RCM October06 Perspective

The debate rages on; will the economy make a soft landing, or is it in freefall? Investors are watching every economic statistic, every indicator, and all other signs for an answer to this question. Quite frankly, it is early enough in the economic cooling trend to find evidence to make any case one might wish.

Many investors point to the rapidly declining housing market as a major factor in future economic performance. No doubt, housing sales are slowing rapidly. It is just too early to know when and at what rate they might level off. Housing is not a uniform national market, but a local and regional one. So far, the biggest declines are occurring in markets that recently had the most robust activity and rapid increases. In many other areas, activity is relatively tame.

It is important to keep in mind that consumers represent about two thirds of economic activity in the U.S. and how consumers react to the softening housing market is more important than that market itself. In the second quarter consumers measurably became more cautious. So far in the third quarter consumer activity seems to be rebounding somewhat.

Corporate investment continues to be robust. This may off-set softening consumer spending. (Although we expect consumer spending to trend lower we do not predict a precipitous drop off. The American consumer has proven time and time again to be resilient.)

With the cooling housing market and a more subdued consumer, interest rates are declining once again. This does not apply to the very short maturities where the Federal Reserve Board policy has kept rates near its target of 5.25 %. Short rates are now higher than longer ones (what economists call an inverted yield curve). Mortgage rates also are declining and availability of credit appears to be good.

Toward the end of the third quarter, energy prices dropped. If it persists, this decline will add relief to the consumer and the economy at large. The third quarter returns were good, but were focused on large-cap value stocks. The question is how all this will play out?

Riverplace Capital previously predicted that the economy most likely will make a soft landing anticipating that economic activity would decelerate to around 2½ to 3% (slower than the 5+% early this year, but growth nonetheless). This still appears to be the most likely outcome. Employment remains strong and wages are growing. Declining energy prices and lower interest rates are helping cushion the effects of the softening housing market.

International economies also appear to be strong. Because the economies of many nations increasingly are interrelated in a global economy, strength in other countries helps support growth domestically. The U.S. dollar has also weakened against other currencies, especially the Euro and the Yen. This will help our exports and provide a boost to the economy here in the U.S.

At the beginning of this year, RCM predicted that returns this year could be better than average. The basis for this is that earnings long have been growing faster than the prices of stocks making them cheaper in terms of their price earnings ratios. In fact, over the past few years, stocks have gotten progressively cheaper. We expect that earnings on average will continue to expand at a healthy rate. The economy might decelerate, but still grow.

Although growth stocks have lagged so far this year, they should play catch-up as a soft landing for the economy becomes more evident. Investors should regain confidence in future earnings growth. It appears the long awaited era of large cap growth out-performance is finally here. RCM is looking for a strong finish to this year’s stock trading.

In the last Perspectives, RCM stated that rates most likely had peaked; and now, of course, rates are declining. Slower growth and lower energy prices (and therefore less fear of inflation) are a couple of the reasons for this decline. Worldwide liquidity still seems to be excellent, so there continues to be strong demand for safe, fixed income instruments.

With the severe sell-off in growth stocks staring in May, RCM took defensive action to minimize risk and to position accounts to take advantage of future opportunities. Through most of the third quarter, RCM maintained this defensive posture. In some cases we took advantage of low prices to add to positions and use tax reducing strategies where appropriate. (An example of this would be doubling up on a good stock down temporarily, and then selling the original position after thirty days to book a loss which can be used to offset gains.) Recently RCM has added some terrific new positions to its model portfolios. We are in the process of adding these to portfolios where appropriate.

RCM has been buying longer maturity fixed income instruments for its clients, moving our buying target from 2-3 years out to 4-6 years. This newly targeted range has picked up additional yield. Although we are not predicting a recession, bonds maturing in this range would hold their interest rates through a slow-down and into the next recovery; yet the time frame is not so far out such that, if rates increase in the interim, the prices of these securities would be affected only minimally.

One concern one often hears about the economy is the amount of debt that the American consumer seems to be carrying. This concern leads some investors to question, how can the economy grow? They argue that, surely, a piper will have to be paid and the consumer will have to retrench; which, in turn will lead to a general economic recession of some (take your pick minor to major) magnitude. My colleagues and I have heard this argument over the more than twenty years we have been investment professionals. Maybe it is time to look a little more carefully at this concern.

Certainly the economy has suffered recessions during the last thirty years, but one can’t blame a too-high consumer debt load for any of them. Instead these recessions occurred when asset bubbles ended a cycle or burst. One example is 2001. (In fact, this may not have technically even been a recession because GDP growth only declined one quarter - and a recession by definition is two or more quarters of negative growth.) Another is the recession of the early nineties, the product of Federal Reserve policy (e.g. raising interest rates too far until many business transactions simply could not move forward.) And the recession in the early 1980’s was the result of an oil price shock and the Fed’s attempts to reel in inflation by raising interest rates. Not in any of these instances did the consumer suddenly stop buying; in fact, consumer debt totals have risen steadily over several decades.

Some economists argue that 2006 is different, stating that the pace of increase of that load has accelerated over time. However, consumer habits have also changed such as using a charge card for regular monthly expenditures. What shows up in the statistics is that the average debt load is up. What doesn’t show is that this may be a convenience, a way to earn points, or a way of keeping track of expenditures before the bill is paid off at the end of the month.

If someone buys a car with a 0% loan with no payments until 2007, the entire purchase price statistically becomes part of consumer debt immediately. This distorts the front end and may show a decline later. Nevertheless it obscures the true picture.

Significantly, capital gains are not shown as income in the aggregate statistics in calculating income. However, capital gains taxes are shown as expenditures. So how useful are these statistics? The short answer is not very useful at all. Long-term trends could tell us something if financial patterns such as credit card use didn’t distort this picture too.

Total household debt is around $12 trillion. This compares to household assets of approximately $66 trillion. This is not a bad balance sheet. So if you want to worry, RCM suggests that you do so about something else. We view the economy as being on pretty solid footing and are optimistic for the future. Talk with Us.

Notice

On October 1^st Riverplace Capital celebrated its eighth year in business. We are proud of the results we have produced for our clients. Many economic and market challenges have occurred during those eight years, but all along RCM has enjoyed meeting them. RCM is fortunate to have assembled a terrific group of professionals that bring many years of experience to this firm.