Q2 2007 Notes on the Quarter

Q2 2007 Notes on the Quarter

Overview of the Quarter:

  1. The U.S. economy started to pick up steam, after slowing in Q1. This led to a rise in interest rates; the 10 year Treasury note has been fluctuating between 5.10% and 5.25%, up from 4.80%.
  2. Real estate price continue to weaken and defaults continued to rise. The sub prime loan problem extended to a number of hedge funds – though few are owning up to the losses at this point. If prices do not strengthen, more funds will have to admit their pricing is wrong.
  3. Markets around the world showed strength in the second quarter. Year to date, the S&P 500 is up 6.00% and the Russell 2000 is up 5.9%. The energy sector led the markets, both domestically and internationally.
  4. Gasoline prices climbed to around $3.00 per gallon and food prices rose as well. Core inflation (ex – food and energy) was flat.
  5. No substantial correction took place. Hedge funds and others are more heavily short than they have been in a long time. Who will blink first?

Portfolio Specifics:

  1. Seemingly, the best of all worlds continued to bless the equity markets. Inflation, according to the numbers, remained tame and the economy continued to expand. Energy and commodities continued to do well, as did materials. Technology and telecommunications had good performances as well. Utilities weakened as interest rates rose, as did financials, REITs, home builders and building related industries.
  2. Mid Cap stocks continued to shine and Large Caps lagged. Growth outperformed Value – which has not happened for close to six years.
  3. The dollar continued to weaken, which helped earnings for many S&P 500 companies as about half of their earnings come from abroad. Foreign markets continued to show some growth albeit at substantially slower growth rates than last year.

Looking Ahead:

  1. We continue to believe that China is expensive. While we expect the Chinese economy to continue to prosper, we are very suspicious of current ETF prices and believe that Asia – ex Japan is a better way to take advantage of the Chinese economy.
  2. We also believe that energy prices are ahead of themselves short tem. While we like the sector long term, we would wait for a pullback before adding to the sector.
  3. Last quarter, we warned that while the pundits were claiming that housing had hit lows, we believed they were wrong. Let us start by saying, “Neener, neener, neener!” or as my four year old says to me, “Told ya! I told ya!” The housing stocks continue to fall, and announce more write-offs of property value. In addition, most investors in sub prime loans have not marked their portfolios to market, and now S&P is lowering the credit quality on many of these pools. There will be more scares ahead. I do not expect the Fed will have to step in (“systemic risk”), but it will lead to short, violent rallies in bond yields and short, violent losses in the stock market. Unless it becomes a systemic issue, the economy will likely muddle through the rest of the year.
  4. Possible Issues: 1) As the economy continues its current pace, we would not be surprised to see rates rise a little more. The Fed is in no position to lower rates given the currenteconomic environment, especially when one factors in the rising cost of gasoline and food. This could lead consumers to slow their spending a bit. 2) China may slow things down more after the Summer Olympics (2008). 3) We have a presidential election next year, and we may see more weakness as we get closer to it. Finally, 4) the next round of adjustable rate loans will adjust in late Q3 and Q4 of this year; the impact should be felt next year.
  5. If we are correct, then we won’t have a bad market this year, but may experience a slow down next year. This does not mean we couldn’t see a correction this year before moving higher. While we like the prospects of Asia over time (China, Viet Nam and India specifically) and parts of Latin America (Brazil), we would like to see them pull back first.
  6. M&A continues to be the driver for moving the markets higher. The only question, is why is this logical when rates are rising as are energy prices? What may be good for M&A may not be good for businesses. Further, the economy is long in the tooth, and the markets have not had a substantial correction in several years – all which increase downside risks.
  7. We first started expressing this concern last year, and while our expectations have been accurate, our timing has been off; things have simply taken longer than we expected. We will continue to seek opportunities while we watch for signs of cracks, which will happen, sooner or later. In the end fundamentals always win out.

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