Market Commentary:  July 2007

Commentary

With so much talk of “fat pitches” at June’s PMFA Investment Committee meeting, a guest might have thought that we were talking about Barry Bonds’ pursuit of his record-breaking 756^th home run. Unlike baseball’s version, this reference to a “fat pitch” has little to do with a lofty meatball thrown right down the middle of home plate. Instead, in this context a fat pitch is a metaphor for an asset class that has fundamental characteristics that are so attractive that the prospect for strong performance appears extremely high. Small cap value stocks in the late 90’s, Treasury Inflation Protected Securities in late 2001, and emerging market currency in 2006 are a few examples of “fat pitches” from the relatively recent past.

The number of attractive opportunities of late has been fairly limited. One reason for this appears to be the abundance of liquidity that has pervaded global markets. Low global interest rates have kept borrowing costs relatively subdued. For investors, this helps reduce the risk of borrowing and increases potential return. The result has been increased use of leverage and an increased amount of capital sloshing around. Evidence of this has been the incredible increase in M&A activity as well as the now disappearing “cashing in on equity” mentality that typified the home mortgage refinancing boom. In the case of the latter, the process of unwinding the excesses appears well underway. Recent events are beginning to suggest that a tightening of expectations for funding leveraged buyouts is beginning to emerge as well.

The trouble with so much capital is that it can mask much of underlying risk associated with many investments, particularly those of a relatively risky nature. In some cases, it can extend performance to unreasonable levels. High yield corporate bonds may be one example of this. The spread (or additional yield) between high yield bonds and the 10-year Treasury continues to hover near historically low levels, suggesting that high yield bond prices remain historically expensive. This slim risk premium seems at odds with a default rate that appears poised to rebound in the face of a slowing economy after years at a historical low. Such contradictory signs suggest that excess liquidity may be having a meaningful impact on asset prices.

A disproportionate amount of liquidity will continue to flood the investment markets until one of two events occurs: either the cost of borrowing becomes much more restrictive or investors demand higher premiums for their higher risk investments. In recent weeks, the possibility of the former appeared to be setting in for some investors.

After a strong start to the second quarter, investors took a pause in June. In April and May, multiple equity indexes appreciated to all-time highs. Supporting stock prices was the premise that interest rates would likely fall by the end of the year, despite central banks worldwide announcing interest rate hikes, resilient global economic data, and inflation that, while receding from higher levels, persists to the higher end of the Fed’s comfort zone. In June, the expectation that the Fed would not soon trim rates began to sink in. Instead, the Fed appears willing to stand pat at 5.25%, or even potentially increase rates, if inflationary pressures don’t subside further. The conviction of the Fed’s hawkish view became strikingly obvious as final economic data from the first quarter indicated that the economy grew at its slowest quarterly pace since 2002, while the Fed continued to portray inflation as its predominant concern.

The realization that the Fed will keep its focus on inflation, potentially risking further economic slowdown, contributed to a sell off in bonds that pushed 10-year Treasury yields above 5% for the first time since last summer. It’s worth noting, however, that the Fed’s recent comments indicated that it expects to have the best of both worlds: moderating inflation accompanied by a growing economy, albeit at a sub-trend pace.


Source: PMFA

The impact on stocks was moderate, but skittishness sent equity markets negative in the closing month of the quarter. Despite this, the robust returns of April and May kept stocks well in the black for the quarter and through the first half of 2007.

Source: PMFA

Although the economy is currently characterized by slow growth, it continues to show positive signs. Unemployment remained at a constructively low level of 4.5% in June. Tight job markets help support wage growth (0.3% increase in hourly earnings for June) which in turn typically allows consumers to continue to spend. During the first quarter, consumer spending increased 4.2%. Economists forecast that consumers have continued to increase their spending rate during the second quarter. In response, business spending is also expected to gather steam, while strong economic growth abroad and a declining dollar should support U.S. export growth. This combination of factors has led economists to expect a pick-up in economic growth for the second quarter.

Source: PMFA

Situation modeling has suggested that there is a greater than 90% chance that Barry Bonds will break Hank Aaron’s home run record this season. We can say with an even higher level of conviction that a drain in liquidity will occur at some point in the future. However, pinpointing the specific timeframe is significantly more difficult than forecasting a sporting event. We can predict that when that liquidity drain does occur, investors overweight to asset classes supported by that excess liquidity will find elevated prices do not fully compensate them for assuming the newly unmasked risk. When easy money dries up, investors tend to re-price risk and seek the shelter of higher quality. One need look no further than the year-to-date performance of REITs to see how quickly risk can be re-priced.

In the equity market, this may equate to increased interest in the largest companies which have historically weathered market and economic downturns better than small caps. Adding to the attractiveness of large cap has been their relative inexpensiveness, particularly among mega cap stocks. As the graph below illustrates, P/E’s suggest that larger cap companies are selling at a sizeable discount to smaller companies. The relative discount between the Russell 200 (mega caps) and the Russell 2000 (small caps) is near its deepest point since the early 1980’s.

Relative Price/Earnings Ratios


Source: PMFA, Russell/Mellon

In the bond market, we believe that our current disposition to high quality will bode well in the face of a liquidity drain. Additionally, we believe that the current environment provides the opportunity for active bond managers to seek out opportunities through tactical movement along the yield curve, strong credit analysis, and tactical sector weightings.

Given this historical, relative value perspective, we believe that the relative value of mega cap stocks compared with mid and small caps has the look and feel of a “fat pitch.” Although blue chip stocks might not get as much press as supposed “hot plays,” we consider a lesson taught to all little leaguers. “Don’t try to hit a home run, just make contact with the ball.” We believe the same applies in this environment. Success often depends on knowing when to swing for the fences and when to simply avoid striking out swinging at an ill-advised pitch.

Economy

GDP

The final estimate for Q1 2007 GDP growth was 0.7% annualized. This may have represented only temporary weaknesses in certain sectors, as many analyst projections for Q2 have been above 3%.

The significant deceleration in the first quarter resulted primarily from the housing downturn, a larger than anticipated decline in net exports, and a decrease in federal government spending.

Inflation

The Consumer Price Index (CPI) was up 0.6% in May, while Core CPI remained flat. The Producer Price Index (PPI) increased more significantly for the month, at a rate of 0.9%.

Inflation Indices – 12 Month % Change

Source: PMFA, Bureau of Labor Statistics (BLS)

The Core PCE Deflator, the Fed’s preferred inflationary gauge, has moderated to a 12-month trailing 1.9% - just within the Fed’s desired range. “However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated,” stated the FOMC in its recent release.

Interest Rates

The 10-year Treasury reached a five-year high of 5.26% in mid-June then slowly decreased to end the month at 5.03%.

Ten-Year Treasury Yield History

Source: Yahoo Finance

The Federal Reserve maintained the Fed Funds rate at 5.25% at their June meeting. This rate has remained unchanged for over a year now, with the last increase announced on June 29, 2006.

Futures Market Implied Probability – Fed Funds Rate

Source: Federal Reserve Bank of Cleveland

The chart above illustrates the implied probability of outcomes at the October FOMC meeting. The likelihood of a rate change in the short term continues to dissipate.

Treasury Yield Curve History

Source: PMFA, Department of the Treasury

The yield curve is once again generally upward sloping, as shorter term rates have come down while longer term rates have crept slightly higher.

Employment

The unemployment rate has remained unchanged for the third consecutive month at 4.5%. Job creation was again higher than forecasted in June at 132,000, a substantial increase over April’s gain of 80,000.

Regional

The recently released GDP by State for 2006 indicated that the Great Lakes Region again experienced the slowest growth rate for the third consecutive year. Michigan was the only state in recession in 2006, contracting 0.5% during the year.

Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other source believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the sectors mentioned herein may not be appropriate for you. You should consult a representative from Plante Moran Financial Advisors for investment advice regarding your own situation.