Monthly Investment Commentary

Stocks began 2007 with a strong month. The large-cap S&P 500 (as measured by the investable Vanguard 500 Index fund) gained 1.5% in January, while the small-cap Russell 2000 iShares gained 1.7%. Midcaps climbed by 3.4%, outperforming both larger- and smaller-caps. Based on Russell indexes, growth outperformed value across all market caps. Foreign stocks, based on Vanguard’s Total International Stock Fund, were up 1%. On the fixed-income side, domestic investment-grade bonds were down slightly, while Salomon’s foreign bond index was down 1.4%. Emerging-markets short-term bonds were also down, but fared a bit better than their longer-maturity, developed-market counterparts. PIMCO Developing Local Markets lost just over 1%. REITs continued their relentless climb with an 8.5% gain in January.

We are not making any changes to our model portfolios this month, but as we noted in our year-end commentary, we have been reassessing our commodity futures position. While our work isn’t final, we can report that in all likelihood we won’t be making any changes to this position (at least not in the near term). We’ll give our analysis next month in our model portfolio commentary. We have also been researching mid-caps and how they impact our asset-class exposure. The result of that analysis could be a further increase in our small-cap underweighting, in favor of larger-caps, in our equity-oriented models.

Our model commentary this month is a Q&A, in which we address questions from.

If there are so many strong arguments that an eventual dollar decline is inevitable, doesn’t it make sense to overweight foreign equities?

It is true that a declining dollar would enhance returns from foreign stocks thanks to currency translation (since investments held in foreign currencies are worth more in dollars as the dollar weakens 1). However, this same effect would hurt the profits of some export-driven foreign companies. For example, if the euro appreciates relative to the dollar, it becomes more expensive for U.S. consumers to buy products exported from Europe. In most situations, this will hurt sales. So a European company’s profits could be hurt by an appreciating euro, and this could offset some of the positive translation effect of U.S. investors who own its stock. This risk is why we chose to use fixed-income investments, rather than equities, to gain foreign currency exposure. (It is also worth noting that we do not see foreign equities as offering a compelling valuation advantage relative to U.S. equities.

I have noticed that even though your models follow asset-allocation targets, you are willing to accept a certain degree of “style drift” on the part of your managers. How does one stay consistent to an asset-allocation model without controlling for managers who drift among styles and asset classes?

Obviously, target allocations have a purpose—which is to help meet a specific risk threshold while maximizing long-term return potential—and so the real question is whether style drift detracts from this goal. It is possible that it could, and this is something we are aware of when we set our initial allocations to managers and as we do ongoing research on them. But knowing our managers’ investment approaches extremely well helps us in constructing our own portfolios, in that we can allow sufficient leeway for managers who are opportunistic in looking for great stocks to own. This last point is important, because finding managers who will add value over their benchmarks is also crucial to our process, and most of the time that means letting managers look different than their benchmarks (you can’t beat a benchmark without investing differently from it).

In practical terms, given that we already have portfolios that are well-diversified in terms of asset classes and managers, we consider it unlikely that a manager will invest so wildly different from our original expectation that it will materially throw us off our risk targets. If the style exposure is a little off because specific managers are finding opportunities in nontraditional areas, this isn’t a concern to us. Assuming they are true to their discipline, we believe that the specific opportunities they uncover at a stock-picking level are more likely to add value than we are by obsessively fine-tuning our asset-class exposure. We also suspect that investors who obsess over precise style exposure at times inadvertently diminish or negate the value added by their active managers by making counter moves at the asset class level.

Have you done any work on international real estate, and if so, what is your outlook for this asset class?

We have done a significant amount of preliminary work on the international real estate asset class in recent months. The objectives of this research were to:

• become familiar with the history of international property markets
• understand the opportunity set and the future growth potential of these markets, which included getting a handle on the pending REIT legislation in different countries
• look at return and correlation data against U.S. REITs as well as other major asset classes
• get a handle on the various benchmarks as well as the available investment options in this asset class

We recognize that international property has delivered very strong returns in recent years, and that it may continue to do so in coming years, but compelling past returns are not sufficient to justify a position in investors’ portfolios. We are wrapping up an initial analysis this month and will be publishing our preliminary opinion in March.

The yield curve has been inverted for awhile. Doesn’t this suggest a high likelihood of a recession?

Since 1959 the yield curve has inverted nine times prior to the current inversion. In seven of those instances, the economy was in recession within 20 months. That is a pretty strong correlation with recessions. But just because something is correlated with something else doesn’t mean it causes it. What might be different this time? One theory, suggested by PIMCO (among others), is that the global savings glut has caused bond yields to decline more than would typically be the case, perhaps to the tune of 100 basis points. This is a structural factor that is new. If they are right, it means that the savings glut is an important contributor to the yield-curve inversion. Heavy demand for our Treasuries by Asian and other emerging-market central banks are also part of the story behind lower bond yields.

Another argument is that economic volatility has declined over the past 25 years and factors that stimulated inflation in the past are less powerful now. If this is true, it would reduce risk premiums in the bond market and in turn result in lower interest rates.

We find both these arguments persuasive. We have not postured our portfolios based on an expectation that a recession in the next year is likely but we also maintain fairly healthy recession hedges via our bond positions and we are not overweighted to equities because we are respectful of recession (and other) risks.

You’ve noted that earnings are above their long-term trend and profit margins are at 50-year highs. Are we likely to see a big earnings decline?

We believe it is highly unlikely that earnings will continue their torrid growth of the past few years. Earnings estimates call for a slowdown in 2007, but that is not necessarily a problem if earnings still grow at a reasonably good pace, such as mid to high single digits. At present, earnings growth of about 10% is forecast for 2007. Having said that, it is difficult to accurately forecast earnings, and the sustainability of profit margins is a legitimate question. On the other hand, there are some observers, like GaveKal, whom we interviewed in our December commentary, who believe that sustainable productivity increases and structural shifts have changed the metrics. They make the point that there are many more companies that focus their efforts on design and distribution and leave the production to low-cost producers outside the U.S. These design- and distribution-oriented companies are less capital intensive, more productive, and have higher profitability—so maybe profit margins will be higher going forward than in the past. It is an interesting theory and GaveKal may be right. But we’re not willing to be too quick to buy into this argument given the complexity and number of variables at play in the world.

So we believe that the earnings outlook is questionable. If earnings growth stumbles, what might happen to stocks? It depends on the severity of the earnings slowdown. A mere slowing is not necessarily a concern. In fact, stocks have performed quite well in past periods when earnings slowed, as long as stocks were not overvalued when the slowdown began. Valuation is the key, and since we believe stocks are at worst fairly valued—and possibly undervalued—we are not overly concerned. Even if earnings go down, multiple-expansion can contribute to positive returns. The most likely key over the next several years is the economy. If we get reasonably good earnings growth (albeit slower), returns should be fine, and that is our steady-state scenario.

The economic expansion is now longer than the average. How does that factor into your risk analysis?

The average post-World War II expansion has lasted almost five years, though the last two expansions were eight and 10 years, respectively. So far, the current expansion has lasted around five years, so we’re about average in terms of duration, but clearly not “overextended” by historical standards. In terms of magnitude, this expansion has fallen short of past expansions, with cumulative “real” (net of inflation) GDP growth of only 17% versus 25% for the average. Though there isn’t a compelling historical argument to be made that the expansion is on its last legs, cyclical risk does seem to be one of the most identifiable near-term risks. These risks generally fall into two different, but closely related, categories:

Recession: The manufacturing sector has clearly weakened and housing continues to be weak. Encouraging signs suggest that housing may be close to bottoming, but it is too early to assume that is the case. Either way, the ripple effects of the housing slowdown, especially to housing-related industries, are just now kicking in (housing’s impact on the labor market has always lagged). The concern is that the economy may already be headed into a recession.

Inflation: During 2006 the core inflation rate (inflation excluding food and energy) spiked up to its highest level in almost a decade. And even though there is concern about a possible recession commencing in 2007, some economists worry about the opposite—that the economy will turn out to be stronger than expected resulting in higher-than-expected inflation. This could lead the Fed to go back into inflation-fighting mode by raising interest rates again. If that happened, the stock market would likely sell off and it would again raise the risk of the Fed being overly aggressive and actually triggering a recession.

Some observations on these risks: Inflation numbers have dropped from their 2006 peaks, and the bigger-picture factors that have held inflation generally in check haven’t gone away. The huge increase in global competition in the last 15 years from China, India, former Eastern-Block countries, and many other emerging markets, coupled with productivity-enhancing technology has resulted in an excess supply of labor and manufacturing capacity in the world. We will still see cyclical inflation spikes, but the recent weakening of the economy seems to have lowered that risk in the near term. Recession risk seems like the greater near-term risk given the housing market’s weakness, but the evidence is beginning to suggest that this too is lessening. The global economy appears healthy and China is now a second engine of global economic growth.

All this economic forecasting must be taken with a grain of salt. It is one of the least reliable foundations for investment decision-making because it is one of the hardest to consistently get right. Regardless of how it plays out it is likely there will be at least one economic scare during 2007 where markets react to economic numbers that suggest that either inflation will be stronger than expected or recession more likely than expected. That could be welcome news because it could trigger a stock market sell-off that would be a buying opportunity for long-term investors like us. If the economy does deteriorate, the Fed will lower interest rates, probably mitigating the downturn and setting up a new cycle.

What were the best- and worst-performing sectors in 2006, and was the dispersion between them a contributing factor in the underperformance of many of your Recommended funds this year?

By and large, traditional value sectors (such as energy, utilities, and materials) were the best performers last year, and traditional growth sectors (technology and health care) were the worst. While it isn’t easy to say the extent to which specific sectors contributed in 2006 (sector factors were more obvious in 2005 and 2004), there is definitely a style issue that has come into play. Value stocks hugely outperformed growth stocks last year (22% versus 9% based on the Russell 1000 style indexes). At the same time, many of the managers we like are finding good values in the growth-stock universe, and those kinds of stocks have not been doing well. Examples of names that are owned by at least two managers in our models include Dell, Sprint Nextel, Intel, eBay, Home Depot, and Microsoft. Another interesting observation that supports this explanation is that some of our “value” managers have been reclassified by Morningstar as “blend,” which is a statement about the degree to which these funds’ holdings fall outside of the traditional value universe. The message, to us, is pretty clear: most of our domestic equity managers are finding the best long-term investments on the growthier side of their respective universes, and in the short-term this has been a headwind for them.

A logical follow-up question would be, Does it bother you that your managers are buying stocks they don’t ordinarily own? We’re always curious to understand why managers make the choices they make, and that curiosity becomes even higher when those managers are doing something “unusual.” If we see something that looks strange to us, we’ll investigate it with the manager. And when we’re talking to managers about stocks, we test their assumptions, we press them on the details, and we want to be really, really sure that they have sound reasoning behind their investment decisions. Right now, our managers own a larger-than-average number of stocks that are deeply out of favor, and while it’s not fun watching it happen, we’ve come away from our conversations with these managers confident that they will ultimately be rewarded for these decisions.

—Stapp Financial Planning, PLLC

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— Stapp Financial Planning, PLLC

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