Equity Market Overview
While 2005 was full of surprises that had the potential to derail the economic expansion, perhaps the year's real surprise was the fact that the economy remained very robust in the face of the negative shocks. Despite oil prices hitting $70 per barrel and the City of New Orleans devastated by natural disaster, the economy still posted better than average growth. The long Treasury note did not rise, core inflation remained benign, and the dollar strengthened despite the pessimists' fixation on the trade deficit. True to its form, the U.S. economy has once again demonstrated its resiliency and breadth. Unlike the late 1990's expansion that was driven primarily by the Information Technology and Telecommunication Services sectors, the current economic expansion enjoys broad participation across many sectors. Looking back, our optimistic view of the underlying economy was essentially correct, as was our expectation of continued strength in the global equity markets, although the U.S. equity markets' performance proved lackluster in the face of a rising U.S. interest rate environment.
U.S. Market Outlook
Now, with interest rate rises largely behind us and the underlying economy remaining in the middle of its stable-growth phase, we believe that the equity markets are poised for a good year. When considered in the context of interest rates, the market P/E level is at the low end of the historical range. We have had a record 13 straight quarters of double-digit earnings-per-share growth, and expect earnings to continue to grow at similar rates in 2006. With corporate balance sheets in great shape, capital spending should also continue at a healthy clip. Additionally, relatively low inflation and interest rates should continue to provide further fuel for the equity markets.
The economic outlook reflects the mid-phase of the economic cycle which, if it remains on track, can last for several years. Entering 2006, strong economic fundamentals are providing a positive backdrop to the financial markets. We currently see many potential positive influences on the economy and financial markets, including:
- Oil prices may decline, easing the consumption squeeze for the lower half of wage earners
- Housing prices remaining in an uptrend
- Corporate spending continues to be strong
- Wage and salary levels increasing at a faster pace
- The Fed nearing the end of raising interest rates
- Recently reduced tax rates on capital gains and dividends likely to be extended
- Europe and Japan joining in on the global expansion
- Iraq is stabilized and Iran held in check
- The U.S. trade deficit shrinks
In the light of these expected positive trends, it is also important to recognize the factors that we are monitoring which could have an impact on our outlook and portfolio positioning as history has shown us that good economies do not die of natural causes, rather, they are brought down by the Fed or Congress. Whether the danger stems from miscalculations on interest rates by the Fed or Congress tinkering with policies that are disruptive to a growth-oriented economic environment, we monitor the factors that could have a negative effect including:
- The Fed overshoots its marks and yield curve inverts meaningfully
- The overall housing market drops dramatically
- Protectionist policies in Congress gain traction
- Tax rates on capital and savings are increased
- The Fed becomes overly concerned with asset prices
- Iran becomes more aggressive
- Iraq becomes unstable and terrorist activities increase
- The U.S. dollar comes under undue pressure
- Inflation concerns increase
U.S. Market Review—Fourth Quarter 2005
The broad equity market (as represented by the S&P 500 Index) posted another positive quarter, up 2.08%, bringing the 2005 return to a modest 4.91%. Performance continues to come in spurts, with the majority of the fourth quarter gains stemming from a strong November, with the S&P 500 up 3.78% during that month.
Across market sectors, Energy was the worst performer for the quarter down almost 8%, giving back some of its gains from earlier in the year. Despite its fourth quarter retrenchment, Energy remained the best performing sector for 2005, returning 29% for the year. On the positive side, Materials and Financials were the best performing sectors for the quarter, up 10.6% and 7.5% respectively.
During the 4Q, we were encouraged to see large-cap, and what we would view as higher quality companies, up 2%, placing them on par with the mid-cap segment. Small-cap stocks underperformed again, up only 1%. For 2005, the mid-cap segment was once again the clear winner, with the Russell Midcap® Index up 12.7%. Small-cap stocks, as measured by the Russell 2000® index, however, underperformed with a mere 4.6% return for the year. While large-cap securities, as measured by the Russell 1000® Index, rose 6.3% in 2005, the large-cap growth universe has lagged mid-cap and small-cap growth stocks for some time now as indicated in the following charts. With the performance gap and the valuation opportunity becoming as wide as it has been in a generation or more, the relative cost of growth is cheapest in the large-cap universe (see charts below).
Current Portfolio Positioning/Outlook
Portfolio construction is not static from one calendar year to the next, but instead evolves, often incrementally, and will change as the year proceeds and events occur. As for our current portfolio positioning, we continue to believe that we are in the middle phase of the economic cycle, which is characterized by solid growth, although not at the dramatic levels witnessed in the earlier recovery phase of the cycle. In response, the portfolio is positioned for a market ready to recognize the economy's strength and benefit from strong corporate profits, increasing capital expenditures, and solid consumer sentiment.
We remain constructive on the Information Technology sector and favor companies with supply-side driven business models, high ROIC ratios, and healthy cash positions on their balance sheets. We continue to increase exposure to the Financials sector which has the potential to benefit should consumers shift to saving and investing in order to maximize household net worth. Given the sustained high energy prices and its impact on lower-income earning consumers, we have reduced Consumer Discretionary throughout 2005, focusing on companies within the sector that serve the high-end consumer. Overall, we are finding more attractive risk/reward opportunities among larger-cap higher quality companies with stable growth records, which is consistent with our assessment of being in the middle phase of the growth cycle.