August 2007

2007: The (Half) Year in Review

Despite a recent dip in the market, 2007 has been quite good for investors. The Dow Jones Industrial Average returned 8.8% in the first half and set all-time record highs along the way. The S&P 500 also flirted with record high levels while returning a solid 7.0% and the NASDAQ composite returned 8.2%.

In spite of these sound returns, the financial markets still find themselves reasonably valued. The forward price-to-earnings (P/E) multiple of the S&P 500 index is around 16, close to its long-term historical multiple but below its five-year average. Interest rates remain low, as the ten-year U.S. Treasury bond yield continues to linger near 5%. Economic growth, while not awe-inspiring, is still healthy, and inflation and unemployment remain benign. The long-awaited slowdown in corporate profit growth has yet to materialize, but the earnings reports for the second quarter are still coming in.

Several big stories have dominated headlines in the financial press so far this year. Perhaps the most prominent has been the ownership changes in corporate America. These transactions have many names – mergers & acquisitions, leveraged buy-outs (or LBOs), private equity take-outs – but all involve one company buying another. Generally speaking, when such offers are made public, the stock price of the target company shoots up to the offer price. This offer usually represents a nice premium to current market prices. All this activity has certainly helped propel an accelerating stock market.

While this “unlocking of shareholder value” is a boon for investors, it sometimes forces them to take an unwanted tax hit in the form of a capital gain. With so many companies being subject to large offers, client portfolios have had to realize a fair amount of gains already this year. Given this scenario, thinking about tax issues (such as capital gains) should not be a consideration only in the winter months. At RiverPoint every account is continually scrutinized in this regard with an eye to where it stands relative to year end. The good news is that the current rate of 15% on long-term capital gains is at its lowest level ever. It warrants noting that certain 2008 presidential candidates have already suggested a repeal of the legislation that reduced capital gains tax in 2003. Realizing gains now at a lower capital gains tax rate may be essential for investors with large positions in single stocks with a low cost basis.

Another major story in the first half of 2007 highlights the troubles plaguing the housing market and its partner-in-crime, sub-prime mortgages. At the national level, housing prices were flat, or even fell slightly, in the year’s first six months. Large homebuilding firms continue to report disappointing earnings, marked by steep discounts and land inventory write-downs as they work through a glut of excess homes on the market. As builders and homeowners lower their asking prices, homeowners who borrowed up to capacity now find themselves owing more on their homes than they are worth on the market. This has caused a rise in delinquencies, contributing even more homes to the supply of homes on the market and the downward spiraling of home prices. Rising interest rates have also caused the introductory “teaser” rates to be reset at much higher levels, adding to borrower worries.

As a result of these events, some large mortgage lenders went bankrupt during the first half of the year, roiling the stock market and raising concern that the sub-prime crisis may spread. In the weeks following June 30^th, there have been signs that the fear in the housing and sub-prime sectors have made investors in other parts of the market nervous. This news has caused investors to project their worries onto companies that may have little to do with the sub-prime mortgage market. We view this “guilt by association” as an opportunity to purchase shares in firms that have been unduly punished.

The third major story of the year’s first half involves hedge funds, private equity, and “liquidity in the marketplace”. Between the high-profile IPO of the Blackstone Group, the Bear Stearns meltdown, and constant reference to the giant troves of cash these funds hold, a day does not go by without one of these topics in the headlines. Based on recent Congressional testimonies, it might seem that these funds are bad news for investors, with their gigantic profits, use of leverage and short-term exit strategies. However, the “liquidity” provided by private equity firms and hedge funds could serve an important role in controlling widespread market shocks. If for example, a hedge fund, such as the recent Bear Sterns funds, begins to implode under the weight of collapsing sub-prime mortgage prices, there could be several hedge funds there waiting to purchase these distressed securities. This is exactly the type of situation that many of these firms attempt to exploit. As such, this “liquidity” in the marketplace could provide a nice cushion to an otherwise unpleasant downside.

The Dow at 20,000?

In just four years time the stock market, as measured by the Dow Jones Industrials, could surpass the impressive 20,000 level. What needs to occur in order for the Dow to reach that impressive benchmark? Actually, not much. At RiverPoint, we projected what each Dow company would likely earn over the next four years using consensus estimates. We then calculated each company’s future estimated price using current P/E multiples. Finally, we used the Dow's current divisor to estimate what the index would be. Using this methodology, the Dow would hit 14,921 by next June, 16,385 by the summer of 2009, 18,156 in 2010, and yes, 20,132 in the summer of 2011!

It is possible to get there even sooner. For our calculations, we used the Dow's June 30, 2007, P/E ratio of 16.1 for our valuation. That is a shade over the historical average, but is slightly low for the modest inflation, low interest environment in which we are currently. If the P/E ratio were to adjust upwards to about 18, we could reach 20,000 in 2010. Of course, there could be some stumbling blocks along the way.

First, the global economy could slow, causing earnings growth to slow as well. Earnings for the 30 Dow companies are projected to grow at 10.5% over the next four years which could be somewhat optimistic. At 8 to 9% growth, the Dow would reach the 20,000 milestone in 2012. Of course a recessionary environment would slow this even more.

Second, P/E multiples could contract for any number of reasons including rising inflation and a subsequent rise in interest rates. A drop in P/E multiples to about 15 would delay the Dow’s progress by a little less than a year.

While many scenarios are possible, one thing is certain: the stock market will continue to have its upswings and downswings. However, over time, stock prices are ultimately driven by earnings which lend credibility to a 20,000 Dow in the not-too-distant future.

Market Summary	07/31/07	YTD Price Change
Dow Jones Industrial Average	13,211	6.0%
Nasdaq Composite	2,546	5.4%
Standard & Poor’s 500 Index	1,455	2.6%

For information about RiverPoint Capital Management or to view our report archive visit us at www.riverpointcm.com.