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R I V E R P O I N T |
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R E P O R T |
December
2006
2006 Market Recap
2006
was a rewarding year for equity investors, with major equity indices averaging
returns of about 12% or better across the board. Within the equity market, value stocks
continued their dominance over growth stocks for the seventh consecutive year. International stocks reported healthier returns
than
On
the economic front, this year contained mixed news. Positive catalysts included robust corporate
earnings growth, reasonable equity valuations, cash-rich balance sheets, low
interest rates, and frenetic M&A activity.
However, this news was offset by highly volatile commodity prices, a
slumping housing market, declining-yet-still positive economic growth, and
geopolitical instability. As the books are
closed on 2006 and 2007 looms, many of these same themes are still present in
the marketplace.
At
RiverPoint, we expect an overall positive economic outlook for 2007 that will
again favor stocks over bonds. We find
market valuations attractive relative to inflation, interest rates, and our
outlook for earnings growth. The S&P
500 is trading at a P/E of roughly 16.5 with a 1.7% dividend yield. The last time the S&P traded at a
trailing P/E multiple that low was in the middle of 1996. The earnings yield (defined as EPS / Price)
on the S&P 500 is slightly over 6% - substantially more than the 4.5% that
5-year U.S. Treasury bonds are yielding.
Historically, an earnings yield greater than the yield on 5-year
Treasuries has been a bullish indicator.
In fact, the difference between the earnings yield on the S&P 500
and Treasuries has not remained positive for this long since the late
1970’s and 1980’s.
Looking Ahead
Such
low valuations (and low yields) will likely continue to stoke M&A
activity. With large corporations and
private equity firms flush with cash heading into 2007, large transactions
could spur higher multiples in the marketplace resulting in higher stock prices. Corporate profit growth is expected to be
roughly 8% in 2007, a solid number in its own right though
not quite as robust as 2006’s 13% growth. The proliferation of corporate cost-cutting
initiatives following the market swoon in the beginning of the decade should
continue to provide operating leverage and allow profit growth to exceed sales
growth.
An
environment of reasonable valuations, stable interest rates due to tame
inflation expectations, and strong profit growth portend well for equity
markets in 2007. However, this benign
backdrop is not without risk. The
slowing residential housing market will likely persist well into 2007. But while the real estate slowdown may
capture its share of headlines, it is unlikely that the industry’s
troubles will draw the
Another
potential economic risk is the weakness of the dollar relative to other
currencies, which will likely continue in 2007.
While this may appear negative at first glance, a weak dollar
(especially versus the euro) could make
Event
and political risks remain ever present.
Geopolitical risk from heightened tensions in the Middle East and
Despite
these risks, current market conditions suggest that 2007 could be another profitable
year for equity markets in general. At
RiverPoint, we continue to work diligently to uncover the most promising
equities trading at reasonable valuations.
We remain resolute in our commitment to independent market analysis. In doing so, we hope to provide our clients
with the types of returns that will make them look back at 2007 with the same
fondness that we now feel towards 2006.
Municipal Bonds
Just
like the start of any new tax year, the financial press is focusing on tax
avoidance and reduction strategies. One of the most popular strategies is
investing in municipal bonds in lieu of corporate bonds. While traditional corporate bonds are issued
by for-profit companies as a way to generate funds for a variety of
profit-enhancing initiatives, municipal bonds are issued by state or local
entities for projects that directly impact the local communities.
Municipal bonds generally fund projects such as road enhancements, sewer
upgrades, park development, school levies, and stadium construction.
These bonds have interest streams backed by either the issuing entity (called
General Obligation Bonds) or by the revenues generated by a specific project
(called Revenue Bonds). If an investor purchases a municipal bond issued
by an entity within their state of primary residence, the interest paid on that
bond is exempt from both state and federal income tax.
Thus,
municipal bonds can offer higher after-tax yields than comparable corporate
bonds when considering normal tax situations. However, investors subject
to the Alternative Minimum Tax (AMT) may not enjoy this income tax
exemption. While income from most municipal bonds is tax exempt, income
from municipal bonds issued for “private activities” such as
housing projects or airports is still subject to the AMT. Even some
so-called AMT-free mutual funds are not totally made up of AMT-free munis – many such funds are allowed to invest between
20% and 40% of their portfolio in “private activity” munis. Segregating the income from such a fund based
on tax treatment would prove to be a nightmare.
As a matter of policy, RiverPoint avoids purchasing AMT-free bonds and
funds in our clients’ portfolios.
While
municipal bonds can provide tax-efficient income, investors need to be
cognizant of their own tax situation and the taxability of the bond
itself. For this reason, we suggest that you contact a RiverPoint
professional or your tax advisor prior to investing in municipal bonds as part
of a tax reduction strategy.
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Market Summary |
12/29/06 |
YTD Price Change |
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Dow Jones Industrial
Average |
12,463 |
16.3% |
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Nasdaq Composite |
2,415 |
9.5% |
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Standard &
Poor’s 500 Index |
1,418 |
13.6% |
For information about RiverPoint
Capital Management or to view our report archive visit us at www.riverpointcm.com.