2007 Mid-Year Review & Investment Update

The first half of 2007 has been a pleasant surprise with the S & P 500 returning as much in six months as we anticipated for the entire year. Both the S & P 500 and the Dow Jones Industrial Average reached all-time highs before pulling back modestly. The table below illustrates year-to-date performance for a number of broad indexes, and we include some observations below it.

Foriegn Indexes Local U.S. $ Domestic Indexes
Brazil Bovespa 22.02% 34.21% S & P 500 13.2%
CAC 40 (France) 8.69% 10.97% Dow Jones Industrial Avg. 7.20%
China (Shanghai Composite) 52.92% 56.62% NASDAQ Composite 7.19%
DAX (Germany) 20.51% 23.04% S & P 400 (Mid-cap) 11.44%
FTSE 100 (U.K.) 5.57% 7.82% Russell 2000 (Small-cap) 5.98%
Hang Seng (Hong Kong) 10.19% 9.71%
Mexico Bolsa 19.64% 19.32%
NIKKEI 225 (Japan) 5.59% 1.57%

Recap of the first half of 2007

1. Second-longest cyclical bull market without 10% correction since 1945 continues
We still haven’t seen a 10% correction in the markets, but from the last week in February through mid-March the markets did correct almost 5%. This proved to be a healthy breather, as the S & P 500 and Dow Jones went on to all-time highs. Private equity deals keep stocks well bid. That phenomenon and healthy skepticism from several quarters leads us to expect a decent second half of the year.

2. Foreign Investments Outperformance
Continuing a theme of the past few years, foreign indexes continue to outpace domestic indexes. Predictably, this has lead to investors favoring foreign investments over U.S. investments by a wide margin. Indeed, for every $1 invested in domestic funds, $3 are invested overseas. This popularity makes us a little nervous because it’s beginning to look like everyone is on the same side of the boat. Still, with foreign investments representing at least 50% of world equity capitalization, U.S. investors likely remain underweighted, and some shifting makes sense.

3. Interest Rates
Interest rates have risen dramatically since year-end, with the yield on the ten-year Treasury note rising from 4.68% to 5.15%, a 10% increase. Much of this can be attributed to the pull of higher global rates and a strengthening domestic economy. Outside the U.S., central banks in Japan, Canada, Great Britain, and Sweden are in tightening mode in response to economic strength and inflation fears.

4. The Consumer
In the face of higher food and gas prices the consumer continues to be resilient. Consumer sentiment and spending remain strong, buoyed by low unemployment levels and wage gains. We are concerned, however, about the massive amount of adjustable rate mortgages due to reset in the next 24 months, the huge majority of which are subprime. The big question, of course, is what will be the effects beyond subprime.

Global Portfolio Asset Allocation Product Changes

For some accounts, we utilize a mutual fund/asset allocation approach, and the following section details the most-recent changes in those portfolios.

Swapping Loomis Sayles Global Bond Fund for Oppenheimer International Bond Fund

In the fixed-income segment of our Global Portfolios asset-allocation product, we are exchanging our holding of the Loomis Sayles Global Bond fund for Oppenheimer’s International Bond Fund. The primary reason for this change has to do with the income distribution schemes of the funds. The Loomis fund only distributes income in December, whereas the Oppenheimer fund distributes income monthly. In addition, the Oppenheimer fund had a decent performance edge.

Eliminating direct small-cap exposure for the summer

We are eliminating our sole small-cap fund, Federated-Kaufmann Small-cap, from the equity segment of the Global Portfolios. With this change, our global portfolios have no small-cap exposure, and this is confirmed by an in-depth analysis of all of the funds; i.e. none hold small-cap stocks.

This decision is based on three primary factors.

  • While the May through October period has historically been difficult for U.S. stocks, in general, it is an especially difficult period for small-cap stocks;
  • When the Russell 2000 (small-cap) index is compared to the Russell 1000 (large-cap) index, the former has never been more overvalued since 1983; and…
  • Finally, historically, small-caps have performed badly when markets have become more volatile, and while we don’t forecast this scenario, equity markets are overdue for a correction.

Adding 5% Global Real Estate fund position

Finally, we are adding a 5% global real estate position to all portfolios. This will introduce a component with less-than-perfect equity correlation, but exposure to global growth. The ING Global Real Estate fund has 30% exposure to Asia, an area in which we are especially interested. In addition, the fund sports a 4% dividend yield and top quintile performance over three- and five-year periods.

Investment Management & Trust Services Division Tower Private Advisors


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