Q1 Commentary (2006)
We have focused much of our quarterly commentaries over the last year discussing many potential storm clouds on the horizon and the possible impacts on the US consumer and our capital markets. While not being directly accused of invoking the Sword of Damocles, we do feel it vital to address all potential scenarios in our risk-adjusted approach focusing on the primary objective of principal protection.
After a weaker 4th quarter with GDP revised upwards to 1.7%, the economy appears to have bounced back strongly with estimates of about 4.5% for Q1 continuing a strong though declining year-over-year (YOY) trend to about 3.3%. Core CPI readings remained in a comfortable area around 2% though we are starting to see discernable signs of wage price pressures. Unemployment has dropped to 4.7% with average hourly earnings increases contributing to an estimated 3.3% YOY increase in the Employment Cost Index. While corporate profits continued on the upside with the S&P poised to proclaim an EPS increase of approximately 11% in the 1st quarter on the heels of 14% in 2005, we cannot ignore that corporate profits as a % of GDP are at a 39 year high versus wages.
Amid still strong but increasingly mixed economic reports during the quarter, the FOMC increased the target Fed Funds rate twice to 4.75% (the 15th consecutive increase) and suggested that another quarter point is coming in May reiterating concerns that increasing demands on resources still pose a threat of higher inflation.
The US equity market experienced the strongest 1st quarter since 2000 with the S&P index ahead 4.2% while the Dow Jones and NASDAQ returned 3.6% and 6.1% respectively. The Russell 2000 returned to leadership with a 13.9% return while international markets represented by EAFE and the Emerging Markets Index showed gains of 9.2% and 12.2% each.
On a sector basis, leadership continued the trend of the last year with late cycle such as Energy, Materials and Industrials posting 9.0%, 7.4% and 7.0% returns respectively. Stable growth sectors such as Consumer Staples and HealthCare continued to lag.
In the face of higher market averages, we believe we are witnessing increasing risks. The quarter was highlighted by out performance of more aggressive areas of the markets epitomized by smaller cap, lower quality and emerging markets dramatically outperforming. This is seemingly ignoring historically (mean-reverting) peak profit margins; market valuations not characterized as cheap; 10 year Treasury yields rising from 4.3% to almost 5% (highest since June 2002); and many commodities such as oil and precious metals at multi-year highs.
Headwinds we have spoken of previously are becoming more pronounced. With interest rates spiking and home prices already past areas of affordability for first-time buyers; we are seeing the early stages of a housing slowdown. Mortgage Equity Withdrawal (MEW), which has contributed by most estimates fully 8% of Disposable Personal Income and countered a negative personal savings rate, should experience substantial declines from these levels. Additionally, new home sales showed a 13% YOY decline in February an occurrence that historically presages a strong decline in GDP growth over the subsequent 4-quarter period. A consumer spending slowdown may be shown by weaker March retail sales though they may have been cannibalized by a warmer and stronger January.
While we anticipate such a slowdown with GDP declining towards 2.5% growth and EPS increases moving towards 5%-7% for the balance of 2006, we continue to see very strong corporate balance sheets in the high quality companies in our portfolios. Indeed, there is very strong cash available that continues to foster share re-purchases and dividend increases. Dividend growth in the S&P 500 exceeded 14% in 2005 and was followed by an almost 11% increase in the 1st quarter. This brings the four year increase in excess of 55% and with payout ratios at 29% or near record lows, we believe there is plenty of room for more.
Moreover, the stable growth, demand-defensive companies that continue to comprise the bulk of our portfolios offer lower valuations, higher quality; and stronger dividend streams. These are precisely the characteristics that historically outperform with lower volatility during such periods of economic and profit slowdown.
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