Commentary and Articles

1st Quarter 2007 Quarterly Synopsis

“Showing Weakness”

The concerns we discussed in the 2006 commentaries began to come to light in 1st Quarter 2007. With geopolitical concerns driving oil prices higher and credit quality in mortgages beginning to strain the financial sector, equity investors were given a bumpy ride.

As the U.S. equity markets continued what was already a longer-than-average bull market (over 50 months without a 20% decline), warning signs continued to persist. Oil prices rose again to over $60 per barrel, and foreign and domestic equity markets were down over 4% for the first week of March only to rebound two weeks later. This volatility seems to indicate a lack of decisiveness about the market’s overall direction and makes the future significantly less predictable.

Along with increases in energy prices and housing inventories, corporate spending is becoming a concern in the U.S. economy. January and February brought downturns in orders for capital goods and equipment. This weakness in corporate spending may mean a lower than expected GDP growth for the 1st Quarter. With the high liquidity on corporate balance sheets, the lack of spending shows the lack of confidence in growth prospects for these businesses. Instead, businesses are using cash to pay down debt and buy back stock. These are both conservative strategies which show not only lower growth expectations on the part of managers, but also the perceived opportunity to buoy stock prices by lowering financing risks.

While corporations are becoming more financially conservative, consumers found the need to continue spending using debt. As housing prices prevented the increase in borrowing from home equity lines of credit, credit card debt increased. According to BusinessWeek and the Federal Reserve, credit card debt increased by 6.4% in the 12 months ending March 2007. This is the highest increase since 2001. Such increases in debt coupled with housing concerns put U.S. consumers on shakier footing. In the recent slowdowns in corporate spending, the consumer kept the economy rolling, but now this seems unlikely given this debt picture. Employment will be a key factor in the health of the U.S. economy given the consumer risks.

These concerns seem to be playing themselves out in the earnings pictures of U.S. corporations. Earnings estimates have declined from 10% to 4% in the 1st quarter. Moreover, according to publisher Thompson Financial, for every company that says it will beat its earnings estimate, there are three companies predicting they will miss their estimate. This underscores the perception of corporations that conservatism on growth spending is key in this environment. We believe that volatility in equity markets will increase given the indications of slowing economic growth and earnings instability.

Our portfolios weathered the storm well in the 1st quarter as we continued to focus on diversification and fundamentals. Equity holdings Abbott Laboratories (ABT, NYSE) and Qualcomm (QCOM, NASDAQ) led the way. Many of the other large company stocks such as Microsoft (MSFT, NASDAQ), Johnson and Johnson (JNJ, NYSE) and Citigroup (C, NYSE) did not fare as well. Financial companies as a group did poorly except for holdings in Aflac (AFL, NYSE) and Goldman Sachs (GS, NYSE) which rose for the quarter. We will continue to pay careful attention to fundamentals in our individual equities. Our exposure to small- and mid-cap and international sectors offset problems in the large company holdings. In addition, portfolios with exposure to natural resources and real estate were helped by increases as well. This strategy to diversify to other equity opportunities paid off handsomely in the 1st quarter and we believe this strategy will assist client portfolios in the coming months of expected volatility as well.

Fixed Income performed well for the quarter and we expect to bonds to do well in spite of macroeconomic concerns because of continued low inflation, strong employment, and the potential for interest rate cuts in 2007.