July 10, 2006
If you were watching the stock market this past quarter, you would have noticed a tumultuous market that was, in the end, driven by two uncertainties: 1) inflation concerns and 2) a possible slowing economy. In this quarterly letter, I will attempt to explain why we are experiencing this stock market volatility and what to expect going forward.
If the Federal Reserve (“the Fed”) has learned anything over the past 40 years, it is that their primary goal should be to keep inflation under control. As you can probably imagine, inflation has a double impact on corporations. Higher inflation usually means higher interest costs for companies that are borrowing and less demand, due to the higher prices, for the products these corporations are trying to sell.
The Fed has several weapons at its disposal to use to combat inflation. One weapon is the manipulation of the federal funds rate – the rate the Federal Reserve charges banks for overnight lending. The Fed has consistently raised rates one-quarter point each time they have met since June 30th of 2004. By increasing this rate, the Fed has, so far, dampened any huge inflation increases. The federal funds rate now stands at 5.25%, including the June ¼ point increase. During the second quarter of 2006, many investors were concerned that the Fed did not have inflation under control. They feared that there would be several more interest rate increases yet to come. Thus, I would guess the majority of the daily market volatility during the second quarter was due to the renewed inflation fears.
As we moved into June of this year, another question became apparent. Is our economy slowing down, and if so, would the Federal Reserve push rates up so far that the U.S. economy would spiral into a recession? In other words, would the cost of borrowing money by corporations and, more importantly, consumers freeze spending by these two groups?
In the months ahead, there are a couple of things to watch for. First, if overall corporate earnings come in at or above expectations, then investors will probably forget about a recession scenario. Second, the Fed’s June statement hinted that they might pause with the constant ¼ point federal funds rate increases in the future. A pause with the federal funds rate increases would be welcome news to the stock market. Keeping borrowing costs to a minimum could maintain or increase consumer spending and corporate borrowing and, thus, help future corporate expectations.
Regardless of the economic outcome, our client portfolios remain over-weighted to large-cap stocks with an emphasis in the value category. As I explained in the first quarter client letter, we believe this allocation will offer some protection should investors decide a recession is inevitable and will also give us a firm foundation should the stock market increase. If you have any other questions about the areas we have you invested, I would encourage you to establish a meeting date and time. Katie and I would enjoy seeing you!
Enclosed you will find your Portfolio Performance Summaries, Portfolio Holdings Statement as of June 30, and a quarterly Account Management Fee Statement. Please call us should you desire the most recent copy of our Form ADV, Part II. In addition, do not forget to notify us should your investment objectives or personal financial situation change.
Best regards,
William A. Bullock