Q2 2006 Notes on the Quarter

Q2 2006 Notes on the Quarter

Overview of the Quarter:

  1. May and June reversed the trends of the first four months; commodity prices dropped dramatically, along with the emerging markets, on average between 25% and 30% from their highs.
  2. Housing continued to show weakness. Prices have actually started to decline. The Fed continued to raise rates, and they currently stand above the 5% many expected (now Fed Funds rate is 5.25%) The reason is that inflation is now recognized to be a bigger problem than before. The Yield Curve has become inverted, although only slightly.
  3. By the end of the quarter, the S&P 500 was up less than 2%. Confusion has investors hesitant to make investment decisions.
  4. Earnings for companies have been very good this quarter. The question is what will they be like in six months? In general, technology has reported weak earnings. Pharmaceuticals have had good earnings, as have industrials and energy sectors. Interestingly, while Fed Ex had good earnings, UPS had disastrous earnings, and the transports in general have had mixed earnings. The importance here is that these stocks are typically good economic indicators.

Portfolio Specifics:

  1. This past quarter healthcare and pharmaceuticals have rallied off their lows, but little else worked well. This is a short term problem only, as the companies we have invested in continue to produce excellent earnings.
  2. We were correct that the Fed would raise rates higher than investors expected, so having cash has been good. The sell off is going to give us buying opportunities. The economy still looks good; now the question is how far will the Fed go and will they push us into a recession? We do not think so, but would like further confirmation before we get too aggressive.
  3. Large caps are cheap compared to rest of the marketplace. They may finally shine if the economy slows down, thus making dividends as important to stock picking as earnings growth.
  4. Do not rule out alternative investments such as real estate and private investments in when special opportunities arise. These investments certainly have their risks, but the are also very isolated from the public markets, providing portfolios with a low correlation alternative and some protection from market volatility.

Looking Ahead:

  1. During the latest Humphrey Hawkins testimony, Fed Chairman Bernanke expressed the opinion that economic growth would moderate the rest of this year and next, that inflation was under control, and it was suggested that he might stop raising interest rates before too long. Higher interest rates, higher energy prices, and higher inflation in many broad economic areas certainly should slow down economic growth. If inflation is primarily due to energy prices, then a small reduction in consumer spending should lead to moderating inflation (remember that inflation gauges are lagging indicators). However, if inflation is more deeply entrenched, then for it to moderate, consumer spending will have to slow more dramatically, making a recession more likely, or inflation will remain relatively strong as businesses try and raise prices to maintain their margins.
  2. The markets have priced in a slow down in corporate earnings in the second half. The current gyrations imply that it is still unclear whether the economy just slows or actually turns negative. Unless inflation continues to rise intermediate notes will become attractive. As long as we do not end up in a recession this low point will be a good entry point for stocks as well. Pretty clear, right?
  3. Will energy prices remain high and what will the impact really be? Oil prices have remained in the +$70 range for some time. However, gasoline prices have actually come down some. Natural gas prices have dropped dramatically, although they are still at or near $6/bcf. Until recently, the summer generated relatively little demand for natural gas, and there have been no hurricanes (the press et al were all predicting an active hurricane season like last year). However, even with natural gas prices down some 60% from their highs, the typical historical summer pricing for NG is closer to $2/bcf, not $6/bcf. Thus, profits are still enormous yet stock prices do not reflect this. Dislocations = profit potential.
  4. Longer term, energy, healthcare (specifically pharmaceuticals and biotechs and body parts), and industrials will do well. The drivers: infrastructure growth in China, Hong Kong, India and Brazil and Chile and Japan (to a lesser degree), and the aging population around the world.

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