Third Quarter Overview

• Ending two years of unabated interest rate hikes, the Federal Reserve decided twice to maintain its fed funds rate at 5.25%. Despite lingering concerns about inflationary pressures, the Fed noted the need to at least pause to gauge the lagging effect of a string of prior interest rate hikes.
• Inflation continues to run on the higher side of the Fed’s preferred range. For August, core inflation crept up 0.2% to 2.8%, above the Fed’s unofficial comfort zone for core inflation in the 1% to 2% range. Despite the higher reading, signs of a slowing economy and lower energy prices have enabled the Fed’s pause in monetary tightening, rejuvenating investor sentiment as a result.
• Low unemployment continued to be an indication of strength for the economy. The September rate of 4.6% matches its 5-year low reached in June. While job creation has slowed substantially of late, the strong employment scenario, including real wage growth, should continue to support consumer spending.
• Declines in the housing market persisted during the third quarter. Inventories of unsold homes rose to 3.92 million - the most since April 1993. The median price declined in August, the first year over year decline since April 1995. Given the negative effects on both consumer sentiment and potential liquidity, the markets are focused on the impact of the housing decline on consumers.
• At quarter’s end the Fed’s short term rate was at 5.25%, well above the 4.65% yield for 2-Year Treasuries, and 4.61% for 10-year Treasuries, creating an inversion in the yield curve. Although an inverted curve has previously been a bellwether for a recession on numerous occasions, we believe that other sustainable factors besides lowered economic expectations have contributed to low long-term bond yields.
• The price of oil dropped at least temporarily below $60 per barrel, much to the elation of investors and consumers. A temporary easing in tensions with Iran, a milder than-expected hurricane season in the Gulf, and reduced interest from speculators all appeared to contribute to the pullback.
• The direction of equity P/E ratios was mixed during the quarter, generally favoring small over large and growth over value. Strong relative performance by large cap stocks during the 3^rd quarter narrowed the valuation spread between large and small caps.
• Blue chip stocks outperformed smaller cap issues for the second consecutive quarter. The Dow Jones Industrial Average nearly surpassed its all-time high during the final days of the quarter. Reflecting the strong performance of the blue chips was the S&P 500, which returned 5.7% for the quarter, easily exceeding the 0.4% return of the small cap Russell 2000 Index for the comparable period.

October 2006

Capital Markets

Lately, market commentaries have been reading more like an instruction manual for landing a plane than a summary of financial news. Much of this perception is due to repeated references to terms such as “soft landings”, “inflationary headwinds”, “housing market drag”, and “currency downdrafts” which sound as much aeronautical in nature as they do financial.

The metaphor, however, is not a bad one. In 2006, the economy’s behavior was in fact similar to a plane during its descent, with Ben Bernanke in the cockpit and the financial markets – and ultimately investors – as its passengers. In the first quarter the economy was flying high with strong growth, made artificially higher by the surge in economic activity following the brief but steep fourth quarter slowdown caused by the Gulf Coast hurricanes and surging energy prices. With inflation starting to creep up again and an anticipated return to trend demand, most expected that a slowdown in economic growth was inevitable. The tipping point came in May, when persistent inflationary pressures and intermittently hawkish and ambiguous comments and actions by the Fed surprised many investors and sent equity markets into a downturn. Throughout the rest of May and into June, mixed economic indicators clouded the short-term economic outlook and contributed to higher equity market turbulence. Investors amplified their focus on the Fed as a beacon for the direction of the economy, while criticism mounted about the rookie Fed Chief and his apparent lack of consistency in his messages to the markets.

In the third quarter, the economy finally appeared to break below the cloud line. Ending a string of over two years of interventionist tightening of monetary policy, the Fed turned interest rates back on to autopilot, pausing at least briefly in search of a place to land. Headwinds from the slowing housing market and lagging affects of prior interest rate hikes threaten to slow the economy’s momentum, which could result in a hard landing. Likewise tailwinds from increasing prices and wages could cause the Fed to overshoot a soft landing through further interest rate hikes.

The stock market responded well to measures taken by the Fed during the quarter and cautious optimism in the Fed’s ability to check inflation without completely choking off the economic expansion. The most telling sign may have been the appreciation of the Dow Jones Industrial Average, which posted its second highest close in history during the final days of the quarter (and eventually exceeded that high, days after the quarter end). Much of the current exuberance in stocks seems to be resulting from forecasts of economic moderation. There is no doubt that the economy has slowed significantly since the first quarter below its cyclical trend growth rate. Despite the slowing economy, however, employment has remained solid, with the unemployment rate remaining near 5-year lows at 4.6% in September. However, the rate of job creation has slipped from earlier in the cycle, consistent with an unwillingness of businesses to continue to rapidly ramp up their workforce in the face of a slowing economy. Adding fuel to the stock market have been falling oil prices and strong second quarter corporate earnings. Economists look to both of these as precursors of the potential response of consumers to the sagging housing market. So far, consumers seem to be holding up well to recent developments. In September, the Consumer Confidence Index moved up, apparently fueled by softening oil prices and stabilizing short-term interest rates.

Large cap stocks outperformed the other segments of the domestic equity market for the second consecutive quarter. The return of 5.7% for the S&P 500 Index for the quarter each outpaced the comparatively modest returns of mid and small cap stocks of 2.1% and 0.4% as measured by the Russell Mid Cap and the Russell 2000 Indexes, respectively. A return to dominance by large cap stocks has been widely anticipated. Generally, large cap stocks typically perform better during periods of slower growth or recession, when their lower susceptibility to high interest rate levels and diversified business models make them less vulnerable to economic fluctuations. Conversely, smaller companies can be greatly impacted by the higher cost of capital and may exhibit much less stability in their earnings. Secondly, current valuations suggest that large cap stocks remain relatively inexpensive compared to the small caps. Valuation metrics suggest that some continued correction may be needed to adjust for the extended run up in small cap stock valuations. While the timing of any correction is highly dependent upon investor sentiment and is difficult to predict, the recent rally in large caps may bode well for that segment of the market in the near term.

Around the world, stocks generally performed well during the quarter. The MSCI EAFE Index of international equities returned 3.9%. The uptick in international stocks largely signaled improved confidence in the Fed’s current monetary policy and perceived lessened probability that the U.S. economy is headed for a recession. The improved economic forecast was particularly well received in emerging market economies, which rebounded strongly during the quarter. Adding to positive sentiments about emerging market stocks has been their ability to shrug off potentially disruptive geopolitical events such as the bubbling turmoil in the Middle East, Iran, and North Korea and the recent military coup in Thailand.

Despite a variety of measures that point to moderate economic growth, threats still remain. An unanticipated surge in oil prices, surging inflationary pressures, or unexpectedly poor third quarter earnings reports could lead stock investors to take corrective behavior. Many analysts have noted a pervasive optimism in the markets of late, and a disregard for downside risks. In these situations, the impact of negative news can be amplified by the markets. Because of this, we believe that an overweight to large cap stocks will continue to serve our clients well, if the markets become more volatile and a flight from riskier assets occurs.

Bonds rallied during the third quarter, a result primarily precipitated by the Fed’s decision to pass on raising short-term rates at its two most recent meetings and increasing expectations that the Fed may soon stand pat or even reverse course in the next six to twelve months. The Fed’s comments regarding the uncertainty of the duration and magnitude of the current housing market correction and its potential impact on inflation and the economy sparked much optimism. Short-term bonds rallied for a 2.0% return as measured by Lehman Brothers 1-3 Year Government Index, and a 1.9% return for short term municipal bonds, as measured by the Lehman Brothers 3-year Muni Bond Index. Intermediate term bonds, which are generally more susceptible to changing interest rates and inflation expectations, were receptive to lower prospects for interest rates and inflation, with the Lehman Aggregate Bond Index surging 3.8% for the quarter. Municipals also fared well as exhibited by the 2.6% return of the Lehman 5-year Muni Bond Index.

The yield curve ended the quarter inverted over most maturities. Conventional economic wisdom suggests that an inverted yield curve is often indicative of investors’ negative outlook on the short-term prospects for the economy and is often a warning of recession. We remain skeptical of the likelihood of that outcome in this case, although a slowdown is clearly underway. First, the predictive ability of the inverted yield curve is hardly foolproof. While an inverted yield curve has accurately predicted four of the past seven recessions, over the same period, an inverted yield curve has been followed by no recession on six occasions. Second, extenuating circumstances including the a high level of foreign investment in U.S. Treasuries resulting in part from record trade deficits and the relative scarcity of long-term bonds to meet pension fund demands have kept long-term Treasury yields unusually low for an extended period of time. We believe that this dynamic could extend for some period of time as a result of this global structural imbalance in trade and fund flows. As we continue to monitor developments in interest rates and the yield curve, we believe that investors should continue to benefit from investing in bonds that are short to intermediate in duration.

Like their domestic counterparts, a clearer view of a soft landing for the U.S. economy also strengthened investor sentiment in foreign bonds. For the quarter, the CitiWorld Government Bond Index returned 3.4%. This continues a multi-year run for foreign bonds that has in some cases driven yields below those of domestic bonds of similar quality. A lack of risk premium for investing abroad, along with huge swells of cash flowing into these bonds, may suggest that segments of that market may be overpriced, particularly among dollar-denominated issues. Alternatively, we believe that bonds denominated in local currencies continue to provide an attractive yield and should react favorably to secular fluctuations in exchange rates over time. During the quarter, the U.S. dollar was mixed against major currencies, depreciating relative to the Euro (-1.1%), British Pound (-3.0%), and Chinese Yuan (-1.1%), while gaining 1.4% against the Japanese Yen. Record highs in the trade deficit and the Fed’s pause in interest rate hikes contributed to the falling dollar. Given the significance of the global economic imbalances, it is our expectation that the high trade deficit and an increased likelihood of falling interest rates should apply downward pressure on the dollar over the long-term.

Following a multi-year period of strength, the commodities markets were grounded during the third quarter. The Dow Jones – AIG Commodities Index, which tracks a basket of commodities futures, declined 6.5% during the quarter ended September 30. Although the declining price of oil was the largest driver, many other commodities pulled back as well. Chinese government indications of a desire to slow their economy and reduced commodities demand in the U.S. appear to be at least partially to blame. Despite the recent attention paid to commodities, the performance of the DJ-AIG Commodities Index has actually trailed that of the S&P 500 Index by over 12% cumulatively since September 30, 2004. Commodities may have merit as a strategic asset class through diversification and inflation-hedging benefits. Despite those potential long-term benefits, any perception of recent performance benefit has been overstated.

As noted earlier herein, large cap stocks in particular posted strong performance during the quarter ended September 30. Whether or not the last two quarters of large cap leadership represent a turning point in the domestic equity market cycle remains to be seen. However, we believe that the tailwinds of a slowing economy, the international market presence of blue chip companies, and their comparatively favorable valuations should foster an environment that is more favorable toward large caps than their smaller counterparts. We believe that our clients should be well-positioned to benefit from this potential changing of the guard in the U.S. markets.

As anyone with aviophobia (a fear of flying) will tell you, the scariest part of any flight is the landing. As the Fed slows the economy, the need to balance stifling inflation while maintaining some growth momentum requires a delicate hand in guiding monetary policy. Even moderate surprises in inflation, consumer spending, or corporate earnings could generate crosswinds severe enough to require the Fed to switch off the autopilot and raise rates further. Likewise, the reaction of the markets to negative surprises in the near term is likely to be more extreme. As the economy continues to slow, many in the markets will focus on short-term economic data to try to gauge the Fed’s next move, as the Fed has indicated they have moved to current economic data to plot their course. While it is important to monitor short–term developments, we believe that a focus on the long-term horizon coupled with seeking pockets of opportunity along the way remains prudent. As always, maintaining an appropriate perspective about short-term market turbulence should contribute positively to maintaining one’s ability to remain focused on long-term objectives that will ultimately define success.

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