Issue 34 - December 18, 2006

2006 – The Good, The Bad, & The Very Good

As advocates of long-term investing, our goal is to construct portfolios that can prosper in good markets and provide hardy resilience to downward pressure during market corrections. Perhaps no year in recent memory has provided such a
testament to the importance of this discipline.

At the beginning of the year, expectations for 2006 were modest. The Federal
Reserve was still on its rate raising campaign and Chairman Alan Greenspan was retiring after 18 years at the helm. The housing market had begun slowing and domino effects on the U.S. consumer were expected to significantly slow consumption and thereby corporate profits. So what did the market do in the first quarter? It produced strong returns across all major equity asset classes. Returns ranged from +2.79% in the case of the Russell 1000 large cap growth segment to +14.23% for the Russell 2000 small cap growth segment. Bond yields, which might have benefited from a slowing economy, grudgingly traded back as stocks stole
the show.

Markets continued to thrive until the middle of the second quarter. The Federal Reserve, under the new stewardship of Ben Bernanke, continued the process of normalizing interest rates and raised the benchmark at each of the first three meeting opportunities. However, by mid May concerns over housing combined with profit taking in both commodity and emerging markets spilled over and much of the gains of the first four months were lost. The Federal Reserve then raised the benchmark rate at their June 29th meeting to 5.25% and the third quarter looked like it was going to be painful. August brought a reprieve to the markets as the Federal Reserve moved to the sidelines for the first time in over two years. Interest rates led by the longer maturities rallied and the equity market began picking up the pieces.

The U.S. economy did slow as was widely anticipated, but it did not slow in the manner that was expected. Housing slowed, but corporate profits remained robust and individual tax withholdings ran 8% ahead of 2005. The bears were gone and Goldilocks was back. Readers of our newsletter will recall that in March we discussed qualities of an ideal investing environment: an economy which grows at sufficient speed as to ensure growth and employment but not so fast as to induce inflation. This is exactly the environment market participants perceived as the summer came to a close.

September is traditionally the cruelest month in the equity markets. October gets all the bad press, but September rules as the worst performing month historically. Not this time around though. September was emphatically positive. October’s robust results built upon September’s gains and November continued the trajectory. As a result of this improbable path, 2006 will go down as being an extremely profitable year for long-term investors.

Risks and the Gift of Fear

In looking at the performance of 2006 and assessing the risks of the coming year, it might be instructive to consider how much the perception of risk has changed
during these past few years.

Many large institutions which had been negatively impacted during the bear market of 2000-2002 began to look for alternatives to some of their traditional allocations to stocks and bonds. It became the common wisdom that stocks would only earn 6-7%, a far cry from their 10%+ averages of the late 20th century, and with ten-year bonds yielding 4% or less; there was simply no way for these portfolio managers to keep up with their mandates and actuarial liabilities. It was quite natural then for these institutions to look to their unique structural advantages for ways to enhance returns. Specifically, unlike individuals, they are not taxable and they have extremely long-term time horizons. Short-term gains look no worse than long-term gains and any illiquidity required to drive returns back into the acceptable territory was manageable. Enter the era of Alternatives. Investments in Hedge Funds, Private Equity, and Real Estate have certainly brought the returns that these endowments required and are all happy to advertise. But at what risk?

Not caring about certain risks is not the same as not having them. While an institution may have the ability to participate in more illiquid opportunities, it does not mean that they should not be compensated for taking on that additional risk.
The same can be said for adding in leverage. Wall Street has traditionally valued risk in terms of price volatility to come up with a risk-adjusted return. The hallmark of these modern day alternative returns is their use of leverage and their overall lack of liquidity. It is exceptionally difficult to model these attributes to come up with any type of standard or historical data. Therefore the risk incurred in these allocations is a matter of debate. Have the institutions been fairly compensated for the risks they have incurred? All that has mattered is the absolute level of returns which has been quite good. Which brings us to a modern day definition of risk – one in which the risk of underperforming is perceived as more problematic than the risks potentially incurred with leverage and illiquidity.

We saw a perfect example of this last summer as the hugely successful hedge fund Amaranth lost 65% of its value in the month of September due to losses in energy trading. With leverage of 4.5 to 1 wrapped around illiquid commodity transactions,
a little bit of bad news went a long way. Perhaps a more worrisome issue is that a little bit of good news clearly went a long way in 2005 and no one was asking questions. As investors in the current climate we need to make sure that we are fairly compensated for the risks that we incur – including leverage and illiquidity – and we need to make sure that we all maintain our gift of fear.

2007 – Outlook

The conflicting signals that have characterized 2006 look as though they will be following us into the New Year. Debate regarding both the direction and timing of
the Federal Reserve’s next move dominates the forecasts. Housing activity has clearly slowed and is acting as a drag on the economy, however employment
remains strong and the IRS payroll withholding data continues to post strong gains suggesting that the economy could ride out this slowdown.

The Federal Reserve has been talking tough on the matter of inflation, but they have remained on the sidelines now since August with the Benchmark rate at 5.25% - the highest yielding point on the entire U.S. Treasury curve. Clearly the bond market is anticipating both continued economic slowing and a substantial rate cut in 2007 as ten-year U.S. Treasuries now trade 70 basis points below the overnight rate at 4.55%. An inversion in rates has typically heralded a recession, but then again there has been nothing typical about this most recent rate cycle. It is hard to justify lowering rates while inflation is accelerating, and at the same time it is hard to raise rates while the economy is slowing. Further muddling this picture is the fact that liquidity is ample despite 425 basis points of tightening over two years. As John Ryding of Bear Stearns commented in his year end remarks, “Financial conditions remain very generous.” Given this stalemate, we would expect the Federal Reserve to maintain its current posture well into the New Year.

With continued innovations in technology, productivity, and supply chain management the economy is enjoying a period that features less cyclicality than was historically seen. In addition, the billions of dollars which have gone into hedging strategies have further eliminated inefficiencies in the financial market place. This is not to say that volatility has been repealed. Opinions can vary widely in looking at the same data as this year so demonstrated. But the economic peaks and valleys might not be as great as in past cycles. This may help explain why corporate profitability has, broadly speaking, remained strong throughout this slowdown.

With a backdrop of low and stable interest rates teaming together with the strength and profitability of corporations, there are good reasons to be optimistic about 2007. Certainly risks abound. The recent weakness in the dollar could turn into a currency rout, but that serves no ones purpose; particularly those emerging markets which are so dependent on their attractively valued currency. Geopolitical concerns remain a worry and the trend for commodity prices is likely to be higher as demand grows from the Far East. But valuations in general have not outstripped earnings and as long-term investors we have the mind set to run these long races.

We wish you all a happy and healthy New Year!

• 2006 - The Good, The Bad, & The Very Good
• Risks and the Gift of Fear
• 2007 - Outlook