Second Quarter 2004 Newsletter

In this quarterly commentary, we discuss how we deal with the constant challenge of uncertainty in determining our investment strategy.

In assessing risk, we differentiate between temporary factors (such as corporate governance scandals) and those which are likely to have a long-term impact on the investment environment (such as high debt levels). We also try to differentiate between cyclical and secular trends.We strive to consider every positive and negative factor that bears on a question, and to avoid biased thinking.

Some risks are material but difficult to assess. If we can protect our portfolios from such risks with little or no opportunity cost, we will do so.

Stock valuations are reasonable, helped by strong earnings growth, and our return expectation for stocks over the next three to five years is decent – in the high single-digit to low double-digit range.

Inflation and deflation are interrelated, and we think in coming years we could be in for a balancing act as policy makers try to protect against too much inflation without creating deflationary forces (such as high debt levels leading to decreasing spending.

Quarterly Investment Commentary

Sorting Through Uncertainty Is a Constant Challenge

The second quarter was a volatile one. Interest rates rose and bonds suffered small losses. Small-cap stocks were barely positive on the quarter and foreign stocks and high-yield bonds posted slight declines. Larger-cap U.S. stocks did better, returning almost 2%. Our model portfolios performed in line with their benchmarks for the quarter and year-to-date. Over all longer time periods, each model has bested its benchmark by a much wider margin.

For investors, dealing with uncertainty is a given. But even identifying the potential outcomes and sorting through all the big-picture variables and interrelationships is an enormous challenge. Being able to accurately predict the future on a consistent basis is not imperative to investment success. But understanding the possible outcomes and their odds is an important basis for determining a successful investment policy.

While no one, ourselves included, is able to accurately and consistently predict the future, this doesn’t stop many amateur and professional investors from articulating scenarios with the clarity and conviction that could only come from a crystal ball. They carefully articulate a well-reasoned set of arguments that supports their position, while not mentioning the numerous and also compelling counter-arguments. It is not surprising that they are often wrong.

Trying to base an investment strategy solely on the ability to predict the “winning” outcome is not smart because it is unlikely that anyone will consistently get all of the macro calls right. We have learned that investing is a matter of assessing the odds and attempting to invest in ways that put the odds on your side. We’ve learned not to force ourselves into a high-conviction analysis of an issue whose outcome can easily be swayed by one or more factors that are impossible to predict with confidence. And we’ve learned that it’s not necessary to know everything. Most of the time, we can identify enough puzzle pieces to allow us to make good decisions. When we can’t, we must recognize this and be patient.

Today’s Environment

Valuations

Each of the asset classes we follow is in a fair-value range except for investment-grade and high-yield bonds, which are slightly overvalued. It is worth mentioning that we define fair-value as having a wide range. Within this range, valuations are somewhat better than they were earlier in the year. The improvement is due to the decline in prices from peak levels and improving fundamentals.

Economic activity

The economy has been very strong. With less economic stimulus, the economy will not maintain its recent pace, but the general economic picture looks solid. The business sector is in excellent shape with exceptionally strong cash flow and improved balance sheets. This bodes well for jobs, capital investment, and the rebuilding of lean inventory levels because businesses have cash to spend and there is some pent-up demand. There has been more good news on productivity, which has rebounded to a very high level. This is important because it is one key factor supporting economic growth with moderate inflation. The big area of concern has been the labor market but that too is showing clear signs of improvement. Wage growth is also improving, but off of a very sub-par level. Consumer spending, which is of huge importance, has been healthy and if wages grow (as is likely) spending should be okay for the intermediate term.

Profits

At cyclical peaks, businesses, on average, have too many employees and have over-invested in their operating capacity. They focus on cost cutting, which typically triggers a decline in economic activity and reduced revenues. But when the economy begins to grow again, revenue increases while costs continue to remain low, resulting in improving profits, cash flow, and balance sheets. In the current cycle, because profits suffered an unusually severe crash, the rebound has been almost as amazing. Cash profit margins are at levels not seen in decades, and the level of profits as a percentage of GDP, at over 10%, is extremely high. Earnings are strong outside the U.S. as well. But profit margins are not sustainable at current levels, and a year from now investors will be anticipating earnings levels out into 2006. So while profit forecasts look good for 2005, at this point it is dangerous to be too bullish about the latter half of the year and 2006.

Interest rates and inflation

Inflation is picking up and rates have backed up in the bond market. The bond market has anticipated this pick up and the 10-year Treasury yield has moved about one percentage point above its incredibly low level of last summer. The rise in rates has contributed to nervousness in the stock market. But it is important to understand that rates are rising because the economy is getting stronger, and this is reflected in rising profits. And rates are rising from such a depressed level that it is unlikely that the initial rise will hurt the stock market in a lasting way—especially since bond markets have already moved higher in anticipation of a short-term rate increase. Even the pessimists don’t expect a huge spike in inflation, but there is risk. If inflation is sustained too long at a level much higher than 3%, the corresponding higher interest rates could trigger a cutback in spending and profits, and adversely impact stock prices. The arguments against this are high productivity, and excess labor and production capacity. The primary arguments for it are that monetary policy has been extremely expansionary and is not easily fine-tuned, and spare capacity may be overstated and can be rapidly absorbed.

Near-term risks

We think of risks in terms of cyclical risks, structural risks, geopolitical risks, and sometimes, secular factors. These days the risks most often mentioned are oil prices and their impact on the economy, China’s overheating economy, terrorism (and its budget impact on the economy), and interest rates (which we’ve already discussed). Some of these are harder to assess than others. But in general, outside of terrorism, we don’t consider these risks to be any scarier to investors than the risks faced at any other point in time (there are always risks).

Balancing out valuations, current economic fundamentals, and near-term risks we get to an okay, but not spectacular, investment backdrop. It is easy to allow risk to paralyze you, but the risks we can identify today, with the exception of the terrorism wild card, don’t seem worse than we’ve typically observed over the years. Financial asset valuations seem consistent with this observation. Valuations seem to be in equilibrium for now. Equilibrium may sound like a healthy thing but the real opportunity for investors is when things are not in equilibrium. While the current environment isn’t a bad one, volatility and excesses are what cause market prices to be out of whack and that’s precisely what allows smart investors to capture high future returns. Any of the longer-term problems (areas where things are not in equilibrium) we think about could be the catalyst that sets up the next high-return opportunity. Or it could be something that is not on our radar. One thing we can say for certain is that eventually there will be an opportunity.

We continue to believe that, excluding terrorism, the most likely case is a fairly benign economic cycle. What is fairly clear to us is that while inflation is the near-term risk, deflation risk remains in the background. And while neither is likely to get out of control, we could be in for an economic balancing act that may define this economic cycle and perhaps others that follow. We think investors need exposure to assets that can hold their own in each environment. Thus, the defensive portion of our conservative portfolios consists of some cash even though yields are low. We also own traditional bond funds despite fairly low interest-rate yields. And, we own non-dollar bonds in order to provide some hedge against a declining dollar. If somewhere along the way we become more concerned about the risk from inflation or deflation, we may need to adjust the allocations in all our portfolios. This is something we regularly think about.

In Closing

As we’ve been saying for some time, this is not a time to be overly aggressive or overly defensive. It is a time to be patient. We believe that on average, portfolio returns are likely to be quite decent, though not spectacular, over the coming years compared to average inflation levels. But, there are no slam-dunks we can see. At some point along the way some of the risks discussed (or others not discussed) will turn into reality and there will be temporary losses. The good news is that in all balanced portfolios we have some dry powder that can be re-allocated at lower prices if bargains are created. It is these opportunities that result in good long-term returns. This is why truly long-term investors should welcome temporary market declines as an opportunity to buy assets on sale. And that is what we are patiently waiting for.

Best Regards,

Jon Houk, CFP®