Asset Class Summary

The following commentary shares our views on the major asset classes we follow. We make investment decisions based on longer time frames, and the potential return ranges given in the discussion below are based on a five-year time horizon. We bring this up because at some point over the next five years it is likely that the U.S. and possibly other developed countries will experience a recession. We say this simply because five years from now, this expansion, if still intact, would be of record length. So, at some point during this period, equity-oriented asset classes are likely to experience a cyclical bear market.

Investment-Grade Bonds: The 10-year Treasury yield has fluctuated within roughly a 100 basis-point range this year (one percentage point). As we write this, it yields just over 4.6%—about the mid-point of its range for the year. Given current yields we don’t expect to capture high returns from bonds over a period of years. It is likely that returns over five years will be within striking distance of today’s yields (which for the entire investment-grade universe is around 5%). However, investment-grade bonds (including tax-exempt bonds in portfolios for taxable clients) continue to play an important role in our balanced portfolios by mitigating equity market risk. This was quite apparent in the sell-off this past summer when almost all asset classes declined in value except for investment-grade bonds. Longer-term, if inflation increases, bond returns would suffer.

High-Yield Bonds: High-yield bonds sold off and yields rose to near 9% during the summer credit squeeze. While these yields look generous compared to the sub-8% levels of a few months ago, they are likely to move sharply higher during the next recession—which would result in poor returns for high-yield investors. Investors could capture decent returns for a while if economic growth holds up for a few more years, but with default rates spiking sharply higher in recent months (from under 2% to over 5%) and yield spreads still below historical averages (and far below cyclical peaks), junk bonds do not look particularly attractive. They are certainly not in fat-pitch territory and probably won’t be until around the time of the next recession. (Note: we do have a small amount of non-dedicated high-yield exposure through Loomis Sayles Bond Fund.)

Emerging Markets Short-Term Bonds: We continue to be impressed with the fundamental improvements in many emerging markets. Current account surpluses, large foreign currency reserves, improved balance sheets, healthy economic growth and corporate profits, and reduced inflation collectively make a strong statement. This has translated into appreciating currencies. We continue to view this asset class as an attractive way to hedge a likely long-term decline in the dollar. It also gives us a play on emerging markets that is more conservative than equities and allows us to capture a yield advantage versus investment-grade bonds (recently the yield net of expenses was 6.7%). However, this asset class provides less protection in a nervous market and we saw this firsthand this past summer when investment-grade bonds out-returned PIMCO Developing Local Markets Fund (PLMIX) by over seven percentage points (700 basis points)—a rather startling performance spread over about a month’s time. This underperformance was probably partly due to some unwinding of the carry trade—where investors borrowed at low rates in yen and invested in higher-yielding assets including emerging markets. However, since the July/August decline, the PIMCO fund has experienced a very strong rebound—recapturing more than half the underperformance. This suggests to us that investors are appreciating the underlying fundamentals and coming back to the asset class. For the year, PLMIX is up an impressive 9.9% compared to 5% for PIMCO Total Return, the investment-grade bond fund we use (and from which our Developing Local Markets position is funded), and it has added a material amount of value since we added it to our portfolios in October 2005.

Large-Cap U.S. Stocks: By most measures large-cap stocks are in a fair-value range and our valuation model, which is based on normalized earnings, suggests they are cheap. However, exceptionally strong earnings growth and profit margins in recent years have catapulted earnings far above their long-term trend line. A return to trend-line earnings over the next five years suggests somewhat disappointing annualized returns of 3% to 7% (depending on assumptions and the valuation methodology used). But a return to trend is no sure thing and some of the factors that contributed to strong earnings growth remain in place—so returns could well be higher. Labor cost control has been a key factor, driven by technology and the large global labor pool. These factors are unlikely to be as strongly positive as in recent years but they may still be supportive. We are less sure about other factors such as share buybacks and declining tax rates. Factoring in everything, we believe large-cap returns over five years are most likely to average between 7% and 10% per year.

Small-Cap U.S. Stocks: We continue to view small-cap stocks as overvalued relative to large-cap stocks. Besides valuation, which clearly favors large-caps, there are several other factors that undermine the potential for small-caps. Recession risk has increased and most of the time small-caps underperform large-caps in recessions—especially when they don’t have a valuation advantage. Large-caps have more foreign earnings than small-caps—which gives them an earnings tailwind (according to the Leuthold Group, for the S&P companies that break out earnings geographically, 44% of earnings came from outside the U.S. in 2006). This is probably one reason that large-cap earnings growth has been stronger than small-cap earnings growth. Finally, a shift in relative performance has already started. Though relative performance has been shifting back and forth for almost 18 months, over that time period the S&P 500 (large-caps) has bested the Russell 2000 Index (small-caps) by almost 10 percentage points.

Growth Versus Value: After seven years of value dominance, growth stocks are decisively outperforming value stocks this year across all market-cap groups. Moreover, growth even outperformed value in the July/August market decline. On a valuation basis most of the relative valuation measures we look at don’t make a case for growth being clearly cheaper (though one data set we follow does). From an economic-cycle standpoint, growth stocks may have an advantage. In environments when earnings growth slows, often stocks of companies with consistently strong earnings growth perform better. We may be entering one of these environments. In addition, growth stocks in the large-cap sector tend to have more foreign earnings—a benefit if the dollar continues to weaken. Because the valuation story is not clear cut, we have not directly overweighted growth stocks. However, several of the non-growth funds we own have been finding superior value in some growth stocks for quite a while so that, in effect, we do have a slight bias towards growth.

Foreign Stocks: Foreign stocks have been on a huge run of outperformance that has continued in 2007. At present we continue to view foreign stocks, as an asset class, as selling within a fair-value range relative to larger-cap U.S. stocks. Looking beyond relative valuations, economic fundamentals in much of the world favor foreign economies over the U.S. This is particularly true in the emerging markets and has been the case in Europe, though the region has not been immune to the credit squeeze or potential risk from a housing bubble (this varies from country to country). Related to the economic fundamentals, currency appreciation has accounted for about half of the foreign equity outperformance (compared to the U.S.) over the past five years. We believe it is more likely than not that currency will continue to be a tailwind for some time, though at some point the cumulative impact could undermine the economic strength in certain economies. Our biggest concern is the sheer magnitude of the outperformance (for emerging markets in particular and also for Europe) which, for the entire index, amounts to over 10 percentage points per annum over the past five and a half years. Such performance runs are hard to maintain over periods much longer than this and serve as a reminder to take a close look at our analysis. We value the long-term diversification away from the U.S. dollar that we gain from foreign stocks, but we will continue to assess all the evidence to make sure that we don’t weight this (or any one factor) more than it deserves. Nevertheless, at present we continue to view return potential as in line with large-cap U.S. equities.

REITs: REITs have suffered a devastating bear market since early February, declining almost 30% through mid-August. Since that time share prices have rebounded, returning over 10%—possibly signifying the end of their bear market. The decline from their early 2007 high has brought REITs back into fairly valued territory. From current levels we expect REITs to return in the range of mid to high single digits over the next five years. This return will be made up mostly of dividend yield plus some appreciation. One interesting observation from the July/August market decline is that REITs underperformed equities. A general rule of thumb is that REITs usually outperform during market declines. However, in this instance, REITs were in the midst of a valuation-driven bear market—so the context was not typical.

Commodity Futures: We continue to view commodity futures as a valuable diversifier in our portfolios. We view commodity futures’ expected long-term returns as somewhat lower than equities but quite a bit higher than bonds, with risk in line with equities. Importantly, they have a zero or negative correlation with equities. Their tendency to outperform stocks and sometimes bonds in many market corrections means that the addition of commodity futures in lieu of bonds allows us to increase expected portfolio returns without increasing risk in certain market environments. The primary exception to the diversification benefit is that in periods of economic weakness, commodities tend to underperform bonds by a large margin, exposing our portfolios to more potential cyclical risk. This is why, on average, Fed easing is a negative factor for commodity futures returns (but only one of several factors we monitor). Because of the cyclical risk associated with commodities, if recession risk continues to increase we may choose to tactically eliminate our commodity exposure. It is worth noting that PIMCO Commodity Real Return Fund (which we own in many client accounts) is having a strong year with a 13.2% return but most of the return has come in the last month, underscoring the highly volatile nature of this asset class.

Final Comments

At an asset class level we continue to be challenged in building portfolios without the benefit of any clear return-based fat-pitch opportunities. The two asset classes we hold in our portfolios that are not in our neutral benchmarks, commodity futures and emerging market short-term bonds, have both added value in 2007, as has our tactical overweighting to large-cap stocks (funded by a reduction in small-caps).