Commentary and Articles

2nd Quarter 2006 Quarterly Synopsis

“Nowhere to Hide”

As perceptions of increased risks intensified in the 2nd Quarter, worldwide markets began to retreat. In the 1st Quarter 2006 Investment Commentary, the discussion focused on risks that were largely ignored. The risks of an economic slowdown were clearly not ignored in May. With inflationary pressures continuing, most investors expect to see the Federal Reserve continue to raise rates causing investors to question how much return is readily available from investment opportunities. Central banks worldwide have been raising rates giving few opportunities for easily won gains. This pullback in financial market prices may actually create opportunities for future return.

As of the end of the 2nd Quarter, the U.S. equity markets are in the 3rd longest period without a 10% downturn. In fact, in each year of the last extended bull market in the U.S., there was at least one 10% drop in each year, with 1999 having two drops of greater than 10% in equity markets. These declines are necessary for the market to move forward. In particular, as profit taking occurs, the markets can become “oversold” and stocks become relatively cheap, at which point investors move back in and buy, driving markets forward again. Currently, there is little fundamental change in corporate health. Earnings continue to be generally strong, and productivity appears to be offsetting increasing wage pressures. Corporate cash is still at historical highs. These positives are overlooked as perceptions of risk increase to the point at which the future is so unclear that selling is the best option in the mind of the average investor. That may be where we are now.

The equity markets are still not without significant risks, however. Increasing interest rates, which we still expect to see, will create a difficult climate for stocks. We expect to see consumer prices increase even as the economy slows because of the lag between interest rate increases and their effect on inflation. This could cause a situation similar to that of May 2000, in which the Fed raised rates 50 basis points, even though the bubble had already burst in equity prices causing additional perception-of-risk based selling. Overall, risk factors are growing with little tradeoff to be found in higher returns to compensate for these risks. However, we may see more reasonable valuations as volatility increases.

Our exposure to small-cap and international stocks hurt our portfolios in the 2nd Quarter relative to the Standard & Poor’s 500. Our exposure to emerging markets took a dramatic turn to the downside. In reviewing our continued exposure to these asset classes, we believe that the long term outlook is still rewarding. Many factors are supporting the future growth of small and international companies, and our allocation is small enough to allow us to be prudent as a player in them. On days when markets advanced, small cap exposure helped. On days when markets declined, small caps hurt. This is the nature of owning some of those types of companies. Overall, we continue to believe that having some exposure to this piece of the U.S. market will pay good return premiums over time.

In fixed income, we continue to reinvest at higher yields while still focusing on short durations to avoid price volatility as interest rates climb.