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 Global Asset Allocation
· What Worked?
Real Estate had two stories to tell in the first quarter of 2007. On the residential side, most areas of the country have seen a decline year over year in home values as well as increased inventory in new and existing homes for sale. There has also been the unfolding story of relaxed lending standards of mortgage originators for subprime borrowers and the subsequent increase in the rate of defaults, which we may not have seen the last of in 2007. On the commercial side, M&A activity continues to drive prices high with record deals closing in the quarter. Vacancy rates continue to decline and rents remain steady, both fueling Real Estate Investment Trust’s continued outperformance of the S&P 500 Index.
Small and Mid Cap equities started the quarter off strong and again outperformed Large Caps in the first quarter. January is historically a good month for both, as they capitalized on the slowing economy and the belief that the Fed would lower rates sometime during the year. As the quarter progressed and the investor’s appetite for risk abated in late February, Small and Mid Caps saw a flight to quality culminating in an outflow of funds to lower risk assets such as cash and government bonds.
International Developed Markets, as defined by Western Europe, Australia, United Kingdom and Japan, were again able to outperform their American peers even in the face of rising interest rates by their various central banks. Europe’s economy has been expanding as it copes with the growing pains of including several new members to the economic union and the tight budget restraints that have forced tax increases throughout the continent. Japan is working through the early stages of its recovery from a long recession and showing signs of a resilient economy. We strongly favor its potential over other countries in the region.
Commodities were up for the quarter, as the price of crude oil, which is a large holding in most commodity indices, rose from its close at the end of 2006. Investors drove up the prices of agricultural commodities, such as corn, across the globe as demand for alternative energy sources like ethanol rise to offset the reliance on foreign oil. Gold rebounded as investors scrambled for a safe haven to store capital as the equity markets searched for equilibrium. As the global economy moves forward, fueled by China’s continued internal growth and booming manufacturing sector, basic materials such as copper are still in high demand.
· What Didn’t Work?
Large Cap equities started off the year building on the strong finish in 2006, recording a positive total return in January of 1.9%. Unfortunately, at the end of February we had a reversal of momentum with the S&P 500 Index declining over 3% in one day. This brought the streak of eight consecutive months of positive returns by Large Caps to an end. This was the culmination of many factors including a rapid one day decline in the Chinese equity markets, a lower than expected economic report and comments from former Fed governor Greenspan that the economy could fall into a recession.
Emerging Markets faired poorly for the most part during this first quarter, reacting to a one day decline of almost 9% in the Chinese A-share stock market. The equity markets in China, which were experiencing a meteoric rise in prices with the country’s economy continuing to grow in double digits, are still in their infancy and under the watchful eye of their authoritarian government. As investors looked to shed risk, the other BRIC (Brazil, Russia, India and China) countries experienced a flight of capital from their markets driving equity prices to oversold conditions. The Emerging Markets experienced a rebound as the quarter came to an end; yet still underperformed the larger International Developed Markets.
· What Next?
As the economy continues to move towards a path of slower growth, we believe that the Fed’s recent transition to a more neutral bias increases the possibility of an easing before year-end. This should be beneficial for both the Mid and Small Caps as the cost of capital will be lower and should help continue their gains in 2007, albeit perhaps at a lower rate of return than other asset classes. The increased volatility in the global markets should create opportunities to rebalance assets to areas previously viewed as fairly valued. As the economic news continues to paint a picture of a slowing economy the rotation to larger cap companies, both domestically and abroad, with a global presence should persist throughout the rest of the year.
The pullback in equity prices in the Emerging Markets in early March presented an opportunity for investors without exposure to initiate new positions and for those underweighted to add to existing positions. With the rise in volatility, opportunities will continue to be identified going forward.
Real Estate has come under review because of the rising concerns in the real estate markets and also from the drop in interest rates which we believe is nearing an overheated condition. Valuations are fundamentally stretched and we remain cautious.
 Large Cap
· What Worked?
Within our portfolio, the Health Care sector was a big winner for the quarter as some gains were a result of an overreaction to last year’s elections in Congress and any legislative changes that may have been put forward as the new session convened under Democratic Party control. Drug distributors, PBMs (Pharmacy Benefit Managers) and medical product companies all outperformed during the quarter while the pharmaceutical companies continue to struggle, hindered by the potential for government interference. Materials also had positive returns for the first quarter as the global economy continues to grow, maintaining the demand for raw materials. As new wealth is created in the Emerging Markets, this trend should continue.
· What Didn’t Work?
Energy stocks were under pressure for most of the quarter due to lower demand expectations, as a weaker economy should moderate future consumption. A neutral position in Energy was maintained for most of the quarter due to concerns over a possible supply disruption as well as increasing instability in the Middle East. As there seems to be an increase in supply coming on line, our weighting was lowered late in the quarter. The Finance sector is another area that came under fire during the quarter as the issue with subprime lending and the potential fallout took center stage. In particular, the larger institutions were driven lower due to uncertainty regarding the extent of their exposure. Believing the sector was oversold during the recent correction, an increase in exposure is currently underway, with careful attention being paid to any subprime issues. Information Technology was hurt during the quarter as investors reduced risk and moved out of high beta names. Continuing to like the sector, additions have been made to positions during the quarter in names oversold during the recent pullback.
· What Next?
The increase in volatility experienced may continue into the second quarter of this year and the capital markets are closely reviewing economic data to better gauge the direction of the economy and any moves the Fed will make.
We still believe we are entering into a period of slower economic growth and contained inflation, as was the case in 1995. Typically “mid-cycle” slowdowns have been a very good environment for stocks. An as such, we continue to look to increase our systemic risk as we move toward the second half of 2007. We remain overweighted in the Information Technology, Industrials and Financial sectors as all three should benefit when the Fed lowers interest rates later this year.
 Fixed Income
· What Worked?
The first quarter began with signs that the mid-cycle slowdown experienced at the end of last year had mostly played out, leaving interest rates too low for comfort and vulnerable to signs of faster growth. As evidence of accelerating job growth and rising inflation unfolded the bond market responded, pushing 10-year Treasury Notes back to 5%. This presented an opportunity on a couple of fronts; namely the high relative rate for holding cash and the increasing attractiveness of investments with shorter maturities particularly in tax advantaged Government Securities and Municipal Bonds. As the quarter progressed, news began to emerge regarding problems in the subprime credit market. These problems, because they primarily affect the banking industry and financial lenders, generate the kind of concerns that drive investors out of stocks and into the highest quality bonds. By the end of the quarter, the 10-year Treasury Notes was back at 4.5% and investors holding Government Securities including government-supported Fannie Mae, Ginnie Mae and Federal Home Loan Bank were the beneficiaries of the “flight to quality.”
· What Didn’t Work?
Municipal Bonds also performed well as interest rates dropped, helped by a slowdown in issuance and relentless demand for quality insured bonds. But unlike Corporate Bonds which saw yields rise with the market, Municipal yields stayed stubbornly low. This behavior is due to “spread” which refers to the extra yield an investor is rewarded for owning bonds riskier than Government Securities. Because taxable accounts own mostly insured Municipal Bonds (the safest), the spread stayed very narrow even as market yields rose. Corporate Bonds also underperformed Treasury Bonds as the flight to quality hurt the credit rating outlook for many well-known companies.
· What Next?
Much is made about the shape of the yield curve and its implications for future economic growth. When the yield curve is said to be “steep” it means 30-year Treasury Bonds have a higher yield than 3-month Treasury Bills. This is due to the fact that the longer maturity dates should provide the investor with a higher yield for taking on the risk of the longer period of uncertainty. A steep yield curve implies the expectation of stable future economic growth. However, these days the yield curve is “inverted”; namely 3-month Treasury Bills have a higher yield than 30-year Treasury Bonds. An inverted yield curve implies the expectation of slow future economic growth. This is because the Federal Reserve Board has been aggressively raising rates. And even though there have been no recent rate hikes, past actions by the Fed are creeping into the economy. We agree with the economic outlook for slower growth implied by the inverted yield curve and will continue to seek opportunities to be a little less defensive. In the meantime, rates for cash are near 5.25%. In fact, holding cash in taxable accounts has provided an after-tax return that competes with 1-year Municipal Notes making it very comfortable while waiting for opportunities to come to us.
 Economic Landscape
· What Worked?
It has now been a full three quarters since the Federal Reserve Board last raised rates and except for a brief period into the end of last year, economic growth has remained steady, although at or below 3%. The first quarter continued this trend and bounced back from last year’s mid-cycle slowdown with gains in job growth and productivity. Moreover the FOMC maintained its hands off posture allowing the economy to move unhindered by Fed interference. Equity markets around the world benefited from the view, shared at Fairport, that the inflation outlook deserved more optimism than voiced by the FOMC. There was widespread belief that globalization, technological advances and increasing commonality of market platforms undermined the sources of inflation, which seemed driven almost entirely by rising energy costs. And Global Central Bankers voiced concern about being too optimistic, suggesting it promoted benign attitudes regarding risk. They were partially correct as ample liquidity sought return and market reforms gave it access, particularly to the emerging economies of the EU and Asia. Other factors contributing to the favor of the global economy were low interest rates and just enough concern about geopolitical turmoil to keep the extremes of inflation and recession at opposite ends of the court. While there is enough evidence to suggest the FOMC might contemplate lower rates soon, economic growth grew at a below trend pace ensuring that inflation would remain in check and preclude any further FOMC rate hikes.
· What Didn’t Work?
As the U.S. economy expanded at its modest rate, the global economy followed. But as liquidity continued to pour into historically untested markets such as India and the emerging markets of the EU, little attention was paid to the fact that Central Bankers were raising interest rates. By the middle of the first quarter even China joined the fray voicing concerns with the part it played in encouraging broad speculation in its financial markets. China has now grown to rival the U.S. and Germany in exports by 2009 and for fear of undermining its own economic stability, it looked to curb that excess speculation. What might have worked in favor of China’s broad fundamental goals didn’t work in favor of foreign inventors. China’s Central Bank raised lending rates by 0.27%. And although China can raise rates with enough economic tailwind to soften the blow, the move caught the global market off guard and Chinese officials made no statements aimed at containing fears of further rate hikes. Hence, when Alan Greenspan publicly discussed the risk of a U.S. recession, and the European Central Bank hiked its core lending rate to 3.75%, it simply added more layers of nervousness to the already jittery world capital markets. What this means for the U.S. economy is unclear at this point, but with rising concerns regarding subprime credit markets, any stability supported by gains in Industrial Production and Retail Sales could quickly give way should tighter lending standards dampen consumer confidence.
· What Next?
Analysts expect the Chinese economy to grow 9-10%. A rate necessary to sustain China’s rising standard of living and rapid industrialization. Yet if the country begins to grow beyond that pace, inflation could gain traction providing the backdrop for further rate hikes. Investors skittish about prospects in China can turn to the U.S., especially when the FOMC is showing signs of abandoning its bias towards raising rates. The outlook for U.S. economic growth is still uncertain but the impact of the problems in the subprime credit industry is yet to be weighed. And we are a little concerned by the conventional street wisdom attempting to underplay the rising trend in mortgage delinquency. Systemic damage from tightening lending standards is already appearing, and should this evolve into slowdown effecting corporate profitability, there raises the possibility of a credit crunch. For the time being, the expectation of sub-trend growth should temper inflation enough to keep the FOMC on hold indefinitely, just as the stock market likes it. Any signs of trouble in the upcoming Unemployment data along with any weakness in Consumer Confidence would draw the attention of the FOMC that could prompt them to lower rates. A long shot perhaps, but an idea that is alive and well at Fairport.
 Personal Finance
Medicare Provides Preventive Services
Many myths about Medicare focus on what it covers and what it doesn’t. Older Americans are often unaware that Medicare covers a broad range of services to prevent disease, detect disease early when it is most treatable and curable and manage disease so that complications can be avoided. Not surprisingly, older adults are not receiving all recommended preventive services, even with frequent visits to physician offices. So what are some of the screening and prevention efforts covered by Medicare? Of note, individuals must be enrolled in Medicare Part B to get the prevention and screening benefits.
"Welcome to Medicare" physical exam. According to Lita Epstein, author of The Complete Idiot’s Guide to Social Security and Medicare, Medicare beneficiaries get a one-time review of their health, as well as education and counseling about preventive services, within the fist six months of coverage under Medicare Part B. This exam is required and will include screenings, shots and referrals for other care if needed.
Cardiovascular screenings. Medicare covers tests for cholesterol, lipid and triglyceride levels every five years.
Mammogram screenings. Medicare covers mammograms once every 12 months for all women 40 and older. Medicare also covers new digital technologies for mammogram screening.
Pap test and pelvic exam. If a woman has no evidence of cancer risk, she can get a Pap test and pelvic exam once every 24 months. Women with higher risk factors can have a test once every 12 months. This does include a clinical breast exam.
Colorectal Cancer Screening. The doctor and the patient will determine the level of risk and the frequency of which preventive screening tests should be used.
Prostate Cancer Screening. Medicare covers a digital rectal exam and prostate specific antigen (PSA) test once every 12 months for all men over age 50.
Diabetes Screening plus services and supplies. Available to those with any of the following risk factors: high blood pressure, dyslipidemia, obesity or a history of high blood sugar. Medicare also covers this test if you meet two or more of the following characteristics: age 65 or older; overweight; family history of diabetes (parents, brothers, sisters); and a history of gestational diabetes (diabetes during pregnancy) or delivery of a baby weighing more than 9 pounds. Medicare plays for glucose monitors, test strips, and lancets as well as diabetes self-management training.
Bone Mass Measurements. Medicare covers these measurements once every 24 months (more often if medically necessary) for people with Medicare at risk for osteoporosis.
Glaucoma Screening. Medicare covers the test once every 12 months for people with Medicare at high risk for glaucoma. The screening must be done or supervised by an eye doctor who is legally allowed to do this service, according to Epstein.
Shots/vaccinations. Medicare covers the flu shot once a year in the fall or winter. Beneficiaries can also get a Pneumococcal pneumonia shot. Medicare covers Hepatitis B shots for people with Medicare at high or medium risk for Hepatitis B.
Of note, Medicare beneficiaries must be aware of something called “assignment.” According to Epstein, when a doctor accepts assignment from Medicare, it means he/she will submit the bill to Medicare and will be paid by Medicare at Medicare’s allowable rate for 80 percent of the treatment cost. The patient is still responsible for his/her 20 percent co-pay of allowable charges. If a doctor does not accept assignment, he/she still must submit the charges to Medicare, but Medicare will not pay the doctor directly. The patient will receive all payments from Medicare and the doctor needs to collect any money due directly from the patient. Most doctors that don’t accept assignment expect full payment at the time of the appointment. Doctors who usually take this stance want more for the treatment (procedure) than is allowed by Medicare. So, if a patient decides to use a doctor that does not accept assignment, he/she should be aware that the reimbursement from Medicare may be less than the 80 percent of total cost. Going to a doctor that does not accept assignment can become very expensive.
For more details about Medicare’s coverage of preventive services, including costs under the Original Medicare Plan, call 800.MEDICARE or visit www.cms.hhs.gov/PrevntionGenInfo/ and www.medicarerxeducation.org/Guide%20to%20Preventative%20Servics.pdf.
This column is produced in concert with the Financial Planning Association, the membership organization for the financial planning community, and is provided by Gregory P. Althans, a local member of the FPA.
This newsletter represents an assessment of the market environment at a specific moment in time and is not intended to be a forecast of future events or any guarantee of future results. It is for informational purposes only and should not be relied upon as research or investment advice.
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