Q3 Commentary (2006)

The U.S. capital markets entered the 3rd quarter of 2006 apprehensive over concerns of an economy in transition. Following a strong first four months of the year in which the major averages gained over 6%, May and June showed a total decline of over 7% as anxiety over rising inflation, rising energy costs, and a potential housing recession increased investor apprehension towards an over-burdened consumer and the magnitude of an approaching economic slowdown.

While previous commentaries centered on our anticipation of a slowing economy with second half GDP declining towards a 2% annual rate (2nd quarter GDP was revised down to 2.5%) and moderating inflation supporting lower interest rates into 2007, we must admit our surprise with the confluence of positive events that unfolded during the quarter that are easing the economic transition to date and improving our outlook for the balance of the year.

In late June, Federal Reserve Chairman Ben Bernanke alerted the markets that the 17th consecutive Fed Funds rate increase to 5.25% moved the FOMC towards a “data dependent” position optimistic that the lagging impact of previous rate increases would temper inflation and slow the economy. The U.S. Treasury markets ran with this information and a strong bond bull market ensued. The yield on the benchmark 10-year Treasury declined from 5.25% down to 4.63% for a total return of about 6% for the period.

Despite some rising inflation readings as the CPI exceeded 4.0%, the markets viewed the trend in core inflation and the closely watched Personal Consumption Expenditure (PCE) to be easing. As the air was seemingly let out of the commodity markets with gold declining from over $720 per ounce to under $600, the greatest impact may have been felt at the pump. From a peak of over $77 per barrel in early August, a precipitous decline to under $62 left the retail price of gasoline down 25% from a national average of over $3.03 per gallon to about $2.30. Additionally, the quarter witnessed the decline in the prices of natural gas and heating oil of 37% and 17% respectively.

The S&P 500 companies exceeded all expectations by completing a tremendous 2nd quarter earnings season with a 16.3% gain marking the 12th consecutive double-digit gain. As we enter earnings season for the 3rd quarter, we are optimistic that this streak may be extended though by a declining margin. As of the close of the quarter, expectations are for an increase of 14%. Additionally, moderating oil prices and interest rates are increasing our confidence in a stronger than previously anticipated holiday season.

Despite continued corporate profitability, the overriding impetus behind the strong capital market performance has been the moderation of oil prices and interest rates. For the quarter, the S&P 500 enjoyed a total return of 5.7% with the Nasdaq returning over 4% all of which occurred after the early August peak in oil prices. Economic slowdowns tend to favor larger, high quality companies with predictable earnings streams and this was exhibited during the 2nd quarter as the Russell 2000 small cap index lagged with a .44% gain. At the sector level the top performers were found in Healthcare, Technology and Telecommunications as traditionally late cycle areas such as Energy, Materials and Industrials were weakest.

As the markets have seemingly embraced the “soft landing” economic scenario, we continue to be cautious regarding the consumer and the impact of a housing decline that has not been witnessed in many years. With sales of new and existing homes down 12.6% and 17.4% respectively versus the same time last year and inventories of unsold homes in excess of 7 months supply, the industry is facing its first full year national price decline since before WWII. Indeed, the most recent reading shows the median price of a single family home experienced a 1.7% year-over-year decline in August.

While the Affordability Index for first time buyers continues at a 20 year low, the recent decline in interest rates (lowering the 30-year fixed rate from 6.8% to 6.3%) have modestly improved affordability and allowed many homeowners with Adjustable Rate Mortgages to lock-in fixed rates. We believe this issue is critical as Mortgage Equity Withdrawal (MEW) has been the fuel used by the consumer (estimated at 9% of disposable personal income in 2005) to augment spending and is rapidly declining from an annualized rate of about $900B to below $500B. As there is an expected lag of 2-3 quarters, we feel this impact to be more of a 2007 event on consumer spending. Related impacts that may be expected and must be monitored include housing-related job losses and an increase in mortgage delinquencies.

While the potential impact to our economy of housing and related consumer issues causes us circumspection, it is the ownership of stable-growth, demand defensive, high quality companies in our portfolios that continue to allow comfort for our clients and us.

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