Commentary and Articles

3rd Quarter 2006 Quarterly Synopsis

“On the Rebound”

Oil prices dropped significantly and interest rates remained steady in the 3rd Quarter, leading to higher returns for investors. The question now seems to be, “How much upside is left.” The Dow Jones Industrials made the news hitting a new high-water mark even as uncertainty remains over the continued level of growth of corporate earnings and the overall U.S. economy.

Both oil and natural gas prices fell in the 3rd Quarter with the former down to $62 per barrel from $75. The cheaper energy was cheered by investors who drove equity prices upward. The Federal Reserve held off on additional increases in short-term interest rates which gave even more momentum to the markets. While the U.S. economy will benefit from these two effects, we are cautious in our outlook. Most economists agree that the U.S. economy cannot continue to grow at the same double-digit rates seen in the past three years. One clear indicator of consensus on this point is the bond market, where the yield curve is now inverted, meaning that bond investors are willing to accept lower rate for longer maturity bonds, indicating the expectation of lower future rates and slower growth. The inversion of the yield curve has signaled the onset of the last five recessions. However, as mentioned in our 4Q 2005 commentary, 1995 and 1998, were both similar environments where the inverted yield curve did not signal an imminent recession, showing that the predictive value of the yield curve is not perfect.

Even though the economic climate is similar to the mid-1990’s when recession did not follow relatively high short term rates, three primary concerns in the present scenario loom large and cause many to question the overall health of the economy. The first is a generally hawkish stance by central bankers in developed countries. In both the U.S. and Europe, interest rate increases are more likely even with the decline in inflationary pressure from energy resources. Demand is continuing to grow for energy and the lower prices will certainly stimulate economies, potentially even to the point of causing additional inflation fears. Wage increases coupled with decreases in fuel prices could help drive the consumer sector creating a double-edged sword of growth with inflation.

These wage prices create the second concern. Corporate earnings will slow because of recent wage pressure and the equity markets do not seem to have priced this into the recent rally. The third concern is the decline in liquidity in housing. The inability of consumers to continue to tap into the equity in homes has the potential to create a significant problem for the U.S. economy as risks of foreclosures and personal bankruptcies rise with consumer debt at worrisome levels.

In the 3rd Quarter our equity portfolios did well as core holding Microsoft (MSFT, NASDAQ) rose by 19% on news that it is increasing its share buybacks. United Parcel Service (UPS, NYSE) hurt portfolios dropping double digits on concerns over fuel prices effects. We still see UPS as a great long-term holding with a more diversified business model than most realize. We slightly over-weighted cash as money market yields hover at 5% and we seek to lessen risks in equity markets.

In Fixed Income, we benefited from falling inflation expectations and prudent duration management.