Q4 Commentary (2005)

The U.S. economy enters 2006 having just celebrated the 4th anniversary of the current expansion.  This cycle may be defined by increasing productivity growth that has muted inflation and a very accommodative monetary policy that has engendered strong consumer spending.  This powerful combination has fostered corporate profit margins to historically high levels and set the stage for S&P corporate earnings to post an unprecedented 14 consecutive quarters of double digit increases.

Indeed the Federal Reserve has been a dominant influence in this cycle lowering rates from 6 ½ % at the end of 2000 to as low as 1% in the middle of 2004.  While successfully navigating the economy from recession, the resulting economic stability and low, stable interest rates may have propagated an increasing appetite for risk propelling equity and house prices higher.  As the ratio of household assets to disposable income grew to exceptional levels, the consumer has been encouraged to borrow and spend.

Entering 2005 we spoke of just those concerns on the leveraged consumer with low savings levels and the impact even moderation might have.  However, as Newton’s First Law of Motion, the consumer continued to extract equity from rising home values.  In fact, statistics on the new financial acronym MEW (Mortgage Equity Withdrawal) showed that fully 8% of Disposable Personal Income has been comprised of equity withdrawn from rising home values.  Despite modest wage growth, this additional source of cash and spending has moved the already low savings level into negative territory over the last half of 2005 as we were actually spending more than we were earning.

Thus driven by the consumer, the US economy continued to show surprising strength in 2005. Gross Domestic Product for 2005 should show growth of about 3.5%.  Employment growth has continued to be somewhat below the typical recovery pace and has slowed since Hurricane Katrina but the economy has still added over 180,000 jobs per month over the last 2 years. Nominal wage gains have increased to over 3% though falling short of the 3.4% headline CPI increase. S&P corporate earnings should end the year up about 13% as strong productivity negated a deceleration in top line growth. In fact corporate earnings are now up over 60% during the 4-year expansion.

While the economy remained strong, the Federal Reserve was doing its best to both moderate excessive asset price growth and reign in increasing inflationary pressures through 8 Fed Funds increases taking the short-term rates up to 4.25%.  If this were not enough of a headwind for the consumer, energy costs experienced among the greatest year over year price increases as crude oil, heating oil and natural gas rose 45%, 47% and 70% respectively. 

Despite this economic performance, the major US markets experienced a below historical average year in 2005 though one typical of the first year following a Presidential election. Virtually all major indices, styles, and capitalizations remained in a narrow and competitive range. For the year the S&P 500 managed a total return of 4.9% with the Dow Jones and Nasdaq barely in positive territory with gains of 1.7% and 1.9% respectively. The S&P Barra Value rose 5.7% with the Growth index up 4.0%. For the first time in six years, the Russell 2000 did not outperform coming in up 4.5%.  Despite a stronger US dollar, International markets (EAFE) did return a strong 14% outpacing US markets for the 4th consecutive year.

By far the best performing sector in the S&P 500 continued to be Energy which returned over 31% despite a 4th quarter decline of over 7%. In fact the Energy sector alone accounted for over 60% of the index gain. Despite strong spending, the Consumer Discretionary sector showed the worst performance with a decline of over 6% led by the continued deterioration of U.S. automakers.

As we enter 2006, we must be cognizant that we have been in a 2-year period of extremely low volatility fueled by the liquidity that monetary policy has fostered. As policy has become tighter we anticipate 2006 to experience greater price swings in the major averages. Additionally, a flattened, almost inverted yield curve appears to be auguring a profits slowdown as the impact of higher interest rates and energy costs may only now be starting to be felt.  History tells us that it generally takes 12 to 18 months for monetary policy shifts to be fully felt in the economy and this Fed Funds cycle commenced in June of 2004. In fact we are clearly seeing signs that housing and mortgage applications are slowing with price gains abating.

The magnitude of the slowing of the “housing bubble” may be a major story and dictate much of consumer actions. Preliminary data for the 4th quarter indicate that growth may have slowed towards or even below a 3% rate as a moderation in consumer spending disappointed many retailers during the holiday season. Though we may see a seasonal up-tick in the 1st quarter, we expect GDP to slow towards 2.5% as we move thorough the year.

The Federal Reserve appears near the end of the rate tightening cycle with an anticipated additional 25 basis point increase in January at Alan Greenspan’s final FOMC meeting. March may represent a potential inflection point as Ben Bernanke presides over his first meeting as Chairman and additional increases will clearly be dependent on data yet released. While energy and geopolitical tensions remain major wildcards, we anticipate inflation to moderate through the year and declining towards 2.5% in the second half. The end of the tightening cycle should serve to reverse the dollar surge of 2005 and we would expect to see a temperate decline that may already be underway.

These headwinds should presage the end of the double-digit earnings increases though an expectation of 5%-7% EPS growth is very reasonable and current valuations reflect this. Indeed as mentioned above, we have seen over a 60% increase in S&P earnings while the markets have moved up only modestly. This contraction in valuations have moved P/E multiples on the S&P 500 to about 16X earnings based on 2006 consensus estimates, a level that is in line with historical averages. This decline in top line growth should reward shareholders of dividend-paying companies even more. As profits have risen at a 16% annual clip, dividends have yet to keep pace rising just over 11%. With corporate balance sheets awash in cash and payout ratios near historic lows of 28%, share repurchases, increasing dividends and increased M&A activity should be heightened in the new year.

Profit slowdowns have usually been associated with high quality, dividend-paying and demand-defensive companies taking market leadership. The valuations on these companies are also very attractive relative to the market as a whole and represent the core of the Coho portfolios. Our portfolios continue to offer above market yields; dividend growth and more defensive valuations that should provide excess risk-adjusted returns.

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