Perspectives

First Quarter 2006

On a tear!  Stock markets around the world, including our own, have been on a tear this first quarter. (See the major indices on this page.)  The stock returns of small and mid-capitalization companies have far outpaced those of large companies. International holdings also have turned in outstanding performance.  Annualizing the returns for short periods is fraught with peril, but indications are good for 2006.  At RCM, client returns have been exceptional and we do expect more to come.

Good stock markets often seem to climb a wall of worry.  Usually, the worries don’t go away, but prove generally to be overblown.  Some of the worries are the continuing war in Iraq, Iran’s apparent nuclear arms program, tenuous oil supplies, rising interest rates, bird flu, and the upcoming mid-cycle congressional election.  There are plenty more, but the focus on all waxes and wanes.  Despite the worries, this market just does not go down and stay down; a good sign.  (It just goes to show that money responds more to economics than politics.)

The prediction is that corporate earnings for the first quarter will increase by over 10%.  If that turns out to be the case, the spring of 2006 will be the fifteenth quarter in a row that earnings have increased by over double digits.  This is a remarkable record of corporate performance.

Bond yields, on the other hand, have crept up and as a result bond returns in the U.S. are mostly flat to slightly negative.  (Remember, as interest rates increase, the prices of existing bonds decline.)  Interest rates also are rising in Europe and Japan.  This is a sign of stronger economic conditions in all these areas.  The question is whether rates will go so high as to cut off economic expansion.  (See the Forecast section for our view.)

Forecast

Economy

The economy continues to expand at a healthy rate.  U.S. growth greater than 3% for the year is a realistic expectation.  In fact, the first quarter probably is growing at a rate greater than 4%.  So far, high energy prices and higher interest rates have not choked the expansion.

However, the economic expansion of late has changed in character.  Ever greater consumer spending has taken a back seat to business investment.  Capital spending is now growing at a double-digit rate and should continue for some time to come.  In the meantime the consumers aren’t pulling back, they just are not increasing spending at the same pace as before.  (This change in trend was anticipated.)

One important concern is the real estate and housing market, which definitely is slowing.  At Riverplace Capital we predicted a soft landing for real estate some time ago.  So far this looks like what is happening.  We are keeping our eyes focused on this important sector of the economy.  If real estate softens more than we expect, we will have to become more defensive in our investment approach. 

The Federal Reserve and policy makers in Europe and Japan are being careful to bring interest rates from unrealistically low levels to a point more in keeping with stronger economies.  There is always a risk that the policy makers go too far; however, that does not appear to be the case yet.  Deflation as a result of collapsing financial markets and declining economies was a real danger in 2001 and 2002.  This created immediate action and real concern from the Federal Reserve.  Their policy this time will probably err on the side of being lax rather than stringent, especially with the fragile state of our federal government’s and our international finances.

Interest rate increases probably are getting pretty close to a stopping point.  The Fed-funds rate is 4.75%.  We don’t expect further increases to much more than 5% or 5.25%

Equities

RCM predicted a better than average year in 2006 for stock market returns; so far so good.  (The prediction was based upon corporate earnings growing faster than stock market returns, some catch-up from the sub-par returns last year, and growing investor confidence.) 

Sectors that are doing particularly well are those related to increased capital spending, continuing business expansion, and international growth.  More defensive areas, such as those related to the consumer have been stagnant.  Lenders, such as bank stocks, also have fared poorly as the difference between short and long-term rates has disappeared.  This means that banks have a harder time earning a premium over what they have to pay for their deposits.

We see nascent signs of a gradual shift in stock performance from smaller companies to those of larger companies. 

Fixed Income

Interest rates have been rising.  At the end of the year the ten-year Treasury bond carried a yield of about 4.5%; it has advanced to nearly 4.9% during this past quarter.

Interest rates now are increasing in many other parts of the world.  Europe already has begun increasing benchmark rates and Japan has signaled that higher interest rates are on the way.  We envision only modest increases to levels that the world economy should be able to handle.

Investment Strategy

Equities

Over the last quarter, RCM has increased the growth bias in our portfolios.  As a result turnover is increasing over recent experience.  However, total stock turn-over for the year still should remain moderate.  We pride ourselves on being tax efficient managers.

RCM currently emphasizes investments in the materials, industrial, technology, and energy sectors.  Other sectors are either slightly under or at market weights.  Selections in all sectors are characterized by steady and predictable growth.  

Health care is one area that we believe will continue to grow because of demographics; i.e., more and more older people.  Therefore we are maintaining a heavily weighted position in this sector.

Fixed Income

During the past quarter, RCM began extending out new bond purchases to maturities in the 2-5 year range, anticipating that rates are nearing a peak.  We will continue that strategy for the current quarter.  Rates are likely to peak at much lower levels than in past cycles for reasons explained in the Forecast section of this paper.  When rates peak, we again will buy bonds in the 7 to 10 year maturity range.

The U.S. dollar is beginning to weaken, which should help our international bond exposure.  This exposure is used as a hedge, where appropriate, against further dollar decline.

Talk With Us

You may wonder why the Federal Reserve and its monetary policy today are so important to the stock market.  It is much more than just the impact on the economy.  Interest rate instruments, such as bonds, CD’s, and money market accounts provide an alternative to buying stocks.  Stocks may increase in value over time, but of course are never a sure bet.  If rates are high enough, bonds might present a good alternative.  Investors might be more attracted to fixed income securities that promise a known rate of return over a specified period of time. 

Stock values, therefore, are influenced by the level of interest rates.  To be attractive to investors, the prices of stocks have to be at levels that present a good value when compared to the availability of a certain interest rate. For this reason, stocks prices may often go down when interest rates go up.

One exception to this scenario are those times when stocks prices actually rise at the same time interest rates do, usually following recessions when stock prices are low because of poor economic prospects.  Interest rates also are low because there is less borrowing for the same reason.  As the economy gets stronger, both equity prices and interest rates can increase together.  Stocks become more valuable because profits and prospects are improving.  Interest rates move higher because there is more borrowing activity and more demand for capital.  This is what we have experienced since 2002.

As long as rates do not move up to a point where they begin to curtail economic activity, both rising stock prices and interest rates can occur at the same time.  That is exactly where our economy and stock market is today.  And that is why investors are so focused on the Federal Reserve and the future course of rates.  If rates move too high then the price of stocks will go down for two reasons; the first being that there will be a high likelihood of poorer business prospects in the future and the second being that fixed income investments will become much more attractive because of the higher rates.  At that point the higher rates go the lower stock prices will go.

An investment firm like Riverplace Capital understands and evaluates where the stock market is with relation to these two dynamic relationships.  At the moment, RCM believes that interest rates are increasing because of an improving economy, which also is good for stocks.  We further believe that the Federal Reserve has no intention of raising rates to the point where they tip things over.  However, we are closely monitoring the data from the economy and corporate performance.  We will adjust our approach if and as needed.  So if you want to work with a firm that understands and responds to these important relationships, Talk with Us.

Notice

Riverplace Capital welcomes Stephanie Harrington to the our staff.  Stephanie has taken over the receptionist duties and provides back-up support for the portfolio managers.

Major Indices as of 3/31/06

Large Cap Stocks (S&P 500)                       3.73%                       

Dow Jones Industrial Average                       3.66% 

Mid Cap Stocks (S&P 400)                         7.32%  

NASDAQ Composite                                   6.10%

Small Cap Stocks (Russell 2000)                 13.65%

MSCI EAFE                                                 8.78%  

Lehman Corp. Bond Index                            -0.42% 

Inflation                                                          3.6%

(Equity indices are three-month returns excluding dividends)