July 2007 / Issue III
 

 Global Asset Allocation
· What Worked?
Large Cap equities continued to build upon the base established as a result of the market correction near the end of the first quarter, posting a total return of 6.28% for the second quarter of 2007. This brings the first half of the year’s total return to 6.96%, recording one of the best second quarters in recent memory. For those of you waiting for the rotation into Large Cap equities at the cost of the Small and Mid Cap stocks, the wait may finally be over. The weaker dollar continued to fuel profit growth, especially for those multinational companies that derive a large portion of their sales from overseas with profit growth higher than expected albeit breaking the streak of fourteen consecutive quarters of double digit growth. Firms continued to buy back their own stock while private equity firms used their cash hoards to acquire undervalued companies and take them private. Volatility was again higher than average during the quarter as concerns from the subprime lending continued to fuel the flight to quality which benefits the Large Caps.

The International Emerging Markets shook off the effects from the sell-off in the first quarter and again assumed its position as the best performing asset class. Capital returned to the Emerging Markets during the quarter, as investors became more comfortable with the increased volatility associated with growing markets. China continued to increase reserve requirements in an attempt to curb excess speculation in their domestic A-share market. Economic growth in the BRIC (Brazil, Russia, India and China) countries is still strong, driven by the demand for raw materials and supply of cheap labor.

International Developed Markets, as defined by the MSCI EAFE Index, advanced again during the second quarter returning 6.4%. Both the Bank of England and the European Central Bank raised rates during the quarter, though many believe the end is near for the current tightening cycle. Europe, driven by Germany and the UK, had strong returns from their capital markets as the combined economy continues to grow at a healthy pace. Japan continues to show signs that their economy is on track and deflation has come to an end.

· What Didn’t Work?
Mid and Small Caps underperformed during the second quarter due to several factors. One of which included increased volatility within the capital markets that drove many to the relative safety of Large Caps; this may have brought what was a multiyear cycle of outperformance to an end. The spike in interest rates observed during the quarter, which pushed the 10-year Treasury yield over 5.25%, would have over the longer term drove the cost of capital higher, hurting many Small and Mid Cap companies that depend on the funds to fuel future growth. We saw this as an opportunity to add to positions within our portfolios for those accounts that did not have a full position.

The broad based commodity indices, such as Dow Jones-AIG Commodity Index and the Goldman Sachs Commodity Index, saw mixed returns during the second quarter of 2007. Crude oil ended the quarter up slightly from where it began, as the price again flirted with $70 per barrel during June before retreating at the end of the quarter. Metal prices were mixed as the price for copper increased while aluminum fell lower, sending mixed signals on the demand of the global economy heading into the second half of the year. Gold rose for most of the quarter, but finished lower as more data pointed to steady to lower inflation and slower economic growth in the U.S. We took advantage of the drop late in the quarter and averaged into positions within the commodity allocations.

We expected Real Estate to come under scrutiny during the second quarter, as more light was shed on loose lending practices and the low interest environment was overextended, creating further concern that the fundamental valuations for REITs (Real Estate Investment Trusts) were stretched. This turned out to be true as more data about subprime lending surfaced and the back up in interest rates proved too much to handle as REIT indices sold off during the quarter. In an effort to diversify our holding away from domestic real estate markets only, during the correction we added exposure to International Real Estate and initiated positions within client accounts. The global economic growth should continue to fuel the demand for real estate overseas as many countries are beginning to recognize REITs as an investment vehicle.

· What Next?
As we enter the second half of 2007, the probability that we see some consolidation in the capital markets is high, as the third quarter has historically been weak as more people focus on summer vacations and thoughts other than the direction of the market. The slowing growth of the domestic economy, the inflation outlook and any indication of the Fed’s next move in interest rates all could have an impact on where the markets go from here.

Corporate profits should remain strong, as companies continue to buy back shares and look for efficient ways to utilize their growing cash balances. Expect the current wave of M&A to run through the second half of the year, as the record pace reflects the large amounts of liquidity in the global markets.

The International Markets should continue to benefit from the weakening dollar, strong global growth especially in the Emerging Markets and the high level of global liquidity looking for a home. Any further tightening by foreign central banks should be taken in stride, while Japan looks to continue raising rates as their economic health improves. Commodities, driven by global demand, could consolidate through the summer months but look for further increases by year-end.

We remain cautious on Real Estate as inventories build and prices come under more pressure. The direction of interest rates will also play a role, as any back up in rates would push valuations to more reasonable levels creating opportunities to add to positions.


 Large Cap

· What Worked?
Within our managed portfolios as well as the market, the Information Technology sector contributed strong double digit returns for the second quarter. We continue to overweight the group and look for companies that exhibit strong market share and profit growth. As we approach what we believe to be the second wave of internet technology, or what Cisco Systems’ CEO John Chambers calls “Internet 2.0,” we continue to invest in companies that we believe will benefit from the build-out of increased connectivity such as IPTV (Internet Protocol Television), third generation wireless and on-demand video conferencing. We also were rewarded from our oversized position in the Industrials, with most companies we hold outperforming the market. Global growth is still strong and companies are being recognized for their strong balance sheets. The continued weakening of the dollar continues to add a strong tailwind to the sector as well. We are still underweighted in the Consumer sectors (both Discretionary and Staples), as they underperformed the market during the quarter, due to our beliefs that the economy will continue to slow into the second half of the year and the decline in home prices may constrict spending.
 
· What Didn’t Work?
Energy was again one of the best performing sectors of the market for the second quarter of 2007. Earlier this year we moved to a slight underweight in the Energy sector relative to the S&P 500 Index as we believed that new capacity coming online would meet demand and price pressure would dissipate slowly throughout the year. The Health Care sector slightly trailed the market while still generating a positive return during the last three months. We continued our overweighting into the second quarter and believe much of the underperformance can be attributed to consolidation after recording large gains in the first four months of this year. The medical suppliers and pharmacy benefit managers were sub sectors that continued to show relative strength versus the market. The Financials got hit as well during the quarter as the increase in interest rates, the uncertainty of the direction of the Fed and an unraveling of the subprime story all took their toll in the past few months.

· What Next?
As the second half of the year unfolds, the market will be looking for indications on the overall strength of the economy, the inclination of the Federal Reserve and what havoc, if any, inflation may provide to the overall economic picture going forward. The dollar should continue its current weakening trend, which in turn should help the bottom line of the Large Cap multinational companies that have a significant portion of their revenue derived from overseas sales. Price to Earnings (P/E) multiples should expand as the overall picture becomes clearer and corporate profits remain strong. We remain overweighted in Information Technology, Industrials and Healthcare and look for those companies that will capitalize on the current trends. 

Fixed Income
· What Worked?
The second quarter began with a steady, rising flow of positive economic growth, bringing increased interest into the stock market at the expense of bonds, which were struggling for evidence validating yields below those desired by the Federal Reserve Bank (FRB). Throughout, the yield curve maturities from 2-year Notes to 30-year Bonds traded at 4.58% and 4.84%, respectively. This was a dangerous condition for two reasons. First, the cost of holding cash has remained over 5% since the FRB stopped raising rates last year and second, the competing yield made it increasingly difficult for investment managers to find value in the taxable and non-taxable bond markets. Another concern rested in the shape of the yield curve. In normal times, when economic growth is around 3%, 30-year Bonds would pay a higher yield than 2-year Notes, because the investor is taking more risk represented by the longer holding period. When the reverse happens, called an “inverted yield curve,” the risk is made all the more unacceptable. An inverted yield curve implies the expectation that future economic growth will slow. When stronger than expected growth materialized, interest rates had nowhere to go but higher. As we entered the end of the second quarter, 2-year Notes and 30-year Bonds were 4.90% and 5.18%, respectively. This worked out well for Fairport clients, as short ladders of bonds performed positively to the change in the shape of the yield curve, called “steepening.” The other positive development came from the exposure to mutual funds that caught most of the rise in yields, thereby making accounts a little “longer” at the very time when the risk was less than the potential reward.

· What Didn’t Work?
When the bond market is acting adversely, as it did in the second quarter as rates moved higher, the common scenario is for extremes to be reached. If 5% was the conventional wisdom’s target, then bond yields were sure to go beyond that. That’s because of the widespread panic that ensues when a shift in public opinion occurs for no specific reason. In this environment, accounts that were fully invested coming into the quarter benefited from having positioned defensively and accounts that were heavy in cash benefited from being able to invest that cash at higher levels. However, bond ladders are the best way to preserve stability in a rising rate environment. New investments are trickier since the immediate effect will be negative performance. This is particularly true with municipal bonds, where demand is always high and yields are kept unattractively low and there are few options to park cash in state-specific money market funds.

· What Next?
What “didn’t work” in the second quarter should prove temporary. As the new ladders are completed and existing ladders are added to, holdings will go through a “seasoning period” whereby the ladders will eventually mirror the yield curve. There is still reason to expect interest rates to continue to rise in the near future as pressure from sub prime mortgage failures and concerns about companies like Bear Stearns who are currently the last holders of those mortgages stoke nervous public reaction. But rising rates will present new opportunities to invest and even if the economy disappoints, the majority position that GDP will accelerate in the third quarter, the probabilities change to a more positive outlook slowly enough for most cash to be actively invested. If the economy does remain in a mid-cycle slowdown, as we are currently forecasting, the revived decline in rates should benefit all the positions on the yield curve. Likewise as the bear market in bonds ages, even Municipal Bonds should begin to reflect more realistic prices and participate in an interest rate decline.
Economic Landscape
· What Worked?
The U.S. economy is coming up on one full year since the Federal Reserve Bank (FRB) stopped raising interest rates. During that time, GDP has grown at a trend roughly over 3%. This is the wide view. Looking at those results on a quarter-by-quarter basis paints a far more mixed picture. Though job security is optimistic and consumer attitudes are confident, trends in productivity have been flat and, lest the FRB allow us to forget, inflationary trends have been on the rise. So when the second quarter began in the throes of a mid-cycle slowdown, investors were scratching their heads as sub par growth failed to impede corporate earnings and P/E multiples continued to expand. Interest rates were already low and as the economy began experiencing a material upturn in growth, the economic data began to dispel any notion that the FOMC would move again before year-end. The Euro and Asian Pacific economies were also experiencing market booms in deference to the public concerns of their respective central banks. And while interest rates began to drift lower, some economists began predicting that the FRB would move to cut rates before year-end. The economic news was so good that plentiful liquidity driven by low borrowing costs helped spark a boom in private equity. The FOMC and its new Chairman were beginning to look like they were in control.

· What Didn’t Work?
All the good news has nurtured increasing investor interest in the stock market and as the U.S. becomes increasingly fair valued, Emerging and Euro markets were viewed positively, beyond their historical risk. However U.S. interest rates, the only secure source of attraction for foreign capital, especially true in light of the weak dollar, were overshadowed by international rates resulting from the aggressive rate hikes taking place in the rest of the world. As Europe, China and Japan were either raising benchmark rates or just talking about raising them, the rest of the industrialized world appeared intent on moderating the speculation growing out of high liquidity. This, in turn, caused a disconnect particularly from the housing recession, which has been going on for nearly three quarters and has negatively impacted GDP growth 1% by some estimates. Although this has kept the FOMC on the sidelines, stubbornly low interest rates and strong employment growth had kept alive, albeit at a minimum, the prediction that the FOMC might actually raise rates before year-end. Sensing this muddled economic environment, stock market volatility increased and interest rates rose, each action making the other worse.

· What Next?
With the economic data pointing to stable productivity and continuing confidence in consumer attitudes, there was little evidence on the horizon to justify rate cuts at all and anticipation faded. Although it has come to pass that the markets were too optimistic in anticipating FOMC rate cuts, the turnaround has now routed bond prices and put fear in the broad equity indexes.

We feel that the late quarter activity, especially in the bond markets, may have been too aggressive in reversing its view of FOMC intentions. With the economy growing over 4% for the last two quarters, consumer spending could likely slow largely due to the impact of rising food and gasoline prices on household income. This is already evident is some of the statistics such as Durable Goods Orders which have recently weakened, and oil prices moving appreciably higher. And although the boom in private equity and the increasing number of mergers & acquisitions suggests that smart money sees plenty of undervalued assets, that may also be an indication of an approaching mid-cycle slowdown. Since European growth has been indistinguishable from the U.S. that region might follow. Japan and China have already signaled they might pause from future rate hikes, perhaps temporarily muting some investor enthusiasm. Otherwise, we think the effect should be benign. 

Personal Finance
Are Charitable Gift Accounts Right for You?
Charitable gift accounts are popping up at major mutual fund companies and may be a good idea for individuals looking for a tax-advantaged way to support their favorite charities, improve their estate tax situation or bring more order to their gift-giving strategy. It might surprise you to know that some of these funds can start with an initial contribution of $10,000 and allow additional contributions of as little as $1,000.

Charitable gift accounts offered by the mutual fund companies come in two varieties -- donor-advised funds or pooled-income funds. Donor-advised funds allow a donor to deposit a specific amount in the fund for an immediate tax deduction equal to the full value of the contribution, allow the donor to direct the investments within the choices provided by the fund and then direct where the money is given over time. Pooled-income funds, meanwhile, allow the donors to receive lifetime income from the funds’ investments while allowing the value of the account to go to designated charities after the last designated beneficiary dies.

Depending on a donor’s particular situation, these two options can be a relatively attractive idea based upon whether the donor’s focus is on obtaining the maximum tax deduction or retaining income for life. That’s why it is a good idea to discuss either option with a trusted financial adviser such as a CERTIFIED FINANCIAL PLANNER® professional or a trained tax advisor to see if either of these choices or other tax advantaged charitable options are right for you.

Some general points about these options:

Know the kinds of assets you can deposit: Most funds will allow you to deposit cash (by checks), publicly traded stocks, bonds and mutual fund shares and, in some cases, life insurance policies. Highly appreciated securities are often a good choice since the tax deduction is based on the fair market value of the asset.

You can reduce the overall size of your estate: In 2009, the estate tax exclusion amount is scheduled to be $3.5 million per person, but it is set to be repealed in 2010 and re-set at $1 million in 2011. No one can know the future, but for taxpayers with significant estates, charitable gift funds might be a good way to reduce the size of a taxable estate.

You need to keep an eye on fees: These are not passively managed accounts, so you will probably be paying higher fees than the average index fund or similar pooled investment. Always consider management fees when considering any potential benefits. However, this option is typically cheaper than starting your own foundation or similar charitable giving vehicle.

This decision is irrevocable: Understand that your gift is final. Because of the tax-advantaged treatment, you’re not going to be able to reverse this decision if you find you need the money later. Give careful consideration to how prepared you are for retirement and long-term care spending before you make this choice.

Watch the IRS: The Pension Protection Act of 2006 attempted to tighten some of the rules for donor-advised funds, and has directed the Internal Revenue Service to investigate these funds’ personal uses in more detail.

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.