Q4 Commentary (2006)

When looking back at 2006, the most striking characteristic is the obvious divergence that bordered the precise middle of the calendar. The first 6 months behaved in an indistinguishable pattern from 2005 as interest rates, energy prices, precious metals and the Federal Reserve all appeared to be characters in an economic version of the movie, “Groundhog Day”. Indeed, even the equity markets played by the S&P 500 woke up to relive the same day generating a paltry 2.7% mid-year return that mimicked the 4.9% return for the entire 2005.

In late June, Federal Reserve Chairman Ben Bernanke tore up the script and decided that a re-write might be in order. The FOMC declared at least a temporary halt to the continuous Fed Funds increases amid optimism that the lagging impact of 17 consecutive rate hikes just might be enough to tame inflation and moderate the economy.

Taking this cue from the director, the U.S. Treasury markets ran with this information initiating a bond rally that precipitated a drop in yields from 5.25% on their way below 4.4%. Within 2 weeks we witnessed the peak in oil prices of $77 per barrel and enjoyed the subsequent decline back to $60 for a year long round trip. Even Gold having peaked over $720/oz dropped back towards $630/oz.

As the chart to the right depicts, it was no coincidence that the last 2 quarters of the year were the strongest back-to-back quarters observed in our major indices since the late 1990’s bull market with a rise in the S&P 500 of 12.7% occurring precisely as rates and energy declined.

For the year, the S&P 500 gained 15.8% with the technology-laden Nasdaq index returning 9.5% and the small cap Russell 2000 totaling 17%. Foreign markets continued their string of excess returns with the MSCI EAFE moving forward 16.5% and the MSCI Emerging Markets Index gaining 28.5%. Domestic sector based returns were led by Telecommunications, Energy and Utilities.

The bond market was a difficult place for positive returns as both short and long interest rates rose leaving the Lehman Long Treasury index with a miniscule .85% return for the year. In this area it was most rewarding to remain short duration as the 91-Day Treasury Bill index enjoyed a total return of 4.8%.

Earnings for the S&P 500 continued an unprecedented string of consecutive double-digit increases with the 3rd quarter representing the 13th such period and a gain for the full year of 13% to about $86. Along with the strong earnings, corporate dividend increases approximated 12% all of which kept valuation levels to a historically reasonable Price/Earnings ratio of about 16 and a downright stingy corporate payout ratio of dividends of 28%, near a historic low.

While productivity is a major reason for the continued strength in earnings, tepid wage growth over the last 8 years has led to the highest profit margin enjoyed in over 40 years. Consumer spending which had been anticipated to slow has subsequently been buoyed by gains of over 4% in Average Hourly Earnings (AHE) and what is now approaching the highest real wage gains since the 1990’s. The job market has remained tight with an unemployment rate that was as high as 6.3% in 2003 moving down towards the current level of 4.5%. This tightness and resulting increase in labor costs has concerned economists for the resulting inflationary impact though for now it has helped maintain spending and offset the impact of a declining housing market. Moreover, inflation as measured by the core CPI has moderated from a peak of 2.9% to the current pace of 2.6 % year-over-year (YOY) and appears headed lower as the impact of declining energy and commodity prices work their way through the economy.

Despite expectations of an economic slowdown, the full year 2006 GDP is expected to moderate at about a 3.1% gain which while below trend is welcome for the markets. Additionally, the 4th quarter and even early 2007 appear to be showing a modest re-acceleration of trend growth as much warmer than normal national weather patterns are very positive to housing starts and jobless claims while reduced energy prices buoy consumer spending. Still, it is hard to ignore that the major economic sectors of both Residential and Nonresidential Fixed Investment will be a further drag on 2007 GDP expansion.

Concerns expressed in prior commentaries that centered on housing and the consumer did not play out in 2006. However, that does not imply that we are not mindful of seeing their shadows in the coming year. Indeed, the suggested weakness in this market manifested itself in full force as housing starts, new and existing home sales and resulting high inventory levels all reached heights not seen in over 20 years. Additionally, the affordability index for first time home buyers is still at a 20-year low so recent apparent stabilization in some of the numbers may only be due to seasonal weather factors and cannibalizing much of the typically strong spring selling season.

Mortgage Equity Withdrawal (MEW) which had contributed fully 8% of Disposable Personal Income (DPI) in 2005 and helped fuel consumer spending has declined from an $800 billion annual rate to about $375 billion in 2006 as house prices flattened and short rates rose. This reduction in additional consumer ammunition has a lagged impact on subsequent spending and has yet to play out. In summary, we must be respectful of the strong possibility of another leg down in the housing market and the residual consequences this might have on the job markets and the consumer. Currently the consumer Household Debt Service Ratio (debt payments as a % of DPI) is at an all time high of 14.5%. Almost one-fourth of all existing adjustable rate mortgages will be reset in 2007 and these should be at much higher rates putting further strain on this ratio.

Though valuations in the major markets do not appear excessive based on current earnings and interest rates, we remain cognizant of a few facts. The economic cycle is entering its 5th year of expansion and we may be approaching cyclical earnings peaks with the previously mentioned high profit margins poised to decline amid rising labor costs. By historic standards, this current bull market has enjoyed somewhat muted gains of a 12.7% annualized return compared with tremendous earnings growth of 80% over that time frame. However, we are currently entering the second longest period in history (almost 3 full years) without so much as a 10% correction. Indeed, extremely low volatility and razor-thin credit spreads are pricing in a very low risk premium and a potentially complacent investor.

While our base case expectation is for a modest economic slowdown with lower but still positive corporate earnings growth, we do expect some bumpiness along the way. It is just this environment where our diligence in uncovering companies suffering from investor neglect and offering excellent valuations and predictable cash and earnings streams should bear fruit. We do not mind buying companies early as long as the cost of being early does not involve any permanent loss of principal. We will, of course, constantly remain cautious of shadows and their wintry significance.

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