About Edgewood
Edgewood Team
Performance
Marketing
News
Compliance
Contact

Client Login
Edgewood Management Company

VIEW FROM EDGEWOOD



ECONOMENTS

Edgewood Management LLC
October 2, 2006

The View from Edgewood

The third quarter ended with strong results in Edgewood’s portfolios. The Dow Jones Industrials touched their all time high first reached in January 2000 and, most encouraging for us, a large amount of skepticism remained about the strength of the rally that began in July. Large cap growth stocks are at ten year lows in valuations (P/E, earnings yield) as we argued in our last letter. Profit growth in the portfolio is running at 19% annually, versus an expected 11% year over year gain in the S&P 500 with deceleration in later years. The Dow is attracting some media attention for nearing its high, but the S&P 500 a broader market index is 15% below its all-time high also reached in 2000. In the face of strong equity gains since July, only a minority of investors call themselves bullish in various surveys. In our opinion this represents more buyers who will have to chase stocks as the rally continues.

The promised land was reached for the markets on August 8th when the Federal Reserve’s Open Market Committee, after 17 straight increases since June of 2004, decided to leave the Fed Funds rate unchanged. Again, at their September meeting the Fed left rates unchanged, while after both meetings they talked about keeping a careful eye on inflation pressures and the housing market. In their September statement they seemed to acknowledge that the housing market was no longer cooling gradually; this could be a concern next year if a gradual cooling turns into a rapid chill. Despite continued tough talk from certain members of the Fed about the need for further rate increases, we believe they are finished for this cycle. The bigger danger now, rather than inflation, is too much tightening that pushes the U.S. economy into a recession and slows much of the global economy. As we said in our last letter, we believe the Fed will be cutting rates in less than a year.

Energy prices have started to decline: oil prices are gradually coming down and the price of natural gas has plunged. A severe winter could reverse that trend; otherwise prices should be lower and less volatile in the next six months. The offset to lower energy prices will be increased discretionary funds in consumer’s pockets. If all of that is spent it would probably put excessive stimulus into the economy. We believe the consumer will probably save some of the price break and spend some of it and not have a great effect on the economy’s overall growth rate. This may also support some consumer spending that weakness in the housing market may have held in check. As short term rates peak and start to decline and long term interest rates remain lower, the Federal Reserve has to be careful that an inverted yield curve, a strong warning of a recession, does not persist. There are a variety of reasons why long term rates are already declining, but one of them must be a belief in the bond market that not only is inflation under control, but that the economy will slow a fair amount to keep it under control.

We have mentioned several times in our letters that the best environment for growth stocks is that point where interest rates have peaked, the overall economy is slowing and the corporate profit growth rate is declining. In a normal market cycle consistent earnings growth becomes more highly valued at this stage of slowing economic growth. This has not been a normal cycle; the overhang from the 2000 to 2002 market decline has left large cap growth stocks out of favor for over 5 years, an unusually long time for an asset class to be ignored. For the last couple of years the U.S market has been one of the weaker global performers and U.S. equities have been underowned by international investors. Within U.S. equity markets, large cap growth stocks have had the least exposure in investor’s portfolios, while their returns on equity and profit margins are reaching all time highs. Large cap value and small cap growth and value have had several strong years, but money has started to flow out of those sectors and residential real estate has peaked for at least this economic cycle. To report what we said in our last letter: the valuations on large cap growth, using a variety of measures, has not been more compelling in over ten years.

Back to the top of this page

 
350 Park Avenue, 18th Floor New York, NY 10022 - Phone: (212) 652-9100 - Fax: (212) 652-9101

Legal Disclaimer / Terms of Use