7/31/2019 2nd Quarter 2006 Commentary
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QUARTERLY COMMENTARY SECOND QUARTER 2006
TURBULENT 2ND
QUARTER
The second quarter of 2006 was not kind toinvestment markets. In
the first quarter, investorswere optimistic and upbeat anticipating
that the Fedwas nearing the end of their rate hikes. In the
secondquarter, fear of rising inflation drove the markets asthe Fed
continued to raise rates. Large capitalizationU.S. stocks were down
-1.4%. This performancewould have been much worse had it not been
for the2%+ market rally on June 29th. Small stocks declined5.0% in
the quarter. The fixed income markets werealso off, falling -0.3%
as bond prices declined bymore than the income they yielded. Large
foreign
stocks were up 1.0%, but emerging market shares fellby -5.2%.
Housingmarkets in many partsof the U.S., includingSilicon Valley,
havemoderated. Gold rosedramatically from $583per ounce to a high
of$730 falling back to$583 before closing thequarter at $615.
Thevolatile markets were
not a reflection of thecontinued strength inthe economy as
GDPgrowth was revised upto 5.6% for the firstquarter.
Ben Bernanke had a bumpy start to his first fullquarter as the
Chairman of the Federal Reserve. InApril, he showed his
inexperience when he casuallymentioned to a reporter at the White
HouseCorrespondents Dinner that the markets had
misunderstood his recent comments. The marketsfell the next
trading day after his comments werewidely broadcast. Mr. Bernanke
is learning thatwhen speaking with reporters nothing is off
therecord. At the May and June meetings the FederalOpen Market
Committee (FOMC) raised the FedFunds rate by percent for the 16th
and 17thconsecutive increase. The markets are not convincedthat
Chairman Bernanke has the conviction to keepinflation under
control, but reveled in the language
within the committees statement that further rate
increases may not be necessary.
The current account deficit continues to rise as weimport far
more than we export. (Please see the chartbelow.) This means that
the U.S. is becoming similarto a profligate spender who risks
maxing out allavailable credit only to find it daunting just to
repaythe interest required on all outstanding debt.Someday this
deficit will have to decline or we willsee a run on the dollar as
our foreign lenders, whohold U.S. Treasury bonds and invest in U.S.
assets,refuse to offer us more credit.
The fixed income markets areincreasingly sensitive tocomments
about future Fedaction. The quarter beganwith a flat yield curve,
withinterest rates between 4.8% at6-months to 4.9% for U.S.Treasury
bonds maturing in30 years. In response to theFOMC raising
short-termrates, yields on longer-term
bonds have also risen. Thismeans that longer bonds havedeclined
in price. Over thelast 12 months the 30-yearU.S. bond has seen its
pricedecline -16.9%, for a totalreturn of 12.4%. In
contrast, our portfolios durations have continued tobe very
short; as a result, we have out performedbenchmarks and have
positive returns from our fixedincome investments.
EARNINGS REMAIN STRONG
For the 16th quarter in a row, the earnings of the S&P500
companies grew more than 10%. Investorscontinue to worry that
double-digit earnings growthcannot continue, leading to the muted
performance oflarge cap stocks over the last eighteen months.
Thecombination of earnings growth and moderate priceappreciation
has resulted in the valuation of the S&P500 trading at 17 times
earnings. This is veryreasonable given it traded at 27 times in
2000 and 43times in 2002.
Source: US Dept. of Commerce
-240
-200
-160
-120
-80
-40
0
40
1998 1999 2000 2001 2002 2003 2004 2005 2006
Balance on Goods
Net Unilateral Current Transfers
Balance on Current Account
Balance on Services
Bal. on Income
Billion $U.S Current Account Balance & Its Components
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www.nelsonroberts.com
PORTFOLIO ACTIVITY
On the heels of our March 30th sale of Paychex(PAYX), we exited
our position in Automatic DataProcessing (ADP), completing our
profitableinvestment in the payroll processing companies.During the
quarter, we executed our renewable
resources theme and purchased SunOpta (STKL),Hain Celestial
(HAIN), and United Natural Foods(UNFI). With theaddition of these
threecompanies we are nowvertically invested inthe natural
foodsbusinesses: rawmaterial manufacturing,product processing,
andpackaging anddistribution. These investments also contribute
to
two additional areas of focus. The first is to gainexposure to
under-discovered industries with longterm growth prospects, and
second is to reduce theaverage size of our portfolio companies.
PAYX andADP combined for nearly $40 billion in
marketcapitalization,while the combined market capitalization of
STKL,HAIN, & UNFI is $2 billion. Attractiveopportunities in the
equity markets exist in todaysenvironment. We are currently
researchinginvestments in alternative energy sources such as theoil
sands in Canada, and fountain of youth stocks
(those that will benefit from the aging of the babyboomers).
HEDGE FUND EXPOSURE
The hedge fund industry and hedge fund investmentshave attracted
an increasing amount of mediaattention and investment dollars. We
consider ourposition in Goldman Sachs as a proxy for a hedgefund.
The company is #1 in terms of the alternativeassets under
management at $21 billion. Even withthe stocks 6% decline in the
second quarter it is up15% year to date, surpassing the average
return ofhedge funds themselves during that same time period.
NEW TREASURY SECRETARY/WEAK U.S . DOLLAR
President Bush named Hank Paulson, the CEO ofGoldman Sachs, to
replace John Snow as TreasurySecretary. The U.S. Senate voted
unanimously onJune 28th to approve Mr. Paulson. We believePaulsons
appointment will be positive for theeconomy as he brings
credibility and a deepunderstanding of the risk and return factors
of themarkets.
One of Paulsons primary focuses will be tackling abulging trade
deficit. He has already hinted at oneway to address this issue: to
convince the Chinese toallow the Yuan to rise and to further open
up theirmarkets to U.S. goods and services. Having traveledto China
seventy times over the last 15 years, Paulsonhas the experience and
understanding to deal with theChinese government and to convince
them that it is in
the best interests of bothcountries to close thetrade gap. If
Paulson issuccessful, we believethis will put pressure onthe dollar
to weaken.As a way to profit froma falling U.S. dollar, weare
looking at investing
funds into un-hedged non-US sovereign debt. Weanticipate adding
a small percentage of foreign debtwhile maintaining a 12% target
for foreign equities.
ESTATE TAX
We have seen some recent progress in Congresstowards permanently
amending the estate tax.Proposals for a $5 million personal
exemption andthen a 15% tax on the next $25 million in assets,
lookpromising and could mean significantly lowercontingent estate
tax liabilities for all but the ultrawealthy. Additionally, the 15%
Federal capital gainstax would be extended and there is a proposal
to
eliminate the $100,000 Modified Adjusted GrossIncome limit on
Roth conversions. If passed this lastitem will be important for all
of our clients withsignificant retirement accounts.
OUTLOOK
In the near term, if domestic interest rates continue torise
faster than those in Europe and Japan, the dollarwill likely move
higher. The effect will be furtherwidening of the trade deficit and
current accountbalance. Longer term, increasing deficits will
exertdownward pressure onthe dollar in order to financethese
deficits. A weaker U.S. dollar will benefit theU.S. economy,
especially larger capitalizationcompanies who sell goods and
services overseas. Atpresent, the stock market offers reasonable
value.However, as the economy begins to slow, themarkets concerns
will make increased diversificationparamount in buffering the type
of volatility weexperienced in the second quarter.
Index Performance Q2 06 YTD
Dow Jones Industrials 0.94 5.22
Standard & Poors 500 -1.44 2.70
EAFE (international stocks) 1.00 10.56
Russell 2000 (small stocks) -4.98 8.26
Lehman Intermediate 0.21 -0.17
Lehman Municipal 0.03 0.28
