Market Commentary:  June 2005

Second Quarter Overview

• The Fed again raised short-term rates twice during the quarter, bringing the Fed Funds rate to 3.25%. The ninth increase of 25 basis points came a year to the day from the first hike. The Fed continues to intimate that they believe monetary policy to still be “accommodative”, suggesting that further rate increases are likely forthcoming. Long-term bonds rallied, however, driving the yield on the ten-year Treasury down 50 basis points to 3.94% and further flattening the yield curve. 

• Consumer prices flared early in the quarter before receding in May. The March and April gains in the CPI were the largest back-to-back monthly increases since 1990. The trailing 12-month CPI slipped 0.2% from the last quarter at a 2.8% annual rate through May 31, while the core rate, excluding food and energy, also declined by the same margin to 2.2%.

• The U.S. dollar continued to strengthen against major foreign currencies, building on first quarter gains against the Euro, Yen, and British Pound, despite the widening current account deficit.

• The unemployment rate continued its gradual decline to 5.1% for May. Preliminary estimates indicated 474,000 new jobs created during the three months ended May 31.

• The direction of equity valuation ratios were mixed during the quarter across market cap and style. Generally, P/Es have trended downward over the past year, most notably in Large Cap growth stocks.

• U.S. stocks were up for the quarter, paced by Mid and Small Caps which both returned better than 4.0%, outperforming the S&P 500 return of 1.4%. International stocks slipped by 1.0% during the period. 

• Bonds rallied across the board – taxables and tax exempts, domestic and foreign. The Lehman Aggregate Bond Index gained a strong 3.0% during the period.

Data Source: Barra

July 2005

Markets

A year has passed since the Federal Reserve embarked on its cycle of gradual tightening of monetary policy. On June 30 – one year to the day from the first quarter point hike – the Fed again announced its ninth 25 basis point increase, bringing the Fed funds rate to 3.25%. Despite this gradual ratcheting up of rates, the Fed continues to conspicuously refer to their current policy remaining “accommodative”, suggesting that there may be more increases to come. While economic growth would also suggest that is likely the case, the capital markets have been less enthusiastic about this cycle of tightening.

Although both the bond and stock markets have posted positive results over the past twelve months, much of those gains were realized in the two-month post-election rally last fall. Since January 1, stocks have drifted generally lower. The S&P 500 Index is down 0.8% since the beginning of the year, despite valuation multiples that appear increasingly attractive. Mid Cap stocks remain the relative bright spot in the domestic markets with their year-to-date return of 3.9%. After falling precipitously in the first quarter, Small Cap stocks rebounded robustly in May; through June, however, the Russell 2000 Index remained in negative territory with a year-to-date loss of 1.3%. International stocks, which held up better than U.S. stocks earlier in the year, did not participate in the recent rally and remain down 1.2% through the first six months of 2005.

Bucking the trend of rising short-term rates and better than average GDP growth, bonds have ironically outperformed stocks over the preceding six months. The Lehman Aggregate Bond Index returned 2.5% year-to-date, exceeding the return of the short-term Lehman 1-3 Year Government Index by almost 1.6%. International bond returns outpaced their domestic counterparts with a strong 4.2% gain by the Citi World Government Bond Index Hedged during the corresponding period.

Influences and Strategy

In this period of flat returns, we see two underlying themes developing that merit further discussion herein. The first is the significant flattening of the yield curve and the corresponding decline in long-term interest rates. The second is the chipping away of the valuation premium that has long been attached to growth stocks since the late ‘90s. We believe that each of these dynamics will be significant factors in capital market returns in the next phase of the market cycle.

Much has been made of the unanticipated rally in intermediate and long-term instruments and the flattening of the yield curve. While short-term rates rose 2.25% since June 2004, the ten-year U.S. Treasury yield fell almost 0.7% to 3.94%. Currently, the spread between two-year and ten-year U.S. Treasuries is a paltry 0.3%, providing little yield incentive for most investors to buy longer term bonds. Fed Chairman Alan Greenspan recently referred to this dramatic flattening as a conundrum; clearly, long-term rates have not responded as the Fed had hoped. A handful of plausible explanations have been proposed by economists and market observers; perhaps the most widely embraced hypothesis is that foreign demand for Treasuries necessary to finance the burgeoning U.S. trade deficit has kept downward pressure on long-term rates. Greenspan’s public comments indicated that the Fed did not necessarily embrace that view, but that no better explanation was forthcoming. While it is possible that long-term rates could remain low, or even go lower, we continue to believe that a defensive to neutral maturity posture remains advisable.

Broad equity valuations (Price/Earnings, Price/Book, and Price/Cash Flow) appear to have stabilized, although some market segments continue to show further contraction in these ratios. By most measures, Large Cap growth stocks have continued to become more affordable, even as Large Cap value stock ratios have steadied. In smaller cap stocks, value and growth stocks appear to be fairly comparably valued. Consequently, while most valuation measures indicate that the market is fairly valued, the recent decrease in the yield of the ten-year treasury has not provided the tail wind for the stock market that most would have expected. Generally, there is a high negative correlation between the P/E ratio of the broad stock market and the yield of the ten-year Treasury. Lower bond yields typically accompany higher P/E multiples; consequently, a rally in long-term bonds is often seen as a positive for the stock market.

As mentioned previously herein, the yield on the ten-year Treasury has actually dropped from 4.62% to 3.94% in the past year, despite rising short-term rates. Most economists had been predicting that the yield on the ten-year would rise with short-term rates as the market priced in higher expected inflation. It is possible that the stock market has been relatively flat this year because this has weighed on equity investors who are expecting that inflation will continue to pick up steam, even if the bond market is not currently pricing in that potential. Further, there may be fundamental reasons beyond inflation expectations that have contributed to the decline in long-term rates. The relative attractiveness of U.S. interest rates compared to fixed income yields abroad may be creating enough foreign demand to keep long-term rates low, despite the risk of accelerating inflation. These fundamental influences in the bond market would not necessarily affect the equity markets, thereby creating the disconnect between the typical negative correlation of bond yields and stock P/Es.

An additional consideration that is likely weighing on domestic stock performance relates to corporate earnings growth, which appears to be retreating from its previously high levels of 2002, 2003, and 2004. Preliminary reports by Standard & Poors of S&P 500 earnings indicate that the rate of growth dipped from 20.6% in the fourth quarter of 2004 to 13.1% in the first quarter of 2005. Early second quarter estimated growth of 7.8% year over year suggests that a further slowdown is expected. Even with a backdrop of moderate and mildly decelerating economic growth, further slippage in corporate earnings growth will not be favorably received by investors. Earnings yields of 6% to 8%, combined with flat to increasing P/E ratios would result in stock returns that exceed bond returns in the upcoming market cycle. The keys will be whether or not long term interest rates stay low, and whether or not GDP growth and productivity gains can support such modest earnings growth. Either way, many believe that the returns of stocks and bonds will likely be lower than historical norms, as we have stated in the past.

We continue to evaluate a wide range of investment opportunities in the capital markets within the context of the current economic environment. In addition to assessing current allocations to traditional asset classes, we continue to research alternative investments and strategies including real estate, investments in commodities futures, private equity, and various fixed income options. In general, the current market scenario suggests cautious optimism but lacks the “fat pitch” opportunities that we have selectively implemented in the past. While some of these alternatives may merit consideration at a different point in the economic cycle, we will not recommend implementing an investment unless we believe it is at least reasonably valued and prudent. In the interim, we will continue to evaluate our current allocations and seek opportunities to add value through a combination of periodic rebalancing, tactical re-allocations, attractive implementation options within existing asset classes, or the introduction of alternative investments.

Industry Matters

We continue to monitor the status of the investigation by the Securities Exchange Commission (SEC) into the trading methods employed by a number of the largest brokerage firms, including Charles Schwab. The investigation relates to allegedly inappropriate trade routing of certain Nasdaq stocks which may have created a conflict of interest for the brokerage firms involved.

Schwab’s policy is to not comment on ongoing SEC investigations, and there have been no other publicly disclosed developments related to the Schwab investigation in the past quarter. They continue to state that they remain confident that the investigation will show their commitment to providing best execution for client trades. We will continue to monitor the situation and keep you apprised of any significant developments.

Conclusion

This report is prepared solely to help you with your investment planning. Accordingly, it may be incomplete or contain other departures from generally accepted accounting principles and should not be used to obtain credit or for any purposes other than your investment planning. We have not performed an audit, review or compilation engagement in accordance with standards established by the American Institute of Certified Public Accountants.

As always, if you have any comments, questions or suggestions on the report, please do not hesitate to call.