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VIEW FROM EDGEWOOD



ECONOMENTS

Edgewood Management LLC
July 2, 2007

The View from Edgewood

There is a saying on Wall Street: “Sell in May and go away”. Some years that appeared to have been a very good idea. This year, however, a heeder of the adage would have missed a strong rally in May and June and a Dow Industrials return not seen since the 4th Quarter of 2003. As usual there are issues to worry about, but the stock market, in its wisdom, seems to have decided that they are either not catastrophic or will prove to be short term issues. The market also has broadened its focus from the Federal Reserve’s next move as evidenced by reduced wild market swings awaiting their interpretation of economic strength and inflation momentum. While interest rate concerns continue to influence share prices, the volatility associated with the Fed’s next move seems to have ended for the summer at least.

We have been consistent in our forecast that the Federal Reserve would not cut interest rates until at least the second half of this year. We have been proven right in that nothing happened in the first half of the year, but it now appears the Fed will do nothing the rest of this year. On June 28 the Fed governors ended a two day meeting by noting that inflation had moderated slightly, but was still a concern and that while growth had picked up in the second quarter they preferred to look at an average growth rate for the two quarters. From that perspective GDP growth in the first half of the year looked relatively moderate. They left the Fed funds rate unchanged. The market seems to have gotten used to this; right now a rate hike would not be welcome and a rate cut would be taken as a sign that the economy is weakening surprisingly fast. The market’s April and May rally came as the market became comfortable that no action may be the Fed’s stance for a while.

As a market bellwether the ten year treasury rate is at least as important as the short term Fed funds rate. In less than four weeks the ten year treasury rate went from 4.5% to 5.3%, although it backed off slightly to 5.1% by the end of the quarter. The reasons for this have been much debated. Is it a response to inflation fears? A decline in Chinese buying of our treasury notes? Is it just the normalizing of interest rates on the yield curve? We believe that it is mostly the latter; long term rates should be equal or higher than short term rates. For two years that has not been true as the Fed raised short term interest rates and long term rates actually declined. As the economy has grown nicely and inflation has stayed above the Fed’s targets but not wildly out of control it was to be expected that interest rates, as reflected in the yield curve, should return to a more normal structure. While the Chinese have diversified their purchases of financial assets using their foreign currency reserves, the U.S. treasury market is, and will remain, the biggest recipient of those funds. We also believe that part of the Fed’s and the stock market’s lack of concern over inflation and growth is that long term rates have a much stronger effect on the economy than movements in the Fed funds rate. The move above 5% will take some of the excess heat out of the U.S. economy over the next twelve months.

In the middle of June two hedge funds run by Bear Stearns needed to be bailed out by their parent company after their large bets on sub-prime mortgages went wrong. While they are the most prominent, they are not the first to float to the surface and they will most likely not be the last. The market is watching closely to see how far the problem spreads. Wall Street firms will make every effort to contain damage to their alternative debt areas, but right now it is too early to tell how far the problems could spread. The trouble in the lower end of the mortgage market has ended the housing boom and slowed the economy dramatically in the first quarter of this year. Housing, along with higher long term interest rates, should help slow the economy without any more action from the Fed this year.

We always want to be aware of the negative issues that may affect the investment outlook and there are, as always, several: accelerating inflation; sub-prime lending and the housing slowdown; the Middle East and Iraq. That said, we think despite the market’s strong rebound from the lows of last year that at least the next twelve months remain very favorable for growth stocks as their valuations continue to remain as historically attractive as they have been in a decade.


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