Third Quarter Update

Interest Rates and Bonds (The conundrum)

Recently, we have been considering some of the data that have diverged from our previous assumptions. One question that continues to arise is, why have long-term interest rates remained so low, in light of our strong domestic economy and the Federal Reserve Board's persistent steps to raise short-term interest rates? While bond yields have risen in recent weeks, long-term interest rates are still well below their historical average. For example, the ten-year U.S Treasury bond currently yields about 4.0%. But over the last fifty years or so, the median yield on that bond is nearly two percentage points higher.  In fact the spread between the 10 year note and the 30 year bond is almost 20 basis points a historical low. 

With economic globalization, doing business in the U.S. and the rest of the industrialized world has undergone vast change. Most major companies are no longer integrated manufacturers. Rather, collectively, they design, market, and sometimes assemble the products they sell. For the most part, these companies now outsource their basic manufacturing to the lower-cost, less-industrialized parts of the world.

There are many consequences of this trend. One is that the basic nature of U.S. domestic employment has changed. With fewer of the more volatile manufacturing jobs here, U.S. employees in general now have greater job security. And with increased job security, workers and their families can spend more confidently. And although the data shows the U.S. consumer to be very heavily indebted, a significant portion of that debt is in the form of fixed-rate mortgages at historically-low interest rates. (As a simplistic framework for the discussion that follows, interest rates are a function of the supply of funds, the demand for funds, inflationary expectations, and risk.)

From a corporate point of view, the new U.S. economy requires less spending on plant and equipment. So one reason interest rates have remained low is that companies now have less reason to borrow (the demand for funds). In fact, U.S. corporate cash hoards are at record levels, leaving one to wonder what will be done with all that liquidity. Rising dividends and increased appetite to buy back stock at reasonable valuations and an increasing level of acquisition activity seem most likely. Also, with favorable balance sheets, the probability of corporate defaults is relatively low (risk).

From a supply of funds standpoint, there is a substantial amount of liquidity in the financial system, both domestically and abroad. We have heard it said that the financial infrastructure of the Western world is organized to facilitate the provision of capital to the more-industrialized nations. However, by outsourcing manufacturing to the less-developed parts of the world, we have also outsourced at least some of that need for capital.

Economic globalization has also served to reduce inflationary pressures and contain inflationary expectations. While there is no question about the influence of rising commodities prices, globalization has resulted in tremendous competitive pressure to keep prices down. In the current age of information and mobility, businesses respond quite rapidly to new trends. As a result, there are few truly unique products or services that allow for long-term pricing power. So in order for companies to prosper without something unique (i.e., a coveted brand or patent), they must constantly strive to be a low-cost provider.

But not all of the current influences favor low interest rates. In addition to rising raw materials prices, there are the cyclical inflationary pressures of dwindling available capacity, slowing productivity growth, and a tighter but still accommodative monetary policy. Furthermore, we have a growing federal budget deficit and a government that shows little sign of reducing its excessive rate of spending. Taken as a whole, the current U.S. balance sheet is too heavily laden with debt. Thus, the dollar could weaken further and the foreign investors upon which we are so heavily dependent may choose to eschew additional holdings of U.S. bonds.

In conclusion, the conundrum remains.  However, historically, rate spreads as mentioned earlier in this note, have never remained at this level.  In our opinion the risk reward remains favorable to the equity market over the bond market as the spread may widen and rates move higher as the Fed rate increases take hold and a stronger economy take effect.   So if you are considering refinancing your home, do it now. 

SWCM Composite Portfolio (Equity and Fixed Income)

 As mentioned in the past updates we continue to remain very optimistic with the current equity market conditions and consequently the current holdings in the SWCM composite.   Recent additions to the SWCM Composite include IACI (Interactive Corporation).   IACI is a holding company, run by Barry Diller, which owns many flagship internet based companies, including Evite, Expedia, the Home Shopping Network (HSN) and Ticketmaster.   In our opinion this is the best ways to play the internet sector by owning a holding company correlated to the rising interest in internet based companies.  IACI trades at a very low cash flow to earnings of 25 times and trades at 1.1 times book value.  In addition IACI has announced that they will be spinning off Expedia into a separate managed company which in turn allows IAC to unlock even more value.  In addition we sold most of our holdings in Eastman Kodak (EK).  EK missed the quarterly earnings estimates for the 1^st quarter and our belief is that future earnings guidance and the transition to a digital platform may take longer than anticipated consequently increasing the risk.  On the Interest rate front we continue to believe the long term rates will climb. While this has not proved to be the case we are still somewhat bearish on longer term bonds and stay invested in interest rate floaters and inflation based floating rate bonds.  Overall, the SWCM composite has underperformed the S&P 500 index by 5.0 percent during the first 6 months of the year.   Similar to the past 2 years we expect a strong second half of the year and SWCM to outperform.

Our approach for the quarter

Market conditions will continue to be quite volatile as we enter the final stages of what we believe will be the end of the Federal Reserve lifting short term rates.   As mentioned in the previous quarterly outlook we are in the midst of a confluence of market changes that once behind us should allow the recovering economy to be reflected in increasing equity valuations.  

 

Closing Statement:

We remain optimistic about the long-term opportunities in the equity markets and continue to feel comfortable regarding the current stock market environment.  Stocks remain the most attractive broad investment category currently available to the average investor.  Bottom line, we continue in our belief that the current risk/reward environment is positive for equity investors. 

While our strategy remains solid we continue to focus on companies with strong earnings and growing revenues as we select new names for the SWCM composite.  Our strategic outlook has us positioned for a longer, more powerful bull market. 

As always, SWCM values each client and continues to focus on your investment objectives.  If you have any questions or concerns please do not hesitate to call.

* All performance measures are based on a model composite portfolio managed with a growth perspective. All numbers are not audited and are not in compliance with AIMR. Ask for more detail regarding the model growth portfolio.

Disclosure: Examples of specific securities and/or sectors are given for illustrative purposes only and should not be used or construed as recommendation for any security and or sector. Past performance does not guarantee future results. Total returns are historical and include security values and reinvestment of dividends. Cumulative total returns are reported as of the period indicated. The results provided have not been audited and are based on a composite of client's accounts. . For information pertaining to the registration status of SWCM, please contact SWCM or refer to the Investment Adviser Disclosure we site (www.advsierinfo.sec.gov).