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 Global Asset Allocation
· What Worked?
The global equity markets embarked on a wild ride during the recently completed third quarter with the Large Caps, represented by the S&P 500 Index, generating a total return of 2.03%. Like a rollercoaster, Large Caps started strong during the quarter climbing to all time highs in the month of July, only to reverse and head lower into August. The decline from the high, 10% in all, was triggered by several factors including further fallout from subprime lending as mortgages readjusted, a short term liquidity crunch and a reduction of risk within the capital markets, resulting in a move by investors towards the relative safety of blue chip stocks. As the Federal Reserve moved during the quarter to first lower the discount rate in August, and then finally cut the Fed Fund rates during their scheduled meeting in September, the markets reacted by moving Large Caps and the equity markets as a whole higher going into the end of the quarter. Corporate balance sheets remained strong during the quarter helping to fuel further reductions in corporate issuances through stock buybacks.
International Developed Markets, defined by the MSCI EAFE Index, kept pace during the secon quarter slightly outperforming the S&P 500 Index in dollar terms by returning 2.18%. Japan, one of the largest allocations within the index, continued to struggle as political infighting, lingering effects from deflation and anemic growth still plague the economy. The British and European economies grew during the quarter, while their central banks held off lowering rates to match their American counterparts. The dollar further weakened against the Euro and the Yen during the quarter, adding to gains from positive currency translation.
The International Emerging Markets reached new highs during the quarter with China, India, Russia and Brazil all finishing strong as the quarter came to a close. South Korea continues to capitalize and build on its relationship and proximity to China increasing trade between the two countries. China continued to increase reserve requirements in an attempt to curb excess speculation in their domestic A-share market while food prices rose, increasing the risk of further inflation. Economic global growth within the emerging countries was strong, driven by the demand for raw materials and supply of cheap labor.
As the global economy continued to be the engine of growth during the third quarter, the demand for Commodities once more drove prices higher. Crude oil led the way again, hitting an all time high before finishing the quarter above $81 per barrel. Investors flocked to gold, driving the price to an all time high of $750 per ounce, as the dollar depreciated and the threat of inflation continued to bubble under the surface. Agricultural commodities gained as well during the period as demand for food to feed the growing global middle class picked up strength while the search for alternative fuel sources, such as ethanol, intensified.
· What Didn’t Work?
As it became apparent during the quarter that risk aversion and volatility had returned to the equity markets, Small and Mid Caps came under pressure. The rotation into Large Cap equities continued for most of the quarter as the direction of the economy become unclear. With the seizing of the credit markets and the increase in credit spreads on Corporate Bonds, the risk premium was insufficient to keep investors in the space. As clarity began to increase near the end of the quarter predicting the Federal Reserve was going to lower rates, investors were willing to start revisiting Small and Mid Cap equities.
It was more of the same as it relates to residential Real Estate, as housing inventories rose during the quarter fueled by declining new and existing home sales. Foreclosures, as well as delinquencies, rose throughout the country as more and more mortgages readjusted during the period. On the commercial side, Real Estate Investment Trusts (REITs) seemed to find a bottom in early August, as the stocks found support trading near a 20% discount to Net Assets Values (NAVs). As it became more apparent that the Fed was going to cut rates, income investors returned to REITs to capitalize on their dividend yields.
· What Next?
With core inflation now falling within Fed Chairman Bernanke’s target zone, the domestic economy slowing to below trend growth, and the Fed entering an easing cycle, Large Cap stocks should build on gains from the previous three quarters and finish 2007 with a strong fourth quarter. As the Fed eases rates going forward, it should drive the cost of capital lower, allowing Small and Mid Caps to outperform the Large Cap stocks.
Strong global growth should continue into 2008 as the Emerging Markets capitalize on their competitively low labor cost and the strong demand around the globe for finished goods and services. Japan, Britain and rest of Europe will probably put further interest rate increases on hold and will come under pressure at some point to lower rates going forward, as the dollar should continue to weaken.
REITs should continue to experience a rebound from their lows in February as the new easing cycle should drive income investors to the space, while others shift their focus to a stronger economy in 2008. Residential Real Estate may experience more price weakness as inventory builds up and more subprime fallout may lie ahead of us, lowering near term housing forecasts. Commodities may well retreat from their highs of the third quarter, only to push further ahead in 2008. As global growth continues so too will the demand for raw materials, pushing prices up and demand for alternatives to the forefront.
 Large Cap
· What Worked?
As housing prices continued their decline throughout the quarter and new home inventories piled up, the Consumer Discretionary sector came under pressure again. We have been underweighting the sector for quite some time as the housing news came on top of evidence that the economy was slowing heading into the second half of the year, adding stress to an already overstretched consumer. We again benefited from a weaker dollar, as we continued to invest in Large Cap companies that have a significant international presence. Our bet on Technology once more paid off during the quarter as over half of the sector’s revenue came from overseas. The demand was fueled by the Emerging Markets’ need for networking and storage equipment. The Industrials within the portfolio continued to capitalize on the building of infrastructure both here at home and abroad, as more global demand has increased the need for new and more efficient power generation and capital projects benefiting durable goods manufacturers, equipment and tool makers. The Materials sector returned another solid quarter as commodity prices rose through out the period.
· 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?
If history is a guide, the fourth quarter should again generate strong year end returns and lead us to an even better 2008. The dollar should continue to weaken as the year draws to a close, benefiting our Large Cap multinationals as profits are translated back to domestic accounts. Corporate balance sheets should continue to strengthen and mergers and acquisitions will reaccelerate as companies look to invest profits. The rotation out of Large Cap value and into growth should pick up steam as growth stocks tend to outperform when the Fed eases monetary policy. Technology and Industrials should take advantage of lower interest rates and strong global growth and outperform in the fourth quarter as P/E multiples expand and corporate earnings stay strong. More fallout from the housing glut may hold back the Financials as they will continue to mark down the value of the loans they hold, but a sympathetic Fed may provide cover in the form of rate cuts.
 Fixed Income
· What Worked?
The third quarter brought life to the Fixed Income markets for the first time since the FOMC stopped raising rates in 2005. Beginning with the 2-year Treasury rate hovering around 5% growing concerns in the loan market for subprime mortgages inspired a number of high profile, but often inaccurate, headlines aimed at investors too distracted by the bull market in equities. By the time stock prices, particularly those of financial institutions began falling, the Fixed Income markets did the job they’re often called upon to do - to lend a hand to investors fleeing from uncertain and volatile equity markets. By the end of the quarter, the FOMC acted aggressively to lower the benchmark’s rates thereby ensuring that they would stay low for the foreseeable future.
This worked out well for Fairport clients as short ladders of bonds captured most of this “flight to quality” returning over 4% for the quarter. Accounts holding Municipal Bonds also performed well as investors sought safety in insured issues. The other positive development in accounts came from the exposure to mutual funds, in particular the GNMA fund. As the only MBS product backed by the U.S. government, the GNMA fund benefited from inventors wanting that important structure with the safety of a government security.
· What Didn’t Work?
Above all, the flight to quality came at a price for the Credit markets. The spreads for Corporate Bonds versus Treasuries widened as nervous borrowers began turning away from markets other than the subprime mortgage market. As behavior deteriorated further even the Commercial Paper markets suffered withdrawals of confidence in spite of the stable credit ratings enjoyed by many of the target companies. Particularly large companies in the Commercial Paper Market, using complex structures to provide competitive yields, found no buyers. Eventually this drove Credit Bond spreads to U.S. Treasuries wider; in fact, to levels not seen since the Asian crisis in the late nineteen nineties. Single ‘A’ investment grade 5-year Corporate Bonds went from ¼% over the 5-year Treasury to nearly 1%. Although historically attractive, the value was difficult to capture for investment and nearly impossible to sell into. This left more cash on the sidelines earmarked for Fixed Income than we would normally be comfortable with. However, with aggressive support from the FOMC, the situation has already shown signs of settling down.
· What Next?
2-year U.S. Treasuries finished the quarter yielding around 4% in response to the FOMC lowering rates and uncertainty in the financial markets. Therefore, a neutral weight in Treasures is warranted in favor of some exposure to the spread markets. Specifically, Fairport has sought value in the Credit markets through the use of mutual funds targeting Investment Grade and High Yield strategies. In our judgment, many of the bonds in these markets represent hidden value that is evident in the balance sheets of the parent companies but not reflected in the risk premium. In particular, large companies that have benefited from a weaker dollar have seen earnings growth consistently exceeding Street expectations, growing free cash, and rising current ratios— which is a quick measure of a company’s overall ability to pay down debt—at levels of nearly 2x. In short, with slow calendars over the past year, investment capital favored the equity markets giving many companies time to de-leverage themselves through buyback programs. This trend should continue as the economy responds to the FOMC growth initiatives and confidence slowly returns to the financial markets.
 Economic Landscape
· What Worked?
The U.S. economy began the quarter with most of the important data still pointing to sub-trend growth. Although this was forewarned by the FOMC, the financial markets continued to show the same resiliency they had since the beginning of the year. But then came the disconnect; first there was news of numerous high profile hedge funds holding subprime loans who began defaulting on their ability to meet shareholder demands for cash and then there was the systemic response as the press picked up on the story and inundated the public with concerns.
The consumer, who was calm up until that point, was served a steady stream of reasonable economic news. The firm Civilian Unemployment Rate and Non Farm job growth helped keep attitudes and activity on track. And the flight to quality buying that pushed down Treasury bond yields ensured that interest rates would continue to feed whatever borrowing still existed. In fact, even as the equity markets began to recoil in shock as the credit crisis grew in uncertainty, the driving behavior ignored both the strong international economic trends and the watchful eye of the FOMC. Even as the S&P 500 Index was retracing its steps, falling to levels not seen since the beginning of the year, the overall economy continued to work in favor of the investor with the help of the FOMC. Both the very creative adjustment of the Discount Rate and the temporary changes in some of the rules caught the attention of the markets. By the end of the quarter, the Fed went the extra step and lowered the Fed Funds rates effectively aimed at helping lower all variable rate loans.
· What Didn’t Work?
By the time consumer confidence was released on September 25th, one week after the FOMC surprised the markets with an aggressive half point reduction in the Fed Funds Rate, all the financial markets had recovered except the credit markets. Although the FOMC moved to stem rising loan defaults associated with the housing market, the action came at a price. September’s weak Jobs report and weaker than expected Productivity data were unexpected but probably helped give the FOMC reason to lower rates, especially since GDP still looked to be on track for the quarter. But the weakness in Durable goods and ISM Manufacturing, both indicators of purchasing and productivity strength, nurtured concerns that the effects of the negative housing market were directly influencing the economy. And to that point, it’s still uncertain whether the current mid-cycle slowdown will turn into a full fledged recession.
· What Next?
While we do not view the FOMC moves as conclusive of a moderating economy, we agree with the consensus that a recession can be avoided for some time. However with increasing clarity the U.S. Central Bank has solved both an immediate problem and created an entirely new set of problems. The most important message in the FOMC’s recent actions is that Chairman Bernanke is not one to shy away from moves aimed at shoring up confidence. This is both a surprising and important precedent. First, the aggressive move to lower rates assured that the dollar would continue its year long decline, which will also influence future inflation trends. But much depends on the high levels of productivity seen in both Developed and Emerging economies outside the U.S. Even though they are still strong there are already some signs of spillover from the mortgage problems in this country. There is evidence that although China and Eastern Europe are willing to err on the side of higher rates, we believe that Developed Europe has already signaled a pause in its rate hike schedule.
The point worth exploring now is whether the activities of the global central banks are enough to sustain a moderation in growth. The financial markets seem to think so and so do we.
 Personal Finance
Business Disaster Planning
Before 9/11 and Hurricane Katrina, the concept of a business “disaster plan” was envisioned mainly in terms of weather, or fire-related, disasters and heavy on the notion of evacuation. Business risk today is much more broad – legal threats from inside and outside the company, computer-related losses, regulatory threats, and of course, the potential of human and facility losses due to natural disasters or the possibility of terrorism. Variables like your business size and structure and personal issues like your age, health and your time to retirement also factor into what should be a customized risk management plan. If you are starting a business or already own or co-own a company, the first steps in creating a disaster plan should involve separate visits to tax, insurance and qualified financial advisers. Here are some general issues you should consider in developing that plan:
Your plan depends in large part on your industry and business structure. A three-person law partnership may have a completely different risk profile than a sole proprietor. Whether you use expensive equipment in your business or you produce valuable ideas on paper, you need to take specific steps to protect the value of your business assets in tandem with your personal finances. This process should start with a financial review to assess how to protect your home, your income stream and your retirement savings if particular scenarios happen.
Develop a “what if” list. Be as imaginative and as negative as possible about this. Consider every possible event that could hurt you or your business. The first question – what if you died or became disabled tomorrow? Other questions might refer to specific physical plant or computer risks, as well as employee or customer risks that could affect your future operations. A good way to make the list is to draw a line down the middle. On the left side, list every possible risk, while writing every possible remedy for those risks on the right side. Prepare this list before you meet with experts.
Protect your customers. If you faced a lengthy business interruption, how would you serve the customers who are depending on you? Are there specific customer service and inventory procedures in place to keep them informed, supplied and most important, loyal once you’re up and running again? Do you have options for alternate office and production space as well as resources for temporary workers?
Protect your employees. In a natural or man-made disaster, lives can be lost. But if you’re closed for weeks and months, key employees may leave and that might be a greater long-term danger to your company. Talk to your insurance company about every physical and employment risk your staff could face in a disaster and see what safety nets are available.
Protect yourself. Review your list of worst-case scenarios and how you would protect your home, your health, your retirement, your kids’ education and your estate priorities first. If your business fails for any reason, all of those critical necessities could be jeopardized. Make sure you have appropriate life and disability insurance coverage in addition to a current estate plan.
Protect your information. From proprietary databases and research to customer credit information, this data is critical fuel for your business. What’s to keep a burglar from stealing your computers and taking all your valuable financial, inventory and customer data with them? Better yet, what’s to keep a computer hacker from stealing the information and leaving the machines behind? Data security and backup procedures are increasingly important as disaster-planning priorities. Get help finding the protective measures that fit your industry.
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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