Fourth Quarter Update
The stock market has rallied over the last month, breaking the momentum of a 2 month decline, at least for now. But prior to the rally, the number of questions from clients had begun to increase. For the most part, they were the same questions that are asked almost every time the stock market trends lower. Is this a correction within a continuing bull market, or will it end up turning into something more damaging? If it is a correction, how long will it last and how deep will it go? Before we render our opinion, we should first consider where we are.
We have believed for some time that stocks were due for a correction. Prior to the pullback, the stock market had risen for 795 trading days without having suffered at least a 10% correction. It was the third-longest such period in S&P 500 history. In addition, speculative excesses had developed in the prices of commodity, energy, and emerging-market stocks, and in the past, rising speculation has been a typical sign that a market upcycle was nearing an end. Furthermore, as we have previously written, 2006 is the second year of the well-publicized four-year presidential/stock market cycle - a year during which stock market corrections have consistently tended to occur.
We have been impressed by the stock market's persistent strength, particularly over the past year or so, as stocks rose in the face of so much bad news. In retrospect, we wonder how investors would have positioned portfolios a year ago, had they fully foreseen the unfolding of events.
So what has changed? The primary difference now, as we see it, is in the liquidity environment, both domestic and global. In the days that followed the bursting of the technology and stock market bubbles, central banks around the world injected substantial amounts of liquidity into their economies in order to counteract the rising deflationary risk. Those funds not utilized by businesses and consumers spilled over into the investment markets. It was this excess liquidity that fueled the worldwide price appreciation in real estate, commodities, collectibles, and equities.
Here's what we believe: The pace of economic growth will slow somewhat, but will not slide into an outright recession. Global productivity gains, continuing growth of emerging-market trade, and an exceptionally competitive business environment will keep a damper on corporate pricing power. So we think it is unlikely that the Fed will see the need to raise interest rates much higher. What we anticipate is a mid-cycle economic slowdown.
From a longer-term point of view, the economies of the newly industrialized emerging nations will continue to expand. As they do, tens or even hundreds of millions of people will become new entrants into the middle classes. It is a self reinforcing process. Greater prosperity results in increased consumption of goods and services, higher levels of education, and increased opportunity for ownership. With those factors will come a much larger political base, supportive of fair and open markets. U.S. companies are well positioned to participate in a continuing global expansion.
During the past few months, stock markets around the world have been declining, most notably those sectors which were previously subject to excessive speculation. Yet, trading at less than 15 times forward earnings, current stock market valuations are quite reasonable, overall. Furthermore, the fundamental environment is sound. Inflation is likely to remain contained, the global economy will continue to expand, and Corporate America is in excellent position to grow earnings. Remember that corporate earnings represent the underlying value of the stock market. As earnings grow, stocks become worth more and as prices for these stocks decline the valuations become more attractive. Making equities in our opinion the most attractive investment alternative.
We are closely monitoring the actions of the Federal Reserve Board and our new Fed Chairman, but for now we view the current pullback as a correction within an ongoing bull market. Our stock market position is a compromise based upon time horizon. We cannot know how low the market will go or how long the correction will last. We expect volatility in the months ahead, and are fully aware that in the short-term, investor
psychology can sometimes overpower the fundamentals. The corrective process is probably not over, and may even seem scary at times, but we remember from past
experience that the best values and, therefore, the best opportunities tend to come during those times when the stock market outlook appears most bleak.
At SWCM we have positioned our portfolios in line with our positive long-term outlook. But for now, we have also chosen to retain a modest amount of cash and other short-term reserves so that we may have some buying power available as opportunities arise.
ACM 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 ACM composite. A recent addition to the ACM Composite is OPWV (Openwave Technologies). Openwave is a software developer focused on managing the data aspect of cell phones and mobile devices. OPWV trades at well below 2 times sales and around 1.5 times book value, which is right within the sweet spot of our value investing theme. We have also benefited from the acquisition of one of our better holdings (SBL) Symbol Tech. by Motorola. SBL was purchased by Motorola for 15.00 per share, in an all cash deal. Consequently, we have sold the position and are waiting for an optimal time to reallocate the proceeds. In addition, we have also focused client’s portfolios to benefit from a transition in market leadership. In our opinion the equity markets are moving from a commodity, energy and real estate focused market to a more growth oriented market. This includes financials, technology and retail businesses. This transition has been the main culprit in the recent market sell off and we have positioned portfolios to take advantage of this transition. 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.
Our approach for the quarter
Market conditions will be volatile as we enter the transition stage mentioned in the last paragraph. It is our belief that a larger than anticipated market correction may occur during the beginning of the 4th quarter based on this transition. There is no reason to become concerned or alarmed, this is only a short term correction to be followed by a larger and more powerful bull market. In addition, this may be a very violent and at times very scary correction. The market as a whole has historically corrected during transition times and as mentioned before has not had a 10 – 20% correction in some time. SWCM clients are and have been prepared for this transition.
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 value strategy remains solid we continue to focus on companies with strong earnings, growing revenues and attractive valuations as we select new names for the ACM composite. Our strategic outlook has us positioned for a longer, more powerful bull market.
As always, ACM values each client and continues to focus on your investment objectives. If you have any questions or concerns please do not hesitate to call.
