First Quarter 2006

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Stapp Financial Investment Letter

Quarterly Investment Commentary

Stocks had a good first quarter in 2006, with the S&P 500 gaining 4.2%, but the real standouts were smaller-cap and foreign stocks. The Russell 2000 shot the lights out, gaining almost 14%. Foreign stocks rose 9.5%, with just over one percentage point coming from currency appreciation. REITs also had a huge quarter, gaining roughly 15%. In the face of steadily rising interest rates, the Lehman Aggregate Bond Index struggled to stay in the black, and a tough month in March resulted in a quarterly loss of 0.7%. Commodity futures struggled as well, losing more than 2%. Emerging-market short-term bonds, however, fared better with a 2.6% gain. Most of our model portfolios are trailing their benchmarks so far this year, but our longer-term track record continues to be very strong and we remain confident in how the portfolios are positioned.

Rising interest rates, fear that the housing market may be starting to roll over, a growing current-account deficit, volatile commodity prices, ongoing turmoil in the Middle East—all of these concerns have been on investors’ minds lately. Looking past short-term noise is important in making good investment decisions, but many of these issues are more than noise, and require that we evaluate and try to put them into an investment context. As always, we think in terms of scenarios and probabilities as we try to weigh both the likelihood that any given event(s) might occur, and what the magnitude of its impact on our investment portfolios might be. An important piece of this puzzle is valuations, since valuations impact how well we might do in a more positive scenario and how much of a cushion we have against a more negative scenario. So in addition to looking at both bigger-picture issues and specific issues impacting the major asset classes, this quarter we also discuss our most recent valuation work and what it means for our portfolios.

Equity Market Outlook

Our view continues to be that risk levels are above average, but that valuations appear to be reflecting at least some of that risk. An almost endless list of positives and negatives can come into consideration, and our goal is to make a realistic assessment that weighs optimism and pessimism fairly. We give more weight to factors that are material and knowable, and then try to evaluate how they might relate to a clear, high-conviction argument for making a move in our portfolios. This approach can be applied to all asset classes, but in the tables that follow are some of the specific issues we believe are worth thinking about in the context of the U.S. stock market.

Valuations are at the heart of any market analysis, but valuation work involves a lot of judgment calls. Without going into the gory details of every single valuation method we look at, we’ll give a brief overview. Right now, the P/E ratio of the S&P 500 is around 18. Over the last 50 years, the average was 17.4, and over the last 25 years (which we believe is an environment that more closely reflects the modern market) the average was 20. Based on these absolute numbers, P/E multiples look about average (maybe even a little better than average), which by itself is neither strongly bullish nor bearish. However, we believe that today’s lower interest rates probably justify above-average multiples, and on this basis valuations are actually attractive. Our own valuation model is based on normalized earnings, and it shows the market as being on the cusp of materially undervalued. As weak trailing earnings drop off, it could show even further undervaluation, even as current earnings growth begins to slow (as is likely). The Fed model—which explicitly incorporates interest rates (as does our model)—shows the market as being significantly undervalued. On balance, even when factoring in some negative earnings and macro-economic scenarios, we think valuations are somewhere between reasonable and attractive.

There are other non-valuation-specific reasons to be optimistic: Trailing long-term stock market returns have been below average (2.3% for the S&P 500 over the last five years and 8.8% over the last 10), and over the long term we think the odds favor sub-par performance to be followed by average or better-than-average performance, and vice versa. Turning to economic fundamentals, the overall health of corporate America appears to be quite good, earnings have been on a tear, profit margins are high, and core inflation is restrained (oil prices have pushed up reported inflation, but not to outrageous levels). All these variables—as well as others—contribute to our belief that we should be at our neutral allocation to equities, if not overweighted.

The generally positive fundamental backdrop and attractive valuation level begs the question of why we aren’t overweighting equities. The answer is that there are significant risks as well. The current-account deficit, the impact of a slowdown in housing prices, and other macro-level risks could all create scenarios where earnings could decline significantly (e.g., a weakening dollar could depress demand for Treasuries by overseas investors, leading to recession-inducing interest-rate increases; flat or declining housing prices could cause a negative wealth effect, hurting consumer spending, etc.). Earnings growth is still quite good at the moment, but profit margins are near all-time highs, which leaves little room for improvement, and earnings are way above trend, which in the past has been followed by big earnings corrections.

Turning to the length of the current economic expansion, our economy has been growing for a little over four and a half years, which equates to an average post-World War II expansion. The last expansion (defined as the period between recessions) lasted almost 10 years, so it’s possible that things could continue to be good for a while, but the odds are that we’ll have another recession sometime in the next several years; the team at PIMCO has suggested the possibility that this could happen as early as 2007, as the full impact of the Federal Reserve’s interest rate hikes are felt throughout the economic system.

There is also a general lack of the pessimism normally associated with buying opportunities, and few of the managers we think most highly of are pounding the table with enthusiasm about buying opportunities. So, as always we face a balancing act of pros and cons, and when we weigh good valuations based on current fundamentals against the probabilities and magnitude of future risks and fundamentals, we need a larger margin of safety—in other words, larger undervaluation—as compensation for taking the portfolio-level risk that would come from overweighting equities. From current levels, it would probably take a high-single-digit percentage decline for stocks to get us to the point where we would tactically overweight equities.

Among the sub-sectors of the U.S. market, large-cap and growth stock valuations are favorable versus small-caps and value stocks, respectively, but not sufficiently so to warrant a tactical change in our asset allocation; some of the managers in our portfolios have the flexibility to exploit these valuation gaps at the individual stock-picking level, which we think is the best approach to use for now. In looking at foreign stocks, there are some similarities and some differences in our analysis of the fundamentals relative to domestic stocks, but a big part of our thinking with this asset class is influenced by valuations relative to the U.S. market. Right now, developed foreign markets appear to be within a broadly defined fair-value range relative to the U.S.

Investment-Grade Bonds

Intermediate-term bond prices have finally started reflecting the Fed’s tighter interest rate policy, and the yield-to-maturity of the Lehman Aggregate Bond Index stood at 5.3% as of this writing. With yields at this level, it’s likely that bond returns going forward will both beat inflation and equal their historical long-term average performance. Returns can and will be higher and lower over shorter time periods (anything less than three to five years), but on balance the prospects for bonds are better than they were a year ago, and we’re comfortable saying they’re within a fair-value range. In addition to an improved outlook in a steady-state scenario, bonds could generate fairly attractive returns should a recession (or worse) come about—conceivably even double-digit gains over a 12-month timeframe—and this would provide an important counter-balance to what would be an ugly environment for stocks.

Non-Strategic Asset Classes

Right now, we own commodity futures and emerging-market short-term bonds in our balanced models. Not unexpectedly, commodity futures have been on a wild ride over the past couple of years; historical data shows that this is a volatile asset class, and we knew this from the start. We own commodity futures mainly as a portfolio diversifier (they add defensive characteristics to the portfolios without compromising long-term potential returns), and we increase or reduce our exposure based on their attractiveness relative to other asset classes, as well as a handful of commodity-specific valuation metrics. As equities and bonds become more attractive, it increases the possibility that we will move out of commodity futures. We are not at that point yet, but it’s something we’ll be looking at more closely as the Fed nears the end of its tightening cycle (this is one of the key metrics in assessing when to be “in” or “out” of commodity futures).

The current-account deficit recently hit an all-time record of 7% of GDP. The U.S. continues to import far more than we export, and while there is some debate about the calculations used in measuring this statistic, the trend is clearly getting worse rather than better, and is unlikely to last indefinitely. One way—and probably the most likely way—this will be rectified is through a decline in the value of the dollar relative to the currencies of our biggest trading partners, and if such a decline occurred quickly and in a “disorderly” manner, it could cause foreign investors to lose confidence in U.S.-based stocks and bonds, and our markets could decline precipitously. We don’t know how this imbalance will eventually be corrected, but emerging-market short-term bonds provide a valuable currency hedge, as well as the potential for better-than-average returns compared to domestic bonds.

REIT fundamentals have been improving, but their stock prices have more than accounted for this and we view valuations as being unattractive, if not outright overvalued. In the past, it was possible to argue that cap rates (the earnings yield on real property) were too high relative to other financial assets, and as such real estate prices were probably too low. The evidence we see now suggests that cap rates are at best fairly priced, and may actually be speculatively low in certain segments of the real estate market. So it appears that commercial real estate is no longer undervalued, and this is reflected in the prices of the REITs that own these properties. With NAREIT Equity Index dividend yields of barely 4%, long-term earnings growth that should be close to inflation, and valuations that are—at best—average, it’s hard to make a compelling case that REITs are attractive relative to equities, or even a mix of stocks and bonds.

Final Thoughts

With no exciting investment opportunities, it can be a frustrating time for some. However, a few great investors that we respect have commented that sometimes the big money is made in the waiting. We believe this. There will be times when investor fear will present us with some clearly great opportunities. The key is having the discipline to wait, and having that discipline is something that we take pride in. The good news is that right now, equity valuations are somewhere between average and good, which gives us confidence that even if we don’t get a great buying opportunity, returns on average over the next several years are likely to be at least decent. Rising interest rates have brought investment-grade bonds back into fair-value territory, so their future contribution to our portfolios should be better than it has been over the last year. We have our money invested with great fund managers who we believe can add significant value over their benchmarks over the long-term. These are all good things to focus on while we patiently wait for the next compelling opportunity to come along.

We thank you for your confidence and trust.

Stapp Financial Planning, PLLC

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