Musical Chairs

January 8, 2007

Dear Investor:

A sudden, disconcerting bullishness has thawed Wall Street like global warming on a winter’s day. After several years of bearish sentiment during which stocks climbed a wall of perpetual worry, most analysts are betting on good gains in the coming year. Contrarian as we tend to be, this leaves us increasingly concerned. As you know, we’ve been very bullish on equities for the past few years. We are now considering retracting our horns. While we believe large stocks will continue to appreciate based on their compelling valuation, the rest of the cap-weighted spectrum is in danger of a major correction.

The indices have done exceedingly well in the past quarter. The Dow has risen 1,000 points in the past four months, a gain of nearly 9%. The large stocks have led this recent rally, with the Morningstar Large Growth Index beating the Small Cap Growth Index 4.27% to 3.54% during the fourth quarter. Earnings projections for 2007 are rosy to the point of dangerous.

Though 10-yr bond yields have certainly come up in the past few years (rising over 130 basis points since mid-2003), long-term yields are still artificially depressed, resulting in an inverted yield curve. We believe this distortion is caused by the ravenous purchase of our bonds by China which buys without regard for return or risk due to their dollar peg—a topic we have written about at length in prior letters.

Artificially low yields fueled the spectacular housing bubble, which is now deflating as the dollar-yuan trading band is gradually widened. The psychology of the housing market has finally changed from euphoric to dyspeptic, with panic next on the agenda. But the low yields that fueled housing are not much changed. Only the direction of the money flow has changed–this time back to equities. This musical chairs liquidity cycle, where the easy money continues to bounce from sector to sector will continue for some time. Eventually the music—however melodious—stops. One sector finds itself without a chair. The game goes on. At some point, the musicians pack their instruments and go home.

No one knows when that time will come. As China continues to widen the band on their currency peg, however, their buying of bonds will contract. The yield curve will normalize and money will become expensive again.

The implications are that real estate, high-yield bonds, small-cap stocks, mid-cap stocks, and commodities will all look absurdly overpriced against a backdrop of rising rates, while large-cap stocks will continue to outperform due to discounts to intrinsic value and lesser borrowing needs.

In preparation, we have all clients heavily overweighted in the large-cap sector, relative to their strategic benchmarks. We have also reduced small-caps to the point of residual positions and have reduced high-yield bond exposure by swapping from the Loomis Sayles Bond Fund to the John Hancock Strategic Income Fund where appropriate. Finally, we will be looking to raise cash on rallies, given the attractiveness of current money market yields for short-term periods. The music is lovely, but it’s bound to fade.