The Quarter In Review, Climbing a Wall of Worry

"Climbing a Wall of Worry".... Living up toone of Wall Street's oldest sayings, stocks flourished in the second quarter despiteinvestor fears.  U.S. andinternational equities began a surge during the second quarter that stalled inJune, but resumed in July.  And, marketswill continue to climb if worries (e.g., housing and subprime mortgage marketwoes) are held in check by developments that investors find reassuring (e.g., abooming global economy and corporate profit growth). 

In contrast, weakness in the bond markets in the secondquarter due to rising interest rates partially offset the positive returns ofthe first quarter.  Commoditieswere flat for the second quarter though still positive for the year.  Real estate investment trusts (REITs)suffered a sharp correction, losing 9% during the quarter, and have nowexperienced an 18% decline since peaking in early February.  Of course, a pullback in REITs at somepoint was inevitable given their outperformance for the past seven calendaryears.

Globalization and U.S. Large Caps....Untilrecently, the performance of large U.S. companies has lagged that of otherequity asset classes as the table on page 2 makes clear.  However, a structural shift in themaking for decades increases the odds that large U.S. companies will outperformin the years ahead.

The table on page 2 shows annualized returns of thebenchmarks for the equity asset classes for the seven-year period that includesthe bear market of 2000-2002, and for the four-year period 2003-2006 during whichU.S. and international equities rebounded from the bear market.  Excepting commodities from 2003-2006, thelarge U.S. company asset class was the laggard.

However, the second quarter may have been a turning point forthe performance of large U.S. company stocks, reflecting the increasingglobalization of corporate profits. A broad structural shift in how and where leading U.S. companies earn theirmoney has been in the making for decades and now carries economic implications,as well as significant investment opportunities.

As reported by William J. Holstein in the July 8, 2007edition of the New York Times, United Technologies is a case in point.  Fully 60% of its total sales are eithermade in the U.S. and exported, or made and sold offshore.  Aided by declines in the dollar, thoseforeign sales are boosting the company's bottom line, which grew 18% lastyear.  The price of its stock hit arecord high in July. 

Offshore sales at General Electric will cross the 50%threshold this year.  Its stock, whichhas been flat for years, has recently moved higher in part because of investorenthusiasm for the company's move into markets like India.  Another major company that has crossedthe 50% threshold in international sales is PepsiCo, which reported a 16%increase in first-quarter profit based largely on its sales outside the U.S.

These are not just isolated examples.  Companies in the S&P 500 that breakout their international earnings racked up 45.2% of their sales throughoffshore sales and exports in 2006, up from 32.2% in 2001, according to Mr.Holstein.

It is becoming clear that owning international equities isnot the only way to participate in investment returns generated by the globalboom.   Opportunities in a resurgent Europe as well as the emergingeconomies of China and India are as likely to be captured by U.S. companieswith a strong international presence as by companies headquartered abroad.

In Summary....As we rebalance portfolios, expectus to trim the outperforming international and small cap U.S. equity assetclasses while maintaining significant exposure to large U.S. companies.