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VIEW FROM EDGEWOOD



ECONOMENTS

Edgewood Management LLC
April 2, 2007

The View from Edgewood

Sometimes Wall Street is like the autumn weather in the mountains: if you don’t like the current conditions just wait ten minutes and something new will come along. At the beginning of the year the markets were worried that the economy was too strong and that the Federal Reserve would have to raise interest rates, the opposite of last fall’s conviction that they would be cutting rates by the spring of 2007. The stock market actually behaved pretty well in January and most of February as earnings came in stronger than expected in many sectors. .

At the end of February the weather changed. A speech by Alan Greenspan was fingered as the culprit but that is a simplification. Worries about the sub-prime mortgage market were starting to emerge (the issue is now on the front page of most newspapers), the overall housing market was weakening, and the GDP for the fourth quarter of 2006 turned out to be much weaker than expected. The former chairman of the Fed’s speech raised the specter of a recession in the not too distant future. Those thoughts combined with a strong run in the market spooked enough investors to produce the worst day in four years on February 27, when the S&P 500 dropped almost 5%. Suddenly, the talk was not about the Fed raising rates but, once again, the need to cut rates by summer.

The Federal Reserve met in late March and, while admitting that the economy needed closer watching, it mainly focused on the fact that they see no reason to change interest rate policy in the near future. The Fed now believes it can reach its goal of lower inflation by keeping rates at the current level rather than raising rates. This also means rates will stay unchanged for longer than many had predicted. In three months we have had three different forecasts of the economic weather. We have consistently felt since last summer, when the Fed stopped raising rates, that it would be at least the second half of this year before there was a chance of rate cuts.

While it has roiled the financial press, we do not believe the sub-prime turmoil, by itself, will cause any significant damage to the markets or the economy. The greater threat comes if it weakens the overall housing market to the extent that it affects employment and consumer spending. That is possible, but at this point more uncertain. The most dangerous effect would be a general credit squeeze set off by a mortgage industry debacle. What does seem certain is tighter regulation of sub-prime lenders.

We want to stress that the market drop at the end of February was not due to overvaluation, which would cause us to become more negative on the long term outlook for equities. The market had almost seven months on an upward trajectory without a significant downward move, it was due for a decline of some sort, and the short-term news flow we discussed above gave the market all the reason it needed. We still see large cap stocks as the cheapest equity class. The long-term interest rate environment is still benign and stock buybacks and private equity buyouts have continued apace. We believe the first quarter 2007 earnings reports will differentiate the strength in growth stock profit expansion from more cyclical sectors. With all these factors remaining positive we anticipate a good 2007 for the Edgewood portfolio.


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