Perspectives

First Half 2006

Were you getting bored?  After a three year run of positive returns and relatively low volatility, stock markets around the world took a dive this past quarter.  April, the first month of the quarter, was actually a good month for returns, but then confidence dissipated in May and June.  By the end of the quarter, the great returns from the beginning of the year all but disappeared. 

The reason investors’ mood changed so abruptly has a lot to do with U.S. interest rates.  Obviously rates have been increasing for some time, so why the sudden reaction now?  The answer seems to be that while markets had been anticipating that the Fed was near the end of its tightening campaign, investors suddenly were not sure.  In the meantime, evidence has been accumulating that the U.S. economic expansion is slowing.  Because it might be months before there is sufficient evidence to more definitively assess how much the economy might slow, many investors started taking profits and moving money to the sidelines. 

The danger for the stock market always has been that the Fed would raise rates too much and kill the robust business conditions that investors have been enjoying.  At Riverplace Capital, our assessment is that the Fed will use great caution from this point out; however, another increase in rates remains a possibility.  (For our current assessment, see the Forecast section of this letter.)

Bond prices have been under pressure all year long.  (Remember as interest rates move higher, bond prices move lower.)  The only way to mitigate the damage to bond portfolios from falling values is to maintain short maturities.  (This is exactly what we has done.) 

At the end of the quarter, after hiking interest rates again by ¼ %, the Fed signaled that it was likely to pause in August or September.  We may be at, or within a quarter point of the end of the interest rate cycle.  Investors gave a collective sigh of relief and started buying again.  Longer-term interest rates actually declined modestly after this increase, indicating that bond investors see value at current rate levels.

Forecast

Economy

Economic growth is slowing.  Riverplace Capital forecasted this.  We believe that the expansion will continue, albeit at a slower rate.  The 5.6% rate of GDP growth for the first quarter probably will decelerate to 2.5 – 3% over the remainder of this year.  Profit growth also should slow from double digit gains to high single digit increases.  (This is still very good.)

Although some investors have expressed concern about the future course of the economy (by selling), we believe it is premature to call an end to the expansion.  Clearly there are more sectors experiencing weakness than in the past couple of years; retailing, home building, and traditional banking are examples.  However, manufacturing, health care, and business services remain strong.  Manufacturing benefits from increased international trade and the strength of our trading partners’ economies.  Health care demand is increasing due to the ageing of our population and companies are investing more in their own businesses due to their excellent profitability.

Equities

Riverplace Capital previously forecasted better than average returns for stocks this year.  We stick by that prediction.  The correction we just went through was normal and not unexpected.  Recent volatility, although unnerving, does not alter excellent underlying fundamentals.  Corporate profits have been and continue to grow at a rate that is greater than stock appreciation.  (This makes stocks cheaper as price earnings ratios compress.) The profit outlook is excellent.  International growth is picking up, which helps support growth in the U.S.  Inflation, although rising, is still moderate and likely to fall as the U.S. economy slows.

The second half of 2006 and especially the fourth quarter should be a good period for returns.  With the anticipated halt to interest rate increases, investors should gain confidence that the economy can sustain growth, albeit at a more modest pace.  Volatility, however, likely will continue and periodically test investors’ conviction.  Mid-cycle economic slowdowns subsequently have led to excellent market returns the last two times they occurred, in the mid 1980’s and 1990’s.  In fact the great returns of the late 1990’s began after the economic slowing in 1994.

Fixed Income

Interest rate increases are about finished.  In fact, rates for maturities 5 years and longer are unlikely to increase much from present levels even if the Federal Reserve raises short-term interest rates one more time.  Fixed income markets are now at the point where further increases in short-term rates will depress long-term rates.  That is because investors anticipate that higher and higher rates will accelerate the economic slowing already underway, forcing the Fed to then begin dropping the Fed-Funds rate to stave off a recession.

Investment Strategy

Equities

When the downturn in the stock markets began some weeks ago, Riverplace Capital saw as its first duty the need to protect client capital.  We sold stocks that did not hold up at previously-set floors.  This selling removed under performing stocks from portfolios.

Riverplace Capital is using this opportunity to acquire new stocks we long have wanted to buy at prices we are willing to pay.  The results, we hope, will be stronger portfolio performance.  So far this year, results have exceeded benchmarks.

In portfolios with mutual funds, positions were trimmed according to predetermined criteria in order to defensively increase cash positions.

Fixed Income

RCM is modifying its fixed income strategy of investing in shorter-term maturities. Last quarter we began extending maturities modestly as we sensed that the Fed was nearing the end of its tightening cycle.  This strategy worked well.  Most fixed income portfolios that we manage are comprised of short term paper.  It is now appropriate to start extending maturities by purchasing intermediate term bonds.  Interest rates this cycle are topping out at levels lower than in the past.

Talk With Us

Protecting capital becomes a key focus for Riverplace Capital during periods of heightened volatility.  Even though we believe in our fundamental investment thesis, we constantly evaluate new evidence, paying close attention to how other investors are reacting, and making our own judgments on how to proceed.

Most times Riverplace Capital reacts to short-term concerns by maintaining the focus on our longer-term investment horizon, while looking for opportunities to pick up a few bargains.  However, there are occasions when events signal the potential for a major shift in the investment landscape.  These we take seriously and we take defensive action in order to preserve clients’ capital.

RCM evaluates our current model portfolios and determines where the greatest risks lie.  We first cut positions that are performing more poorly than their sector, especially if the intermediate performance of these positions has not been as expected.  Our Investment Committee also places technical floors below which we will not continue to hold other positions.  This raises the level of cash in portfolios.  In the meantime, RCM’s analysts scour the investing landscape for opportunities and make sure they have identified the best candidates to add to portfolios when appropriate.  Downturns often make it easier to identify the better investments.

The Investment Committee also reevaluates its investment assumptions and makes adjustments to various allocations and sector weightings to further reduce risk and enhance opportunity.  Weightings may shift between stocks and bonds or international and domestic stocks as well as among sectors such as industrial or financial companies.  Other parameters such as the target duration for bonds are reviewed and adjusted as necessary.

RCM’s style is to make adjustments incrementally, weighing the soundness of each move along the way.   Therefore RCM is always in a position to continue or reverse course as needed.  Underlying all investment tactics is RCM’s commitment to long-term investing.  Therefore change is usually not dramatic, but instead is a series of small adjustments. 

Raising cash in order to protect client capital in uncertain times can mean that performance may lag for a bit once markets begin to recover.  However, if portfolios are improved with better performing positions, then performance catches up and ultimately surpasses the previous potential in portfolios. 

So if you want to work with a firm with experience and the methodology to handle challenging investment environments, Talk with Us.

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Major Indices as of 6/30/2006

Large Cap Stocks (S&P 500)                       1.76%

Dow Jones Industrial Average                       4.04%

Mid Cap Stocks (S&P 400)                         3.63%

NASDAQ Composite                                 -1.51%

Small Cap Stocks (Russell 2000)                  7.64%

MSCI EAFE                                                8.50%

Lehman Corp. Bond Index                          -0.19%

Inflation                                                        4.20%

(Equity indices are six-month returns excluding dividends)