Recession
Investors fled corporate bonds and equity markets declined sharply during the third quarter as fears intensified that the ongoing deleveraging of the global financial system would negatively affect growth around the world. Owing to the disorder within the Financials sector, the United States Congress recently passed a financial aid package that may alleviate some of the pressures facing banks and other financial institutions. Given the recent turmoil in the credit and financial markets, however, we now think the US economy has slipped into recession.
We believe the recession should be moderate due to substantial and ongoing fiscal and monetary stimulus. In addition, the continued expansion of the global economy should benefit foreign trade and the lack of operating excesses in the non-financial corporate sector—where most businesses have less inventory or staff to trim—should help reduce the economy's downside risk. While we don’t expect a steep decline in economic activity, we also believe the economy's recovery from recession will be tepid and that economic growth may not exceed 2% on a sustained basis until 2010. In our opinion, the deleveraging of the financial and household sectors, along with the high cost of energy, will be formidable economic headwinds for some time to come.
Boost From Consumer Staples
The Fund lagged its hybrid S&P 500 Index/Lehman Brothers Government Credit Index benchmark slightly during the quarter, though it continues to outperform for the year-to-date through the end of September. A substantial overweight position in Consumer Staples significantly aided performance as the portfolio's holdings enjoyed positive returns. Stock selection within the Consumer Discretionary sector also added to returns as all three of the Fund's holdings posted gains. During the quarter, we increased the position in Johnson Controls following an earnings report that showed sustained momentum in its Building Efficiency segment and price increases and good execution in its Automotive Experience segment. We also believe that the firm's exposure to foreign manufacturers should allow it to continue to achieve healthy growth despite weakness in the North American auto market.
Ironically, despite Lehman Brothers filing for bankruptcy, Fannie Mae, Freddie Mac, and American International Group becoming, in effect, nationalized, and the forced sale of both Washington Mutual and Wachovia by the Federal Deposit Insurance Corporation (FDIC), Financials were the second-best performing sector in the S&P 500 Index. The market appeared to begin to distinguish between the likely survivors and those that are questionable. Solid stock selection in this sector helped returns as we added to the Fund's holdings in Charles Schwab and established a position in Wells Fargo.
Tech Wreck
After strongly contributing to performance during the June quarter, technology stocks were a drag during the recent period. Apple, Google, and Research in Motion suffered sharp corrections as some investors began to question the case for global growth in the context of a deteriorating global economic environment. We had trimmed the Fund's stake in Apple early during the period on our belief that analyst estimates fully reflected the positive sentiment surrounding the launch of the 3G iPhone. Towards the end of the quarter, however, we increased the position following a significant decrease in the price of the stock as the market declined. We also added to Google following its sharp correction given our conviction that the firm's strong earnings growth will continue. We trimmed the portfolio's position in Research in Motion following its second quarter earnings report that disclosed that future gross margins would be considerably weaker than previously expected.
Other moves in the Technology sector included adding to stakes in Electronic Arts and Juniper Networks. A number of catalysts, including the annual E3 trade-show, a large slate of new, wholly owned title launches, and likely hardware price cuts give us confidence in Electronic Arts. Strong trends driven by a focus on high-performance networking solutions, greater product and geographic diversity, strong new product cycles, and a significant expansion of its addressable market to businesses and improved operational execution favor Juniper. We trimmed Hewlett Packard on persistent concerns of deceleration in technology spending growth outside the US and fears involving the integration risks surrounding recently acquired EDS. Finally, we exited the Fund's position in MasterCard as revenue growth will not be as robust as we expected—and slightly lower than 2007—as the US economy slows down more sharply than anticipated, resulting in a high P/E multiple.
Holdings in Industrials and Energy also declined sharply as investors reassessed the global economic outlook, with Emerson Electric and Fluor being two of the biggest detractors on the industrial side. Fluor was trimmed as a source of funds at the beginning of the quarter, but we subsequently added back to the position following a strong second quarter earnings report, and increased it again towards the end of the quarter. We believe the firm's global infrastructure business will remain strong in emerging markets, benefiting Fluor's business—which showed an acceleration to its strong backlog growth during the second quarter. Although the Fund's energy holdings declined less than the benchmark holdings, an overweight position detracted from performance. We reduced the stakes in Devon Energy and Occidental Petroleum following a surge in oil prices at the beginning of the quarter which raised the potential for a correction, and which we think may cause earnings estimates for the integrated oil companies and E&P producers to plateau.
Bond Market
Investors fled the corporate bond market during the third quarter, sending Treasury yields lower and yields on corporate bonds higher. Uncertainty grips the credit markets, with the yield differential, or spread, between corporate bonds and Treasury bonds at record high levels While a return to pre-credit crisis levels is unlikely, a reduction in the yield spread should occur as the financial rescue plan is implemented. Treasury issuance will also increase due to the rescue plan, causing a likely increase in long-term interest rates. Yields on shorter maturity Treasuries should remain low, however, as the outlook for economic growth on an intermediate basis remains weak. In this environment, we are maintaining a duration that is slightly shorter than the benchmark indices. The Fund is overweight high quality, intermediate-maturity corporate bonds given the attractive yields available.
Equity Outlook
Despite the recent turmoil in the financial system and excessive volatility in the marketplace, we believe that we are in the later phases of the bear market and still in the early stages of a major rotation into large-capitalization growth stocks. The S&P 500 Index has declined more than 35% from its October 9, 2007 peak, suggesting investors have already discounted a good amount of the economic and corporate profit weakness. Investor sentiment is extremely negative, another encouraging sign of reduced future market risk, and an indication that greater investor optimism may be forthcoming. Assuming a moderate recession, stock market valuations are quite reasonable at today's prices. At its current level of 1000—and assuming a forecast of no operating earnings growth in 2009 from the recently lowered earnings forecast for 2008—the S&P 500's price/earnings ratio is 14, offering an earnings yield of 7.1%. By comparison, the 10-year US Treasury bond yield is just 3.5%. More importantly, the outlook remains positive for high-quality large-capitalization growth stocks with their strong balance sheets and above-average earnings growth, which will become increasingly attractive amid a more challenging corporate profit environment.
Montag & Caldwell Investment Counsel
October 7, 2008
As of September 30, 2008, Johnson Controls comprised 1.37% of the portfolio's assets,Charles Schwab – 2.46%, Wells Fargo – 1.30%, Apple – 1.84%, Google – 2.60%, Research in Motion – 0.68%, Electronic Arts – 1.62%, Juniper Networks – 1.71%, Hewlett Packard – 2.29%, Emerson Electric – 1.75%, Fluor – 1.56%, Devon Energy – 1.04%, and Occidental Petroleum – 1.47%.