1Since 1895. Member SIPC and NYSE.
Outlook & Opportunities
Terry SandvenChristian Heitzman
April 2007
2 2
First Quarter Review & Outlook
Overview
• Performance• Housing• Economic growth/inflation• Oil• Interest rates• Earnings, valuation & consumer confidence• Employment
3 3
Performance Market and Sector Performance
Total ReturnClose Q1
Index 3/30/07 2007 2006 2005S&P 500 1,420.86 0.6% 15.8% 4.9%Dow Jones Industrials 12,354.35 -0.3% 19.0% 1.7%NASDAQ Composite * 2,421.64 0.3% 9.5% 1.4%Russell 2000 800.71 1.9% 18.4% 4.6%MSCI EAFE 2,147.51 4.1% 26.9% 14.0%MSCI Emerging Markets 929.03 2.3% 32.6% 34.5%Lehman U.S. Aggregate 1,211.13 1.5% 4.3% 2.4%Lehman U.S. Govt. & Credit - Intermediate 1,315.72 1.6% 4.1% 1.6%Lehman U.S. Govt. & Credit - Long 1,784.40 1.0% 2.7% 5.3%Lehman U.S. Short Treasury - Bills 85.34 1.2% 4.8% 3.1%Lehman Municipal Bond 636.33 0.8% 4.8% 3.5%
Percent ofS&P 500 Sector S&P 500Consumer Discretionary 10.5% -0.7% 18.6% -6.4%Consumer Staples 10.3% 2.2% 14.4% 3.6%Energy 9.9% 2.1% 24.2% 31.4%Financials 21.5% -2.8% 19.2% 6.4%Health Care 11.8% 1.0% 7.5% 6.5%Industrials 10.6% 1.1% 13.3% 2.3%Information Technology 15.1% -0.9% 8.4% 1.0%Materials 3.1% 9.0% 18.6% 4.4%Telecommunication Services 3.6% 7.3% 36.8% -5.6%Utilities 3.6% 9.3% 21.0% 16.8%* NASDAQ Composite performance calculated by percent change; excludes dividends.Source: Piper Jaffray & Co.
5 5
Housing
New Home Sales & Housing Starts
• Both new home sales and housing starts continue to decline.
6 6
HousingPending Home Sales of Existing Homes
• Pending sales of existing homes unexpectedly rose 0.7% in February after dropping 4.2% in January.– Considered a leading indicator because it tracks
contract signings.
7 7
Economic Growth/Inflation
Gross Domestic Product (GDP)
• Economic expansion continues.• Final fourth quarter GDP annualized rate was
2.5%; for all of 2006, the economy grew 3.3% versus 3.2% in 2005.
8 8
Economic Growth/Inflation
CPI & PCE
• CPI & PCE are two inflation indicators favored by the Fed.
• Both suggest economic expansion remains intact.
9 9
Economic Growth/Inflation
CRB Commodity Index
• Commodity prices tend to move in opposite direction of bonds.
• Trend line is largely inconclusive.
10 10
Economic Growth/Inflation
Institute for Supply Management (ISM)
• Both manufacturing and non-manufacturing appear at risk.
13 13
Interest Rates
U.S. Treasury Yield Curve
• Appears to be moving toward a more normalized rate.
• Upward sloping typically implies inflationary pressures.
14 14
Interest Rates
China’s Holdings of U.S. Treasuries
• If the trade deficit narrows and/or if protectionism policies become more widespread, it becomes logical to expect China’s appetite for U.S. Treasuries to decline.
15 15
Earnings, Valuation & Confidence
S&P 500 Earnings Projections
• S&P 500 earnings are projected to grow but at a lower rate.
• Valuations are reasonable.
16 16
Earnings, Valuation & Confidence
S&P 500 Valuation Levels
97 98 99 00 01 02 03 04 05 06
14x
16x
18x
20x
22x
24x
26x
28x
800
900
1000
1100
1200
1300
1400
1500
Price (Right)FY1 Price/Earnings Range (Left)Average (Left)
S&P 500 Index (Operating Basis) (SPX)
Data Source: First Call Estimates
Source: FactSet Research Systems Inc.
17 17
Earnings, Valuation & Confidence
S&P 500 Valuation LevelsHistorical Price-to-Earnings Ratio of S&P 500
and Yield on 10-Year Treasury Bond
0x
5x
10x
15x
20x
25x
30x
35x
40x
45x
50x
'50 '55 '60 '65 '70 '75 '80 '85 '90 '95 '00 '05
P/E
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
10-YearTreasury
Yield
P/E (As Reported Earnings) P/E (Operating Earnings) Yield on 10-Year Treasury Bond
Data Sources: Standard and Poor's, FactSet Research Systems Inc. and Piper Jaffray
18 18
Earnings, Valuation & Confidence
Consumer Confidence Versus Performance
• Consumer confidence remains favorable.• If consumer confidence weakens, it seems
reasonable to expect equity prices to soon follow.
19 19
EmploymentU.S. Employment
• Employment is paramount, arguably the most telling indicator of future economic conditions.
• Stable employment and wage growth imply that consumers have the financial wherewithal to support generally high debt levels and continued spending.
20 20
Employment
Jobless Claims
• Jobless claims are a leading indicator.• Should jobless claims accelerate, the
prospects of a recession would seemingly increase.
21 21
Conclusion
Summary
• Pro-growth thesis remains intact.– Inflation will remain contained.– Economic expansion will continue, albeit at a slower
rate.– Fed is not likely to move until second half of 2007;
should sub-prime deterioration continue, next move is likely to cut; Fed is not under any immediate pressure to change its stance.
– Bonds and stocks will likely trend within a relatively narrow trading range, with an upward bias.
• While overall risks have increased, unless deterioration in employment becomes more evident, we remain biased toward a pro-growth economy.
22 22
Fixed Income Investing
Current Environment
• Talk of a Fed ease appears to be over done • Curve should remain near where it is• Opportunities may exist in some option
structures• Credit fears seem to remain• Look for widening where it doesn’t belong• Cash flow characteristics are important• Municipal Market could be in for change
23 23
Fed Funds Futures• Fed Funds Futures are currently implying a
25% chance of a cut at the June meeting. This is down from a high probability of over 70% in early March. In our view this may be too high. We look for the Fed to be on hold though most of 2007.
CURRENT FED FUND FUTURES (4/03/07)
5.00
5.25
5.50
-50%
-25%
0%
25%
50%
Prob 25 bpdecrease
-2% -4% -8% -22% -44%
Fed funds 5.245 5.240 5.230 5.195 5.140
Apr May Jun Jul Aug 7
Source: Piper Jaffray & Co., Bl;oomberg
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Agency Market
Current State• Multi call and single call options seem to be
separating out a bit• Trading volumes in all classes have been
good, particularly in shorter maturities• Spreads have been actively moving
Outlook and Opportunities• Adding optionality may be worth the risk
depending on portfolio structure• Bullets out to 5 year sector appear to offer
some total return potential• Be aggressive in managing your portfolio
25 25
Agency Market
Value of Calls and Bullets
•Bermuda Calls are beginning to offer some value versus European calls. We think that this is a development that is worth the attention of investors.
CURRENT TREASURY & AGENCY YIELD CURVES
4.00
4.50
5.00
5.50
6.00
0 2 4 6 8 10
Treasury Bullet Agcy
European (1x) Callable Bermudan Callable
Yrs to Mat
Source: Piper Jaffray & Co., Bl;oomberg
26 26
Agency Market
The Volatility Wild Card
• Volatility has been steadily decreasing since 2003
• An increase in volatility would hurt any bond with embedded options – including callable agencies and MBS product
MERRILL LYNCH OPTION VOLATILITY ESTIMATE INDEX
50
70
90
110
130
150
170
190
2002 2003 2004 2005 2006 2007
MOVE Index
Source: Piper Jaffray & Co., Bl;oomberg
27 27
Corporate Market
Current State
• Corporate balance sheets in good condition• Limited evidence for a turn in the credit
cycle• Relative credit spreads are still tight
Outlook and Opportunities
• We feel staying short is warranted• Watch out for “headline” risk • Look for bonds that are fundamentally
sound, but have widened in sympathy on sub-prime woes
28 28
Corporate Market
Corporate Credit Spreads
• Corporate spreads still remain tight relative to where they have been in the recent past. Relative value among ratings classes may still be too tight to compensate for the increase in risk. We are wary about spread performance going forward.
10 YEAR COMPOSITE INDEX SPREADS TO TREASURIES
25
50
75
100
125
150
175
Mar-03
Sep-03
Mar-04
Sep-04
Mar-05
Sep-05
Mar-06
Sep-06
Mar-07
Banks UtilitiesIndustrial Composite
Source: Piper Jaffray & Co., Bl;oomberg
10 YEAR AAA, AA, A, & BBB-RATED COMPOSITE SPREADS TO TREASURIES
0
50
100
150
200
250
Mar-03
Sep-03
Mar-04
Sep-04
Mar-05
Sep-05
Mar-06
Sep-06
Mar-07
AAA AAA BBB
Source: Piper Jaffray & co., Bloomberg
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Mortgage-Backed Market
Current State
• Prime collateral continues to perform well• Sub-prime debacle not over yet, but remains
contained• Issuance could slow down – tighter spreads
possible
Outlook and Opportunities
• Look for good collateral – continue to avoid sub-prime
• Mitigate extension risk with structure• Principal portion of cash flows may be valuable
in this rate environment
30 30
Mortgage-Backed Market
Mortgages versus Alternatives
• Mortgages appear to remain attractive versus some of their closer substitutes. The incremental pick up in yield and re-pricing principal flows may be attractive to many investors.
YIELD CURVES – TREASURY, AGENCY, SWAP, & PAC
4.004.20
4.404.60
4.805.00
5.205.40
5.605.80
2yr 3yr 5yr 7yr 10yr
Tsy Agy Swap 5.5% PAC
Source: Piper Jaffray & Co., Bloomberg
31 31
Municipal Market
Current State• Supply is the primary driver in the market at the
moment• We feel tax equivalent yields remain good• Relative credit spreads appear tight
Outlook• New credit derivatives have the potential to
change the market• Look for increased volatility• Secondary market may offer some value
32 32
Municipal MarketMunicipal Supply – Q1 2007
• Supply in the first quarter was up almost 50% versus the first quarter of 2006. This has focused underwriters and dealers on the primary market and offered some selective opportunities in the secondary market.
BOND BUYER 30 DAY VISIBLE SUPPLY (4/03/07)
0
2000
4000
6000
8000
10000
12000
14000
16000
18000Bond Buyer 30 Day Visible Supply
30d moving avg
Source: Piper Jaffray & Co., Bloomberg.
33 33
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