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Capital Markets Outlook

At Cadinha & Co., we’ve long believed in asset allocation as being the most important investment decision any investor can make. Our Managed Allocation Portfolio (MAP) service focuses exclusively on asset allocation to position portfolios for the economic and market environments ahead.

The advent and proliferation of exchange traded funds (ETFs) have greatly sharpened our ability to not only proactively tilt allocations toward those assets we feel offer greater risk/reward propositions, but to also go out and seek non-traditional assets such commodities and equities of various sectors, regions, and styles— in order to add return potential and mitigate risk.

2007 looks to be a pivotal year for capital markets as a global slowdown seems afoot. Should equity markets get dicey, we believe MAP’s proactive asset allocation capability can lead to greater capital preservation than static allocations prescribed by Wall Street.

Investors recently received a reintroduction to risk with the end of historically low volatility. The Dow’s 416 drop on February 27 marked the end of its longest streak in 107 years with a 2 percent single-day drop. Equities markets fell similarly worldwide; Chinese markets slid almost 10 percent. While fears of China introducing new taxes and capital controls ignited the global sell off, its real impact was making investors reassess present risks and how to price such risks into securities.

While slowing economic and profit growth worldwide are not to be overlooked, it appears the greatest risk to global equities lies in the U.S. housing market.

The U.S. housing market is in recession. As with most bubbles, falling prices are uncovering the excesses and improprieties that helped it get to such lofty levels. In this case, it appears to be mortgage securitization and leverage. Vast securitization of most of America’s $10 trillion in mortgage debt and strong investor demand for such securities gave loan originators the liquidity to create increasingly risky and exotic mortgages. This resulted in an explosion of mortgages for those without good credit. Subprime mortgages now account for 10 percent of all mortgages in the U.S.; some 40 percent of all mortgages originated last year were subprime or one level higher, “Alt-A”. Most subprime and Alt-A mortgages have been adjustable rate mortgages (ARMs), often issued with a low “teaser” introductory rate and requiring little or no income verification or down payment.

Even many prime borrowers likely became overextended as they purchased more expensive properties, also using large amounts of leverage for their real estate investments. Many of those who purchased homes late in the housing bull market now have negative equity as housing prices are falling. Combine that with higher payments from resetting ARMs for prime and non-prime alike, and the U.S. housing market may take more time to recover than most think.

Much of the synchronized global economic expansion has been on the back of a consistently strong U.S. consumer. Now with $20 trillion in housing wealth, consumers are now spending more than they make. Should housing weaken further, it’s hard to imagine U.S. consumer spending will continue expanding at previous paces, if not shrink altogether.

A weakened U.S. consumer would likely cause recession in the U.S. Its ramifications may be more pronounced in foreign markets, particularly emerging market economies that, despite their tremendous growth, are still predominantly export-based economies levered to U.S. consumption. This is especially true for China, where exports and fixed investment account for some 80 percent of GDP.

While most expect the Federal Reserve to cut rates soon, we doubt it will as inflation, at 2.5 percent, is above their 1-2 percent comfort zone and ample liquidity still remains. We expect inflation to cool over time; however, higher commodity prices and a flare-up in wage growth should delay inflation’s eventual decent. The Fed and its price-rule chairman may be in a bind should housing, and therefore the economy, continue to slide.

We expect the private equity and leverage buy-out craze to continue through 2007 as funds will justify purchases as long as interest rates are low and return on invested capital exceeds their cost of capital. As the private equity industry increases in size, we suspect larger companies, with their solid balance sheets, strong cash flow, and attractive relative valuations, will be taken private.

Allocation Strategy

Risks are elevated for equities, particularly for foreign markets. Equity allocations have come down somewhat since last quarter, and will likely go lower should the aforementioned risks materialize further.

A slowing economic environment favors large caps over small caps, especially given large caps’ relative valuation, superior dividend and earnings consistency and cleaner balance sheets. Small caps’ private equity advantage should slim significantly as buy-out funds grow ever larger and the advantages to owning larger firms over smaller firms widen.

As foreign equities should act as “beta” securities to American equities should recession in the U.S. materialize, domestic equities hold greater risk/reward propositions, especially against Asian equities.

We’re maintaining allocations in Australia and Gold and have added the Oil Service industry. Robust capital expenditures by oil companies should continue as high global demand and tight supplies keep oil prices elevated. In addition, we view the oil services industry as a hedge should a supply shock occur.

We expect bonds to continue range-bound trading and believe they are fairly priced. We continue to overweight short maturities and cash and will pick up higher yield as we wait for longer term yields to rise or get greater conviction for a recession.

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