Q3 2006 Notes on the Quarter

Q3 2006 Notes on the Quarter

Overview of the Quarter:

  1. Well this was an unusual quarter. Typically one would expect a quiet August and a negative September. Instead, August and September were quite positive. The Dow Jones Industrials hit a record high, but the S&P 500 and NASDAQ are still 13% below their records.
  2. Economically, GDP growth slowed to about 2.5%, productivity also slowed but wages grew. This suggests that inflation may be a bit more of a problem than investors first thought. Also, the question of whether we will have a recession next year is still not clear. With the weakness in housing the Fed may be forced to lower rates. However, unless we see a slow down in the economy, higher inflation would impel the Fed to raise rates. Bonds are betting the economy slows; the stock markets are betting that any slowdown will be mild.
  3. Commodities and energy took it on the chin, losing in excess of 10% in the last month of the quarter. This was largely due to speculators and the demise of a hedge fund. Technology and healthcare did well. Large cap defensive stocks were the strongest performers.
  4. No surprise, housing continues to deteriorate. Fed Chairman Bernanke expects the drop in housing prices may reduce GDP growth by 1.00%. Housing stocks have collapsed by over 50%, although the have rallied recently off of their lows.
  5. Q3 Earnings: Housing companies continue to report weaker earnings, so we do not think that the bottom has been reached yet. So far, reports have been generally good, with few negative surprises or warnings. Those that miss their targets, however, are getting sold off hard.
  6. Internationally, Europe continues to emerge from its slump. The Emerging Markets, since they are so dependent on commodities, weakened dramatically, although Mexico has been strong since their election.
  7. Iran and North Korea are still concerns although they have not had much of an economic impact: note that gasoline prices have been dropping during all of these problems.

Portfolio Specifics:

  1. We said last quarter it was time to add Large Caps, and that ended up being good timing as they outperformed their Small and Mid-Cap brethren. This should continue until the economy starts to pick up steam. Defensive stocks did well, including healthcare, utilities and consumer durables.
  2. We added healthcare and large cap dividend stocks this past quarter. We also added short term agencies paying in excess of 5.4% as a hedge.
  3. The economy continues to look good; Asia and Europe continue to grow. We are seeing some inflation risks, there will be more fallout from housing prices and the economy is long in the tooth. This mixed bag means that a blend of strategies will be most successful.
  4. We expect the commodity areas to be under pressure for a little while longer. We will bide our time before adding to these areas. However, they are attractive long term, so patience will be worthwhile.

Looking Ahead:

  1. A recession or a slow down? The answer is not clear. Therefore a mixture of strategies will be best. We will continue to mix investments that will do well in a relatively good, albeit moderate economy, with those that are more defensive and generate cash flow. Combining this with special opportunities as they avail themselves should provide us with a good year.
  2. Energy prices have dropped as we projected. There could be a little more to go – $55 per barrel, maybe even a little lower. We are at the end of the Shoulder for natural gas, so the conjecture now will be on whether we have a warm or cold winter. Some of the natural gas stocks are starting to look attractive again. Longer term, there is more demand (read Asia) than supply. This will be true of most commodities. But with the massive amounts of capital chasing returns, expect volatility.
  3. We still like healthcare, both from defensive point of view and a demographics point of view. We also like commercial real estate and believe that it is still has plenty of potential. We tend to prefer those that generate cash flow, so triple-net leases and specialty areas are our favorites. Apartments are attractive; we would be careful of retail. Industrials are interesting as they have sold off so much.
  4. Internationally, Europe and Asia look attractive. Brazil and Mexico are becoming more interesting as well.

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