2nd Quarter 2007: Recap and Update

Second Quarter 2007
Market Commentary

First Quarter 2007
Market Commentary


Recap and Update

In this issue, we would like to provide a recap of the 1st quarter of 2007, and then provide a brief update and /or developments within some of the major themes we have used in constructing your portfolios. These themes include globalization, energy, the aging of the U.S. population, and the rise of a global middle class. Then we will take a peek into the exponentially growing world of private equity, and how it relates to the other themes. Finally, our conclusion is to reaffirm a commitment to high quality, consistent earning, dividend paying stocks, which not only serve the needs of providing income, but also provide the products necessary for a growing world wide economy.

First Quarter Review

The 1st Quarter of 2007 was like a train ride that made a circular round trip. It ended very close to where it began, yet it traveled a lot of miles to get there. 1st quarter statistics on the market showed the Dow down 1%, while showing a 6.7% range from high to low, and large swings in both directions during the quarter, ending up at the mid-point.

Hidden within a flat outward appearance last quarter were some of the biggest one day losses recorded this decade. On February 27th, the Dow lost 416 points, followed by another 243 point loss two weeks later on March 13th. The fundamental factor behind these drops was a stock market reflex response to a 9% one day drop in the Chinese market. This just shows us the reality of the interconnected global world we have entered.

In the meantime, the economy remains strong, despite the fact that gasoline prices are back up, corporate earnings are starting to slow, and we are seeing the first signs of weakness in residential housing, via a sub-prime loan melt down.

None of the above seems to have had as much of an impact on the stock market as a growing consensus that, due to the foregoing, interest rates will probably come back down a bit. Given the fact that stock valuations are still relatively low, and that earnings yields are relatively high compared to bond yields, this consensus view on interest rates is providing a shot in the arm to the equity market in the first two weeks of April.

We would like to pause at this point to say that we don't share the conviction that interest rates will come down, (for reasons we will describe shortly). Further, as it relates to the equity market, we believe that a major new development is brewing insofar as providing some support for the equity market; that being the emerging world of private equity. In turn, private equity is merely following and taking advantage of the world of globalization.


Our economy has now evolved into becoming a part of a larger international market, due to the rise of globalism, which encompasses international trade, international business, and global markets.

The primary benefit of globalization has been a strong and vibrant world economy, as world trade has jumped in recent years to record levels. In turn, this expanding worldwide market is creating the emergence of a global middle class, the majority of which desire an American life style. As globalization expands, we believe the best investment strategy to capture the benefits of this trend is to invest in large-cap multinational companies that are leaders in their industry, and in most cases, are also the low cost providers of the lifestyle Americans have come to enjoy. The opening of emerging markets obviously broadens their potential market, and leads to an acceleration of sales as they penetrate these markets. Moreover, the reduced cost of labor overseas more than offsets their cost of operating in the U.S. This labor differential has become one of the primary drivers of the 15 successive quarters of double-digit profit growth the S&P 500 has experienced through the end of 2006.

The other side of this equation is that an increasing percentage of the goods and services we buy are coming from abroad. Along with this has come large and growing U.S. trade deficits, which now total almost $800 billion annually; and which has been growing exponentially over the last few years. In turn, these trade deficits are a major component of the structural financial imbalances of which we have written in past commentaries.


We believe that there is a high probability that the cumulative deficits that have been created in this manner will eventually come back to haunt us, either in the form of a falling dollar, inflation, or both.

Further, either or both of those outcomes in our opinion, also have a high probability of eventually and ultimately leading to higher interest rates. Most analysts on Wall Street however, as mentioned above, are looking for interest rates to fall as the year goes on. This is apparent by the inverted shape of the yield curve, which provides lenders with less of an annual coupon as time goes by. We don't agree with their conclusion, but we don't see any near term crisis either. Nonetheless, the seeds have been sown for all of these consequences to occur (inflation, falling dollar, and higher rates). For these reasons, we are cautious about extending maturities too far out, and defensive in our choices of which securities to utilize for an equity investment.

Chart Compares the Yield Curve of April 16 (green) vs. April 9, 2007 (orange). Currently, 6 Month rates offer the highest yields.

Private Equity

Along with the rise of globalism and international business has come the rise of private equity groups, which in the aggregate, have become major players in the financial markets of the world. We intend to introduce our clients to some of the factors leading to the creation of these investor groups, what their increasing power and influence might mean to our markets, and how they might intervene to offset our concerns listed above.

During Greenspan's tenure at the Fed, the 3-4 years of historically low interest rates created a number of major trends. On the one hand, it lured a significant minority of Americans to ratchet up the size and value of their homes, focusing on what "X" dollars per month could buy, as opposed to looking at the size of the mortgage involved. This acted as a catalyst to the rising prices of homes , and ended with the sub prime mortgage mess many financial lenders find themselves in today.

On the other hand, at the same time that John and Suzie Public were leveraging up their house, large pools of private capital were gathering together to leverage their asset base by borrowing huge chunks of money at the same relatively low rates. When the Federal Reserve started to tighten short term rates and the yield curve began to invert, institutions satisfied their need to borrow at low rates by initiating a "carry trade" by borrowing money at cheaper rates abroad and then re-lending that same money at higher rates in the U.S. and Europe. This practice seems to be slowing, as spreads between American and major foreign financial centers have been narrowing.

However, these pools of capital that were raised by the methods above were aimed at taking over recognized businesses to increase shareholder returns. We're talking hundreds of billions of dollars of capital. This had led to an explosion in the merger and acquisition business (M&A), and has enriched major investment banks such as Goldman Sachs and Lehman Brothers, as well as commercial banks like JP Morgan and Credit Suisse. In addition to the major banks are the growing numbers of hedge funds, which now control assets of over a trillion dollars.

It has also made heretofore private groups such as Carlyle, Cerberus, Blackstone and Kohlberg Kravis publicly talked about names. To quote Thomson Financial3, a leading distributor of financial services, "In today's competitive private equity marketplace, private equity firms, consultants and mezzanine providers are under unprecedented pressure to structure deals and develop exit strategies that meet or exceed investor expectations."

Last year alone saw the consummation of close to a $1 trillion of deal making, with $100 billion in December alone. Recent 2007 example of such activities include the $40 billion private purchase of Texas Utilities, the largest utility in our largest (lower 48) state. February 2007 alone saw the close of a $38.9 billion deal by Blackstone to purchase Sam Zell's Equity Office Properties, the largest publicly held commercial property holding company in America. Not to be outdone, Zell then took some of the proceeds ($315 million to be exact), and borrowed another $13 billion to take over the Tribune Company, which among other things owns the L.A. Times. The $13 billion debt was against the assets of the Times, not Zell.

Orthopedic-devices maker Biomet Inc. was acquired by a private-equity group for $10.9 billion, which included three of the names mentioned above. Dollar General was bought for $6-$8 billion and just today (April 16th), a $25 billion takeover bid for Sallie Mae (Student Loan Marketing) occurred. Deals like this are rapidly changing the nature of the market place.

One could argue that too much of this type of activity penalizes those companies that have too much cash and / or under utilized assets on their books, and are not using their equity capital as hard as they might. Indeed, those of us with more conservative bent might frown at the rapidity and extent of these publicly traded leveraged buyouts. But it has created a world where everything is for sale at a price, and in today's world no deal seems to be too big if the numbers pencil out.

Without either condoning or criticizing these deals, our observation is that all of this activity is supportive of higher equity values, and is one of the forces acting as an underpinning to stock market valuations. This is because almost all these deals are done at a premium to the daily closing prices, and often include some management participation as well.


Based upon the above-mentioned themes, our recommendation is to stay the course and invest in high quality, consistent earning, dividend paying, multi-national companies that can benefit from these trends. As always, thank you for your support.


William H. Schnieders

John C. Schnieders, CFA, CFP®

James F. Schnieders, CFA

Investor Login