1st QUARTER 2007 MARKET COMMENTARY & OUTLOOKAPRIL 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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