & OUTLOOK
JANUARY, 2007
Given the equity market performance in 2006, we are sad to say good-bye. The market exceeded our overall return expectations and the performance of our model portfolio continued to exceed market returns. We note that many of the themes we discussed in our market commentaries during 2006 proved to be fundamental drivers of equity performance. During the year, fixed income investments provided the certainty we require from this asset class, but, in this low interest rate environment, bonds provided little in the way of return.
Following lackluster domestic equity returns in 2005, 2006 proved to be much more rewarding for equity investors who chose to stay invested. For the year, the most broadly used measurement of the U.S. equity markets, the S&P 500, was up 15.8%; the Dow Jones Industrial Average was up 19.0%; the Russell 2000, a proxy for smaller stocks, was up 18.4% while the EAFE, a commonly used international index, was up 26.9%.
Themes that dominated the equity markets during 2006 included solid economic activity that led to better than expected earnings; merger and acquisition activity which was a result of the strong earnings environment as companies with solid earnings and strong cash flow sought out new places to reinvest their cash; finally, and most importantly, was the signal from the Federal Reserve Bank that the string of seventeen rate increases that began in June 2004 was now nearing or at completion. This combination of themes helped to propel the Dow Jones Industrial Average to new all time highs by year end. Looking beyond the headline numbers, one striking feature of the 2006 equity markets was the eclectic nature of the performance and the lack of leadership by a particular economic sector or industry group.
As we look to the New Year, we believe that themes, as opposed to sector leadership, will continue to dominate the equity market landscape. Determining the themes and the recipients will be the key to above market performance in the coming months. One theme we see continuing for many companies is the benefit derived from a weaker dollar. The decline had a positive impact on international stocks during 2006. As we move into 2007 we expect a weaker dollar will continue to benefit investors holding foreign stocks. In addition, companies with significant operations and sales overseas will have an advantage as foreign profits are translated back at increased dollar values. We expect this will bode particularly well for mid and large-cap domestic companies as well as international mutual funds.
A second theme that we think will play out during the coming year is that of slower economic growth versus higher inflation. Our expectation is for overall economic data to reflect mild economic growth, which should result in the Federal Reserve lowering rates by mid year. The performance of the equity markets during the second half of 2006 indicates an expectation of sustained economic growth with low inflation. Low inflation expectations are also reflected in the current yield curve, which is inverted. Yields on short-term instruments are above 5% while yields on the 2- 30 year treasury bonds trade in a range of 4.6% and 4.75% at the time of this writing. This will reduce short term rates and ultimately provide a more normal yield curve. While low inflation and a more normal yield curve are positive for investors and for stocks in the financial sector, they also signal the likelihood of a slowdown in economic growth which leads to slower earnings growth. As we move through 2007, we will be judicious in our stock selection, as slower earnings growth rates could create disappointments for individual stocks.
A third theme we see emerging within the markets is one of a valuation differential between larger and smaller capitalization stocks. As is typical coming out of a recession, smaller company stocks have outperformed their larger cap brethren over the past seven years. At this point, our research indicates smaller cap stocks are overvalued relative to larger cap stocks. Put another way, larger-cap stocks are more attractive from a valuation perspective. The compelling valuations dovetail nicely with the fundamental theme of the benefits we expect large companies to experience from the weaker dollar.
One important question for investors over the next several months is the change in control of Congress and how that will affect the economy. While no changes seem imminent, a change in tax policy (rising tax rates) would clearly be a concern for investors. Issues that involve greater government regulation would also likely be viewed as unfavorable by investors. While we are not immediately concerned, this topic will deserve attention as the new congress begins to form policy initiatives.
Overall, however, while we have some concerns about a slower economic growth rate, we are optimistic about the economy, the direction of interest rates and the year ahead for investors. As we enter this New Year, we want to take this opportunity to thank clients and friends of the firm for your business and support of Spero Smith Investment Advisers. We wish each of you and your families a very happy and prosperous new year.
Sincerely,
SPERO-SMITH INVESTMENT ADVISERS, INC.
Robert C. Smith Denise M. Farkas, CFA
President Senior Vice President, Director of Research
APRIL, 2007
Financial markets in the first quarter of 2007 provided a pinch of reality-checking. After seven months of steady gains in both domestic and international markets, the steep decline on February 27 indicated a degree of uneasiness about economic conditions and overall valuations. The Dow Jones Industrial Average’s loss of 416 points was the largest one-day decline in points since the day trading resumed after 9/11/2001.
Dow Jones Industrial Average, April 2006 through March 2007
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As widely discussed in the press, precipitating factors included the one-day 9% drop in Chinese share prices, as investors feared Chinese governmental credit tightening, and remarks by former U.S. Federal Reserve Chairman Greenspan that a recession could recur at some point in the future. No doubt, investor sentiment already had grown a bit more cautious as a result of the ongoing turmoil in the sub-prime lending market, weakness in durable goods orders, increases in crude oil prices, and geopolitical challenges in Iraq, Iran and Afghanistan.
Current Fed Chair Bernanke provided some reassurance to the financial markets on February 28, predicting the U.S. economy would continue to grow moderately. For the quarter as a whole, the Dow ended down slightly less than 1% at 12,354.35 and the S&P 500 eked out a gain of .2%. Broad international markets, such as the MSCI-EAFE and the Dow Jones World (excluding the U.S.) were up close to 4% for the quarter. And the Shanghai Composite, despite its huge one-day drop in February, still turned in enormous returns of about 20%.
While we believe the markets in general were due for a breather, we remain moderately optimistic about the overall conditions for the economy and the financial markets. Areas of weakness remain in housing and manufacturing where inventories need to be reduced further before significant new investments occur. On the brighter side, consumer spending and personal incomes have exceeded forecasts and continue to support the economy.
The Federal Reserve, in our view, is demonstrating sure-footedness in walking the tightrope that balances economic growth and price stability. At the end of March, the Commerce Department reported that the economy grew at an annualized rate of 2.5% in the fourth quarter of 2006, better than the earlier estimate of 2.2%. Core inflation (excluding energy and food) is currently running at an annualized rate of 2.4%, higher than the Fed’s comfort zone but not alarming by historical standards. At this point, the Fed appears to be more concerned about inflation trends than economic sluggishness; therefore, we would be surprised to see rate cuts in the near future without evidence of reduced inflation expectations.
Our approach to managing client portfolios is to maintain broad diversification among quality holdings----companies with strong financials that continue to seek growth opportunities while operating efficiently. In the first quarter, our unconstrained stock portfolios had the dubious honor of holding both the best performer and worst performer in the Dow Jones Industrial Average: Alcoa was up 13.6%, and Johnson & Johnson was down 8.2%. Alcoa, the world’s largest aluminum producer, continues to expand refineries around the globe and is experiencing strong revenue growth and margin expansion. Johnson & Johnson shares suffered along with other medical device makers as a result of a study questioning the benefits of certain heart stents. However, we remain positive on the company, which has very strong financials and broad diversification in numerous product lines. Another medical company, Amgen, also suffered losses in the first quarter following disappointing studies regarding its new Vectibix drug for treating colon cancer and its flagship drugs for treating anemia among kidney-disease and cancer patients. Amgen’s stock decline anticipates slower growth prospects, a situation we are monitoring closely.
Our recent transactions in stock accounts reflect our objective of having adequate exposure to growth areas of the economy and limiting exposure to vulnerable areas. We have sold positions in Masco Corp., a manufacturer and distributor of home improvement and building products, and are increasing weightings to three technology stocks: Microsoft, EMC, and Applied Materials.
Internationally, we remain committed to broad exposure as strong economic growth is occurring in numerous countries around the world. We anticipate making some regional adjustments among international mutual funds.
As for our fixed-income holdings, we remain invested in high-quality issues with a laddered approach to maturity dates in order to lessen risks related to changes in interest rates. With 2-year and 10-year Treasury securities both yielding approximately 4.6%, we have a flat yield curve which, in our opinion, is not providing sufficient returns on long bonds given their greater risk. As a result, we have undertaken a thorough analysis of the maturities and durations of all bonds in managed accounts, and may be reducing certain exposures to long-duration bonds.
Sincerely,
SPERO-SMITH INVESTMENT ADVISERS, INC.
Robert C. Smith Mimi Lord, CFA
President Sr. Vice President, CIO
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