Q1 Commentary (2006)
After a sluggish start to the new year, performance improved markedly over the past two months. March was a very strong month for domestic equities and we are very pleased to have outperformed over this period. Linking March’s performance to the earlier months, we were able to finish the quarter with a competitive return during a strong period.
Since we are not “market timers”, the return during the first quarter was more generous than we would have expected and this has dampened our enthusiasm for future returns over the balance of the year. In our portfolio construction process, we try to balance the outlook for a company’s fundamentals with the “macro issues” that could impact its valuation. We are seeing some storm clouds on the horizon, but nevertheless, we believe that the portfolio will perform well even if our fears are realized. Those possible storm clouds include the slope of the yield curve, the declining health of the housing market, the dramatic increases in many commodity prices and the ongoing global tensions. Let’s examine each of these risks.
Just last week, the Fed increased the Fed funds rate for the fifteenth consecutive time by a quarter point. This put the Fed funds rate at 4.75%, and the language clearly suggested that another quarter point is coming in May, when the Fed next meets. As of today, the yield curve is essentially a flat line from the two year to the thirty year, with the yield on the two year note at 4.73% and the yield on the thirty year at 4.72%.
Ever since the Fed began its tightening policy, the yield curve has gotten progressively flatter. The current slope, or possibly an inverted slope going forward would not be optimal for economic growth. Without knowing when the Fed will stop, or when the yield curve will return to a more normal slope, we would expect to see a slowdown in economic activity as the year progresses.
We have talked previously about the housing market, but this remains an area of concern. The supply of homes for sale is growing rapidly and homes are staying on the market for significantly longer periods of time.
On top of this, we worry about housing affordability for the first-time buyer and the pressure many homeowners will feel when adjustable rate mortgages reset to higher rates. Clearly, homeowners who were attracted to “teaser” rates will be facing much higher payments when the teaser period resets.
Over the past year, commodities had been rising steadily, but beginning around September of 2005, there was a marked acceleration in price movement. Most people seem preoccupied with oil and natural gas, since they feel these higher prices weekly at the pump and monthly on their heating bills. However, the commodity advance includes many of the industrial metals and many food costs. These higher prices are working their way through the system and we will all be paying for them. This is just another headwind for the consumer.
Global tensions remain high. This in part explains the rally in commodities, but it also will limit the market’s ability to achieve multiple expansion. The market can climb this proverbial wall of worry, but we would be surprised if the overall P/E on the market, which now stands at about 16x for 2006 expands meaningfully from here.
Given our outlook, you might wonder why we have any monies invested at this time. Well, we are long term investors, focused on understanding the operating and financial strategies of our universe of high quality companies. Within this context, we are still finding excellent investment opportunities and we believe we are well positioned for the uncertain future. If we are correct and the market experiences a slowdown later this year, we would expect our demand defensive orientation to provide strong relative results. The financial characteristics of the portfolio have never been stronger, which is to say, the dividend yield remains comfortably above the yield on the S&P 500, our holdings have been increasing their indicated dividends nicely this year, the multiples remain well below those of the general market and the balance sheets are very underleveraged.
