Market Review & Outlook

By: Vaughn Antley MBA, CFP Vice President Senior Investment Officer

After four years in a row of positive market returns and current evidence of a slowdown in the economy, where do we go from here?

2006: A Year In Review

Oil started off the year at around $60 per barrel, about $10 below its peak of the year prior, but still higher than what the markets had become accustomed to. As the months moved on, so too did oil prices, ultimately peaking near $80 per barrel, amid a widespread belief that this would either ignite inflation or cause the Fed to raise interest rates to a recession-inducing level. Today, oil is back to roughly the same place at which it began 2006. We don't make portfolio changes on the basis of something as difficult to predict as short-term oil prices, and we didn't buy the secular arguments that ever-rising oil prices are inevitable, so from an investment standpoint we didn't take much action in response to oil prices.

When we started the year, the Fed was about 300 basis points (3%) into its tightening cycle, and investors were beginning to grow concerned about the possibility of an interest-rate overshoot causing a recession. By the time summer rolled around, the Fed had added another 125 basis points (1.25%) to the Fed Funds target rate, raising these fears even more, and the stock market started to feel the pinch. However, once the Fed finally announced that it was on hold for future hikes, the market spent the rest of the year bouncing higher. Throughout the year we maintained a neutral to slight overweight on stocks mainly because valuations were very attractive in the asset classes and sectors we favored. In addition, we felt that much of the negative scenarios on the economy were already factored in to the prices of the stocks we owned.

During the early part of the year we maintained very conservative short-term high quality bond portfolios. When Treasury bond rates spiked up in the early summer we thought rates were very close to a peak. This view was confirmed by the weakness in the housing market that seemed to be accelerating. Based on these facts, we extended our bond maturities to lock in the higher yields. Eventually, rates began to fall and our bond portfolios out performed their benchmark.

Equity Market Outlook

While the S&P 500 put up good numbers in 2006, the valuation picture has actually changed very little. This is because earnings have gone up along with stock prices, leaving the relationship between prices and earnings at about the same place. The P/E ratio for the S&P 500 currently is about 15.5, its lowest point since 1995. In the realm of long term investing, valuation of assets is critical and today's valuations are very comforting.

The major concern on most investor's minds going into 2007 is how much longer can the positive returns last since we have not had a down year since 2002. We are particularly troubled by the growing consensus of "good times ahead". These are fair concerns due to the fact we are currently experiencing a further slowdown in some economic indicators, particularly the housing market. The longer we go without a recession, the closer we are to the next one, and this is one reason to be careful about increasing the risk level in portfolios.

While our overall equity outlook is mildly positive, that doesn't mean we aren't seeing some opportunities within that universe. The extended period of small-cap out performance has created a valuation disparity relative to large-caps, which has caused us to shift practically all of our money from small-caps to large-caps over the last couple years. We think this valuation disparity offers investors a rare opportunity in the Large Cap market that does not come along very often–a decent upside with a minimal downside.

Although our absolute return numbers were good in 2006, this shift from small to large did detract our performance from the relative benchmark in our mutual fund models. Should Small cap stocks continue to out perform Large in 2007 (and it could surely happen given the short-term focus on the "hot" markets today) we would again fall below our relative benchmark. However, we feel we are taking the prudent position with our client's money when it comes to the ultimate decision of risk/return. In the end we simply have to do the right thing. Long stretches of looking dumb is an occupational hazard in the investment management profession.

We are in the process of preparing a special report that details the disparate relationship currently between Small and Large cap stocks, and the opportunity we think it presents. This report should be completed within a week. If you would like to receive a copy of this report you can email me at vantley@argentmoney.com or call 318-324-8000 and ask for Brandon or Myself.

Important Equity Market Variables To Consider

Much has been made of the recent "new all-time high" for the Dow Jones Industrial Average, and that this suggests the market is overvalued. While we don't believe that the Dow is a particularly representative benchmark, this nonetheless provides a good opportunity to think about what it means. True, the Dow is at a new all-time high. But the prior high occurred nearly seven years ago! In other words, we have only just regained the levels we last saw three-quarters of a decade ago. To us, that's hardly a sign of irrational exuberance.

The S&P 500 is the one we put the most weight on, and it is still more than 8% below its prior all-time high (reached on 3/24/00, almost seven years ago). And the NASDAQ is still an amazing 53% below its peak on 3/10/00. In fact the NASDAQ is at roughly the same place it was in January 1999, before the bulk of the bubble occurred. Let that sink in a moment: if you'd bought and held the NASDAQ eight years ago, you'd have a 0% annualized return as of today. Not exactly a spectacular return from a group that includes many dynamic and innovative companies like Microsoft, Intel, and Cisco Systems.

Bond Market Outlook

We continue to believe that inflation and interest rates will remain subdued for the next few years given the structural global forces holding them down; mainly 1) Cheap overseas labor, 2) Excess savings from newly industrialized and oil rich foreign nations, and 3) The demand for long dated bonds from Developed Nations to satisfy the growing pension liabilities of an aging global workforce.

The Emerging Market nations, such as China and India, offer much lower labor costs than the US worker, therefore, companies who outsource here do not need to raise prices of their goods (inflation) in order to compete. In addition, the wages of the workers, the profits of their companies, and the Reserves of their Governments, are invested mainly in the safety of US Treasury bonds through the banking system. Throw in the high profits from the many oil rich countries that are also invested in US Treasury Bonds, and the demand for our Bonds remains steady. This steady demand allows our country to finance budget deficits and keep interest rates low.

This relationship will most likely persist until the working citizens of these emerging countries become more "consumers" than "savers". Asian workers on average save approximately 35% of their wages, compared to a negative savings rate in the US. For now, they are the world's savers, and we are the spenders. We often joke here in our office that once the Asian factory worker discovers the Apple ipod and the Gucci purse, get the heck out of Bonds.

As a final thought on Bonds, should the housing downturn worsen, it is possible the Federal Reserve could be cutting rates sometime in 2007 to stabilize and re-ignite this sector.

In Summary

We are confident, however, that by remaining aware of overall risks and setting our allocations accordingly, we can continue to earn above-average long-term returns while keeping our shorter-term downside risk within our loss thresholds.

With the new year upon us, we issue our standard reminder to take a look at your portfolio allocations versus targets with an eye towards rebalancing, especially given the wide variation in returns in 2006. As always, we appreciate your confidence and trust, and wish everyone a prosperous 2007.