RCM January07 Perspective

A better than average year. It is just as we predicted. Of course we also predicted that 2005 would be a better than average year, but unfortunately it was a mediocre one. The basis for this prediction was low valuations, excellent profit growth, a good economy, and low interest rates. Investors finally recognized what we saw in 2005.

In fact since recovering in 2003 from the 2000-2002 bear market, stock market returns are up an astounding 73.25%. This is based upon a broad measure, the S&P 500, although some sectors such as small cap and foreign stocks are up even more. At RCM, we doubt that many investors truly appreciate the excellent investing environment that the U.S. market has proven for the past 4 years. To a large extent, investor psychology is still focused upon 2000-2002.

The real surprise this year is that interest rates actually have not risen, but instead declined or stayed flat. Even though the Federal Reserve, during the year, pushed up the very short term rates that they control, longer term interest rates came down. The good news is that inflation which had been creeping up during the first part of the year now seems to have reversed its trend and also is in decline.

So as we start a new year, interest rates are low, inflation is declining, corporate profits are excellent and still growing. Much of the rest of the world is benefiting and growing as well. Our clients have had another excellent year and we think the stage is set for a terrific 2007.

The U.S. economy is slowing to a more modest rate of increase. A growth rate of about 2.5% is expected. This remains a fine growth rate for a large and mature economy such as ours. Higher energy costs and a cooling housing market together mostly are responsible for the more modest economic outlook. The good news is that these forces are only slowing the rate of growth, not destroying it.

We expect the trends in place at the end of 2006 will continue and even accelerate. In short RCM expects another good year, perhaps much better than 2006. Even though earnings growth is likely to slow, stocks may see a multiple expansion (that is the price investors pay for earning likely will increase). The reason is continued historically low interest rates and increasing investor confidence. Unfortunately these good returns may be accompanied by increasing volatility. For the last few years stock markets have actually become less volatile than usual. Due to events we foresee in China (to be discussed in future Perspectives), the advent of a power shift in our U.S. Congress, and periodic surprises, volatility is bound to increase. However, this should not prevent good results.

Interest rate behavior has been surprising for the past few years. Rates never climbed as high as expected in relation to the economic recovery, and continue to be low in relation to the current inflation rate. The good news now is that inflation is presently declining.

The yield curve continues to be inverted (short term rates are higher than longer term ones). This anomaly is likely to begin to shift back to a normal increasing yield curve toward the end of 2007.

RCM expects that the Fed likely will begin lowering short term rates in the second half of 2007. Rates on maturities up to about 5 years should also fall. In fact, it appears that the 5 year maturity for the highest quality debt paper should benefit the most from this normalizing of the yield curve.

In general, small company stock prices have out-performed those of larger firms for the past 7 years. That has recently begun to shift. In 2006 the performance between the large and small cap sectors was about the same. However, large cap stocks are, in general, much cheaper than small cap ones. We, therefore, believe that larger companies’ stock valuations will most likely catch up. That is why we are increasing our emphasis here.

International markets have been out performing our domestic market. RCM does not expect that to reverse, but we do expect more similar returns. Therefore RCM’s international exposure, where it has been appropriate, will remain about the same.

In general, we are pleased with the performance of our portfolios. We will continue to evaluate and seek out those companies that can grow above our hurdle rates (the minimum acceptable rate as set by the RCM investment committee) in this economy. Much of that growth may come from international sources; therefore global companies are potentially attractive.

In fixed income portfolios with individual bonds, RCM continues to make new purchases in the 3 to 5 year maturity range. Even though interest rates are historically low, they probably have peaked for this cycle. The next big change in rates should be that short term rates decline and the yield curve begins to normalize. To benefit from this process, RCM will purchase more maturities near the 5 year mark.

Many investors remember vividly the market’s roller coaster ride of the late 1990’s and early 2000’s. Some still feel traumatized by that experience; as a result they have failed to benefit from the excellent recovery starting in 2002.

Most investors recognize that since September 11th, event risk in the stock market is a real factor in investing and applies to more than the business side of the environment. The initial response to this change in the investing landscape, on the part of some investors, has been to avoid this risk entirely and avoid stock market investments. However, this is not a beneficial approach. Most of the world’s growth is produced by business. The public markets are the only way for most investors to participate and profit from this growth.

Saving is important, but over time investment returns add much more to wealth than savings returns. Then, of course, there is the investment return on the past investment returns (compounding) that really increases the original investment. This type of investing is necessary for most individuals in order to afford educating their children and a comfortable retirement. Even if a worker is covered under a generous retirement plan, investment returns are a very important part of providing future benefits.

So how can investors cope with uncertainty and volatility? Maybe their expectations need to adapt to the realities of our present environment. During the late 1990’s, many new investors came to believe that 20% returns would be the norm for stock market investments. With that kind of return they could accumulate a great deal of wealth and not even have to do any saving. In fact, a few even thought they could make a living by day trading. What a shock when that scenario went out the window.

The reality is that continuous saving always is important. Investment returns have always been volatile and require patience and perseverance. Diversification also is important, because no one always anticipates the next new source of good investment returns. Time smoothes out the ups and downs as long as investors do not compound the effect by jumping out when times are bad and regaining confidence and re-entering only after markets have already improved. This same rule applies to the poor practice of concentrating investments in sectors of the market that are doing well only to bail out after they decline or under-perform. Some investors become emotional when things are not going well and become their own worst enemy for producing good results over time.

Being realistic about the process can help. Do not expect the world. Do not over commit to the point where you feel vulnerable when the unexpected happens or times get rough. Keep enough liquid assets so that you are never forced to make a bad decision (forced to sell quickly). Seek the help of professional investors if you feel the process is more than you want to take on yourself. And if you want to work with a firm that has seen almost every type of investing environment, has been steady in its approach and has seasoned professionals to help you with your needs then Talk with Us.

Notice

Riverplace Capital Management is proud to announce the appointment of Terri C. Kimball to the position of Conptroller and Vice President.

We congratulate C. Ronald Belton, Executive Vice President, for his appointment as Chairman of the Boys & Girls Club of Jacksonville. The need to provide positive alternatives for our young people is great; thank you Ron. Riverplace Capital encourages community involvement. Periodically, we will highlight the volunteer contributions of our staff.