Q1 Commentary (2007)

In the opening quarter of 2007 the U.S. economy continued the expected moderation that began in the second quarter of 2006.  While final real GDP numbers for 2006 were consistent with trend line growth of 3.2%, the year's first quarter gain of 5.8% concealed the deceleration towards 2%.  Indeed, the decline in the overall CPI as energy prices moderated obscured the diminution of nominal GDP growth from a 7.3% annual gain to below 4%. Further emphasizing the slowdown is U.S. Corporate Profit Growth that completed 2006 with a 21% annual gain though only increasing 2% quarter over quarter since Q1 2006.

Prior considerations regarding the longest period in market history of extremely low volatility, narrow credit spreads and inadequate risk premiums appeared well founded in late February as a decline in China's stock market of 9.2% sparked a three-week sell off with market declines on the S&P 500 of over 6%.  Coming immediately on the heels of former Fed Chairman Alan Greenspan's comments suggesting a strong possibility of a recession later in 2007, the declines increased volatility to levels not seen since the second quarter of 2006.

However, statements released in mid-March by the FOMC interpreted as removing the tightening bias that had been in place since 2004 served to calm the markets as prices and volatility returned near prior levels.  The markets finished Q1 2007 pretty much where they began with the S&P 500 eking out a .64% gain while the Nasdaq and small cap Russell 2000 indices posted modest .23% and 1.07% respective gains.  International and Emerging Markets continued to outperform domestic indices returning 2.6% and 4.1%.

Earnings for the S&P 500 posted the 14th consecutive double digit gain in the 4th quarter of 2006 rising 11.6%.  This unprecedented earnings streak should come to an end this quarter as the impacts of moderating consumer spending and increased labor and input costs contain historically high profit margins. The largest potential offset to this domestic slowing is the continued global growth we continue to experience. The continued tight labor markets  (the recent 4.4% unemployment rate equaling the low of this cycle) are both a pleasant surprise and potential issue as the expected softening of aggregate demand and the resulting impacts of tempered inflation are not materializing. In turn this is increasing the anxiety of Fed Chairman Bernanke as both softening growth and rising inflation have been stated as growing considerations. Indeed, both the core CPI which ended 2006 up 2.7% year over year and the core PCE are exhibiting upward pressure and inflation expectations are rising as evidenced by increasing TIPS (Treasury Inflation Protected Securities) spreads and rising Gold prices (up to new cycle highs). The end result is higher interest rates than expected.

If the hands of the Fed are truly tied, the Housing concerns that have been the focus of much of our prior commentaries may grow even stronger. The early part of the year exhibited some seasonal moderation before more normal weather patterns resulted in the continuing and advancing declines in housing starts and existing home sales. As the Spring season commenced amid rising inventories, the comments emanating from the homebuilding industry and the National Association of Realtors (NAR) indicate the bottom of this cycle to be far off. More importantly perhaps have been burgeoning anxiety in the lending areas. While we have spoken often of our uneasiness regarding the preponderance of exotic and adjustable loans that dominated the landscape in 2004-2006, the resulting delinquencies and foreclosures are occurring with even greater alacrity than feared. Many of us have now added the new terms Subprime and Alt-A to our investment vocabulary though certainly not with affection. With mortgage defaults already up to 2.87% (the highest since the last recession), delinquencies rising faster, and 87% of Subprime loans set to reset in the next 18 months, the impact on housing may be worse than anticipated. The current response is becoming legislative and the reaction of the banking industry has been to already tighten lending standards at the strongest pace since the S&L crisis in the early 1990's.

While the optimists may view this as contained to the Subprime markets, the housing food chain is dependent on the marginal buyers who have helped lead this cycle. Additionally, some very large financial institutions may have substantial amounts of these loans on their books and the packaging in the last few years of many of these loans into CDOs  (Collateralized Debt Obligations) could precipitate an unwinding which might roil the financial markets. While this is certainly not our base case, it remains a possibility of which one must be vigilant.

The current economic slowdown and heightened market volatility should focus investor attention on where it should often be which is a greater understanding of risk and individual investment objectives. In the equity markets focus should be on high quality, dividend-paying companies that can and have successfully navigated economic cycles with strong international exposure to mitigate potential cyclicality. The Coho portfolio exhibits extreme underweight to the Financial sector with no direct exposure to the Housing industry. Additionally, the companies in our portfolios continue to grow their earnings and dividends at above market levels while focusing on shareholder friendly practices such as share repurchase.

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