RCM January06 Perspective

“A glass half-empty” seems to capture the mood of investors in 2005. Higher interest rates, disastrous hurricane damage, war, and the twin deficits of trade and our federal budget: all of these kept investors at bay. On the other hand, corporate profits collectively hit one new record after another. In fact, in the third quarter, profits rose by double digits for the 14th quarter in a row. By the end of the year, corporate profits will have increased over 15% as compared with 2004.

The fact that the broad market averages did not keep pace with the outstanding profit growth admittedly is disappointing. This has been the case for the past three years. As earnings continue to climb faster than stock prices, the price/earnings ratio for the market at large is coming down. The result is a market that is becoming cheaper and cheaper. The P/E ratio, using forecasted S&P 500 earnings for 2006, is approximately 14. This is historically low.

The economy is progressing well. GDP growth this year will be close to 4%. This is higher than most forecasters expected, including us. Many analysts forecasted slowdowns in 2004 (didn’t happen), 2005 (didn’t happen) and now again in 2006. Eventually this forecast will be correct.

Interest rates puzzle investors. The Federal Reserve continued to ratchet up short-term rates one ¼ point at a time, but long-term rates hardly budged. The yield curve (the difference in rates between short and long-term maturities) has become flatter and flatter. In past issues of Perspectives, RCM has offered several explanations, i.e. foreign central bank buying, investor preference for safety, and a perceived safe haven by certain foreign investors are among these. However, no one really knows including, by his own admission, the Fed Chairman.

Commodity prices on the other hand have continued to rise. Copper (which used to trade from 50¢ to $1.00 per pound) this year approached $2.00. A couple of years ago, steel traded for $250 to $300 per ton; this past year it approached $600. Gold is now trading at over $500 per ounce and oil is trading for around $60 per barrel. There are many more examples, but the picture is obvious. The cause is increasing global demand for limited supply.

This new year the stock market starts out at a relatively low (cheap) valuation, with low expectations for stock price gains. This could lead to positive surprises. What do we at RCM expect?

After strong growth since the fourth quarter of 2001, the economy is expected to slow down this year according to many analysts. The expectation is that by the second quarter, GDP growth will decelerate to about 2½ percent (still good). The trouble with this forecast is that it is the same one as for the past two years. However, we don’t believe that the forecast is likely to finally prove correct, and don’t believe that there will be much of a slowdown this year. If a slowdown were to occur, it should have happened this past year (after Katrina, rising interest rates and public concern with the Iraq war). That is not to say that a slowdown or even recession is not in our future, just that we do not think 2006 is the year.

Many major industrial economies in the world began to pick up in 2005. This now should help support growth in the U.S. Interest rates should peak early in 2006 at rates that historically have not been much of a problem for economic growth. In addition, the fiscal stimulus from federal deficit spending, war spending, and rebuilding parts of our Gulf coast, all add to our growth prospects.

One risk to this projection is the course of real estate and energy prices. So long as real estate prices do not decline precipitously and oil prices do not rise dramatically, we remain optimistic for the U.S. economy in 2006.

With earnings increases outpacing stock price increases in 2004, RCM previously predicted better than average returns in 2005. If not in 2005, then we thought that certainly 2006 would be the year. The reasoning is that exceptional corporate earnings performance will produce higher stock prices sooner - or later.

It is now “later.” Except for the mid-cap sector, stock returns for 2005 were sub-par. Therefore, RCM’s forecast is for better than average returns in 2006. This is supported by strong forecasts for profitability by many corporate leaders and some catch-up from lackluster stock gains in 2005.

We no longer expect interest rates to rise spectacularly. If they couldn’t rise with 4% GDP growth and spectacular commodity price increases in 2005, we see nothing in 2006 that can make rates rise significantly. In fact, although we don’t think they are likely, the risks to growth and interest rates are mostly on the downside. The conundrum likely will continue.

That is not to say that the benchmark ten-year Treasury bond can’t approach 5% from the current 4.5%. We just don’t yet see a mechanism to drive rates much higher than 5% and we believe 5% is a level the market can well handle.

During 2005 RCM reduced the volatility of its portfolios by reducing sensitivity to the business cycle. This was accomplished by adjustments to the weightings of certain sectors and selecting stocks that had stability characteristics. Greater diversification also was sought. This was done in anticipation of a choppy environment with a possible economic slow-down. This strategy worked well.

In 2006 the adjustment is back toward a bias for growth. Our preference is for international participation. RCM expects growth in many international markets to even exceed that here in the U.S. Globalization is an enduring trend. Many U.S. companies now make over one-half their sales in markets outside of our own.

We still expect a choppy environment, so we continue to seek stable growth over more aggressive opportunities.

Now that short and intermediate term rates have risen, we are extending out the maturity target for new purchases. That target is now 2-5 years. Where appropriate, RCM also is including some participation in an international bond portfolio. This is to hedge against the possibility that the dollar will weaken again in the face of U.S. trade and fiscal deficits.

We also will include a small allocation to high yield bonds where appropriate. This is because we expect the strong economic environment to help offset some credit concerns.

Many investors are becoming more and more short-term oriented. Some may feel traumatized by the recent bear market and feel that they cannot count on the long-term so they seek to take any profit that comes their way.

Wall Street has long had an affinity for the short term. Most investment opinions are targeted to a six-month time frame. Shows on the CNBC financial news television network accentuate the near term even if they don’t mean to. Investors Business Daily even promotes a short-term trading methodology and its pages are full of ads targeted to traders. (Don’t even get me started on Jim Cramer’s Mad Money television show!)

Unfortunately, this focus is not helping the average investor. That is because this view encourages chasing investment returns. As a result money gets poured in on market upswings and investments are sold on downturns. (Buy high sell low is not a prescription for good returns.) Dalbar Inc.’s 2003 update of its ongoing study, the Quantitative Analysis of Investor Behavior, shows that the average investor earned a very poor 2.57% annual return for the 19 year period from 1984 through 2002. During that time inflation advanced at a 3.14% annual rate and the S&P 500 index earned 12.22% annually. Why such poor performance? Chasing returns!

Most investors need a far better return than 2.57% in order to meet goals for educating their children, making a major purchase, or providing a comfortable retirement. This return does not even keep their savings even with inflation.

Unfortunately almost every investor thinks they perform much better than average; that simply cannot be true. Many investors, who hire an investment professional, expect returns that exceed the market average. They may measure performance by the excess return over a stated index. (This measure, in financial jargon, is called alpha.) However, if an investment manager simply helps keep the investor committed to a long-term investment process, he is adding a great deal more than alpha. Even if the manager just equals the market (the 12.22%), he is likely to far exceed the average investor’s return (the 2.57%). And here at RCM, we have consistently beaten the market.

Through regular meetings and communications, investment managers can help their clients understand the strategy employed in their accounts and see the market with more perspective. This helps these investors weather the inevitable rough periods. RCM meets regularly and always communicates with its clients. This letter is an example of RCM making clear its view of the investment environment and how it plans to respond to changes. We discuss with each investor how we are translating our general views to that particular client’s needs and expectations. Therefore our clients not only benefit by the alpha that RCM regularly produces, but keeps them from falling into the traps that befall average investors. So if you would like to enhance your returns well beyond average and desire to work with a firm that regularly beats the market, Talk with Us.

Notice

Patrick D. Powers, V.P., Managing Director, has been elected to the Riverplace Capital Management Inc. Board of Directors. He joins Peter E. Bower, Daniel B. Nunn Jr., and Duane L. Ottenstroer.