December 2007

WHERE DO WE GO FROM HERE?

Recent market turbulence could make even the most avid roller coaster fan sick to his stomach. Investor fears over falling home prices and continuing credit market turmoil are just a few of the factors causing concern. The confluence of these factors and others resulted in the dismissal of two top Wall Street CEOs – Stan O’Neal at Merrill Lynch and Charles Prince at Citigroup. S&P 500 profits have also come under pressure recently falling 4.4% in the third quarter, the first quarter of negative corporate profit growth since 2002. Treasury yields have fallen to their lowest levels in over three years as investors abandon riskier issues and flock to safe havens.

In recent days, the market has shown signs that a turn may be ahead. On November 28th, Federal Reserve Vice-Chairman Donald Kohn said that “uncertainties” regarding the U.S. economy are “unusually high” at this point, implying that policymakers need to be “flexible and pragmatic” in setting policy. While Mr. Kohn was warning of a potential recession on the horizon, the market instead has taken this to mean that the Fed is hinting at another 0.25% rate cut when it meets in December. Wall Street traders are pricing the odds of a quarter-point cut at over 90% and many think the Fed could cut by .50% similar to their move in September. This came on the heels of a $7.5 billion investment in Citigroup by Saudi based Abu Dhabi. The markets have also been helped by some relief in oil prices as Saudi Arabia said they would increase production if needed. In just a few days, oil prices declined from almost $100 a barrel to under $90 today. A further decline would be welcome news for Christmas shoppers.

Another major story is the status of the U.S. dollar. Every day in the financial press, it seems one group or another – OPEC, the Chinese government, European Central Bankers, overseas tourist destinations – have called for the powers to be to take measures to strengthen the dollar. Yet, Secretary of the Treasury Hank Paulson refuses to budge in his calls for policy actions that would give a boost to the dollar. In time, he says, the value of the dollar “will be reflected in our currency markets”. While the rest of the world waits for that to happen, U.S. companies with strong exports will continue to benefit.

Multinational firms such as United Technologies, Federal Express, Avon, Procter & Gamble, Johnson & Johnson and General Electric transact business in nearly every corner of the planet. Their goods are priced in the currency indigenous to that area – the Euro, the Yen, Brazilian Real, etc. If the dollar is weakening, that means that it takes more United States dollars to purchase one Euro, or Yen. So, as the dollar weakens from, say, $1.20 / €1.00 (the going rate at the end of 2005 and into 2006) to $1.48 / €1.00 (the current price), the dollar has in effect fallen 19%. This sounds bad, and in many ways it is, but in the short term it can be a good thing.

Procter & Gamble, for example, is a company that benefits from a weaker dollar. For the sake of argument, assume that a pack of Pampers costs €2.00 in Prague in early 2006. At that time, that €2.00 was worth $1.20 each, giving Procter $2.40 of revenue when they brought that revenue back to the States. Now, that same pack of Pampers still costs €2.00; however, that same €2.00 now buys $1.48 each, giving P&G $2.96 in revenues. This is how multi-national firms can benefit from a weaker dollar – while the domestic price of specific products can remain the same, the revenue recognized back in the U.S. increases.

It can get even better for P & G. If Procter had a Pampers factory in Prague, it could be producing diapers for the sake of argument, €1.80 / pack (a 10% profit margin). Translating that €0.20 profit back to the U.S. in 2006 would mean $0.24 in profit for PG. If inflation in Prague has remained in “Czech” since the beginning of 2006, that same €2.00 pack of Pampers could still reasonably be produced for €1.80. That means that the €0.20 profit now translates to $0.29 of profit back home!

However, it must be pointed out that a falling dollar is not all fun and games. A weak dollar can translate foreign revenues into greater amounts at home, make domestic goods more attractive abroad, and increase tourism in the U.S. However there can be negative ramifications as well. Psychologically, a continued declining dollar will eventually discourage foreigners from investing in the U.S. Business cycles and credit markets can also feel severe effects as well; all of which can impact global economic growth. Also, a weak dollar causes imported raw materials to increase in price, putting pressure on corporate profits as well as adding inflationary pressure domestically. At RiverPoint, we have positioned our client portfolios to benefit in the near-term from a falling dollar by exploiting the positive effects of foreign currency translations. By investing in large multinational corporations, our clients are benefiting from companies that derive a significant portion of revenue from sales abroad.

At the same time, we have been preparing for the possibility of a slowing economy by strategically shifting assets away from stocks when appropriate, thus capturing profits and providing our clients with some more stability in a highly volatile market. Over the next few months, the Federal Reserve will play a large part in determining where the markets head next. If the Fed cuts rates as Wall Street hopes it will, credit will move more freely within the financial system leading to more robust economic growth. If, however, the Fed focuses its policy decisions on controlling inflation, the markets are likely to react negatively as the prospect of a recession becomes more plausible. Federal Reserve Vice Chairman Kohn got investors’ hopes up with his remarks; now many expect the Fed to follow through on his word.

Market Summary	11/30/07	YTD Price Change
Dow Jones Industrial Average	13,372	7.3%
Nasdaq Composite	2,661	10.2%
Standard & Poor’s 500 Index	1,481	4.4%

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