TREES INVESTMENT COUNSEL VIEWPOINT (Q4 2006) 

In the last quarter of 2006, the markets continued their upward journeys with the Dow and Standard and Poor's finishing the year up 16% and 14% respectively.  The fact is loudly applauded that the Dow is hitting new all-time highs.  What is also important to note is that the Nasdaq is at a mere 50% of the apex reached in March of 2000, and the S&P, after a great run, is now just within 8% of highs reached in that same period.

Having said that, there clearly has been a bull cycle in place since March of 2003, and it is knocking the socks off historical bull runs.  Defying past odds, we have not had a 10% decline in the market since March of 2003.  Furthermore, the market has not experienced a daily correction of more than 2% in    2 1/2 years.  These rosy statistics represent the longest periods (by a long shot) in history without such corrective events.

There are several things that are buoying the markets.  One is the private equity phenomenon.  Private equity firms raise capital in order to purchase companies (public and private) with a combination of debt and equity.  These purchased companies are usually highly levered by the new private equity owner, and are expected to improve profitability and operations.  The intention is for the companies to be resold in several years into the public market (an IPO) or through a sale (to a company or investor group) for significant return on investment.

This practice has been going on for years, but the difference of late is that the scale has gotten much larger as firms have raised gargantuan funds - Blackstone is now raising a $20 billion fund - and as a result, have had an appetite for much larger target companies.  Sample buyouts last year include Harrah's ($17 bn), Equity Office Properties Trust ($36 bn), HCA ($33 bn), and Clear Channel ($27 bn).

The theory is that because there is so much money looking to buy companies, and private equity funds are so flush with cash, many large publicly traded companies are now potential targets.  The potential of private equity buyouts, and the number of competing dollars on the sidelines, offer a floor to the market.  This "larger appetite" has been fueled by low interest rates, a higher tolerance for risk and the fact that the debt markets are flush with cash.

There are several ways that this environment could come to a close including a slowing economy and higher interest rates, both of which would negatively impact cash flows and could potentially lead to an inability to meet debt payments in some of these highly levered entities.

All parties come to an end at some point.  We cannot say exactly what will bring an end to this bull, but it will take a step back at some point.  For now, the substantial liquidity flowing into the market (including private equity and hedge funds) is a positive, but when that tide turns, watch out.

Take heart.  We have positioned your portfolios in solid companies with good cash flow (as is evident from higher than market dividends), strong management teams and defensive characteristics.  When the bear does show its ugly face, we believe these factors should provide a measure of protection in the downside while allowing further gains if the markets stay strong.

 
January 19, 2007