Investor Newsline

July 2008

Strategy comments pertain to Capital Management Group investment strategies and reflect the authors' personal views about the subject.

Market Review & Outlook

A Painful "Flat" Quarter: When tallying up returns for the second quarter, it is likely that many investors will express shock that performance was essentially flat. While broad domestic equity (Russell 3000) and fixed income (Lehman Aggregate Bond) indices declined -1.7% and -1.0%, respectively, the sharp deterioration in major equity market averages during June overwhelmed the positive traction the market established during an April-May rally that was a continuation of the bounce off lows following the Fed-brokered Bear Stearns bailout in mid-March. During the April-May rally, risk aversion lessened with high yield spreads (as a proxy for risk aversion) narrowing by more than 200 bps from their recent peak in mid-March amid hope and widespread optimism that the worst of the credit crunch had past. However, as more bearish economic and housing data emerged and energy prices continued their historic ascent to fuel inflationary concerns, stagflation worries emerged and global equity markets endured a sharp June sell-off that saw the MSCI World Index decline 8.2% and the Dow Jones Industrial Average experience its worst June since 1930 (-10.2%). By quarter-end, investors had received confirmation that labor markets were weak (five straight months of job losses and unemployment rate of 5.5%), housing was in continued turmoil with no signs of stabilization (May foreclosure filings +48% year-over-year and steepest decline on record (-15.3%) for national home prices), banks were much less willing to extend credit (private nonfinancial debt growth slowed to its lowest rate since 1994 and commercial bank credit shrunk more quickly in Q2 than at any time since 1973), and global inflation is on an upward march thanks to soaring food and energy costs (current estimate of 5.5% vs 3.5% at start of 2008 leading three-fourths of global central banks to raise interest rates). Against this backdrop, investments with inflation-hedging properties were the clear standouts - commodities and TIPS were the best performers for the first half of the year and resource-rich emerging markets held up much better than commodity-intensive economies like China and India.

But it Could Get Worse: The bleak global economic backdrop does not bode well for a quick market recovery nor for outsized gains in any asset classes. While U.S. real GDP growth has remained barely positive over the past several quarters and fiscal stimulus has provided a temporary bounce in consumer spending, the Fed has little room left for stimulative monetary policy action and it is unlikely that additional fiscal stimulus will be enacted until after the autumn elections. Despite the gloom that has overcome Main Street and Wall Street, market volatility has remained relatively low with the CBOE Market Volatility Index (VIX) under 25 - in contrast to readings above 30 in March and 40+ in previous crises. This lack of extreme market pessimism does not paint the picture of a "washed out" market poised to rally; neither does a recent Bloomberg survey - that tends to be a good contrary indicator - of ten leading Wall Street strategists who predicted, on average, that the S&P 500 Index would rally 18% over the second half of the year. While the case for a quick rebound is not very strong, there is also some evidence that declines could be limited as well - earnings estimates for 2H 2008 have declined by about 10% since January, creating a "lower hurdle" and P/E ratios on global equities have declined to 13x. With these modest valuations, any correction in the commodities spike - which is likely the result of fear and uncertainty as much as fundamentals - could lead to an improved investment climate in the foreseeable future.

Equity Review & Outlook

All about oil at this point: Over the last quarter investors became more cautious as food and energy inflation combined to turn investor sentiment sharply lower. Housing prices continue to erode, eliminating consumer's ability to increase home equity credit lines. Tax rebate checks began arriving in Q2, with a potential short term consumer spending boost, which we expect will be modest. Corporate earnings, as measured by the S&P 500, are down 24% Y/Y, making this quarter the worst earnings environment since the 2001 technology market collapse The results are most pronounced in the consumer discretionary and financial sectors, where Y/Y earnings are down 65-75%. Since March 2005 net income has risen 4.4% for the S&P 500, but earnings per share have increased 9%, largely because shares outstanding have fallen by 4.1%, driven by corporate buy-backs. Corporate repurchases have declined in the current environment, and will likely remain below recent levels in the immediate future, further challenging Y/Y EPS comparisons. It is also likely that share issuances by financial companies will further dilute upcoming earnings. The bright spot remains U.S. exports, growing to 12% of GDP from 8% in 2005. Housing remains weak, with owner's equity representing only 46% of market value, the lowest level in 60 years, further challenging consumer spending as equity reserves are near exhaustion. Inflation fears may moderate as worldwide slowdown tempers demand, and potential legislation attempts to restrain speculation in the commodity markets. Looking ahead we expect strong margin performance from Energy, Materials, and Technology sectors, and continued weak results from Financial and Consumer Discretionary sectors. For the quarter, the S&P500 index fell 2.7%; with the S&P 400 and S&P 600 rising 5.4% and 0.4% respectively, reflecting the larger concentration of financial stocks in the S&P 500 index. Year to date, the S&P500 is down 11.9%; the S&P 400 is down 3.9% and S&P 600 has fallen 7.1%.

Margins eroding: The FED's General Activity Business Index shows the slowest manufacturing growth since the 2001 recession, while inflation measures are at levels not seen since the early 1980s. This combination leads some to predict that stagflation may lie ahead, an environment that is unfriendly to equity investors. Consumer confidence has fallen to levels last seen in the recession during the early 1990s. Overall inflation in the broad commodity complex is a significant problem for equity markets, including emerging markets. If global growth downshifts then expect lower commodity prices and better performance from the equity markets, until then expect the markets to languish.

Fixed Income Review & Outlook

It's Summer - Let's ride the Roller Coaster: In the first quarter a flight to quality generated stellar Treasury bond returns as buyers flocked to them for safety. Corporate bonds lagged while high-yield bonds lost 4.5%. Then the Fed's rescue of Bear Stearns sharply reduced credit fears and allowed inflation to become the topic of concern. Treasuries fell 4.5% and high-yield bonds gained 6.3%. By June investors weren't so sure, and Treasuries gained about 1.0% and high yield bonds lost 2.7%. The debate over the outlook for the economy, inflation and the credit crisis is in full swing, generating vastly different market outlooks.

Until May, market behavior suggested the "recession" was behind us, or going to be minor, and we should now focus on fighting inflation. Barring a sharp drop in energy prices, we feel that the combined impact of a wobbly financial and credit system, rapidly increasing prices and a drawn out housing recession will keep buyers away. This reduced consumption will lead to weaker economic growth than the markets now perceive. We expect higher inflation rates, at least temporarily. Raising rates in this fragile economic environment would risk an even deeper recession; thus the Fed will likely keep rates low while only posturing about raising rates to fight inflation. In sum, we are underweight corporate bonds, although we expect strong returns for that sector are approaching. Overall maturities are short of our goals to guard against a negative reaction to higher inflation postings. Municipal bonds still are attractive to most investors, but one should avoid "insured" issues unless the underlying issuer's credit is acceptable. Inflation protected bonds (TIPS) are still favorable, given our concern about an inflation outbreak, and investing in international bonds is a good diversification technique relative to the U.S. dollar.