Third Quarter 2004 Newsletter

September was a good month for both the markets and our portfolios, but not good enough to offset the weakness in July and August.

With no compelling asset-class opportunities at this time, we remain close to our neutral allocations, but we are fully invested on the equity side.We list many of the arguments put forth both by optimists and pessimists, but as rationalists we must recognize what we can and cannot assess with confidence.

As always, we remain most confident in our ability to assess valuations. This research tells us that we should be more optimistic than pessimistic.

Macro-economic and geopolitical developments are extremely difficult to confidently and accurately assess. So they are not primary drivers of our asset-allocation strategy. However, we don’t ignore them. Rationality also requires us to assess what could happen and how different scenarios would impact our portfolios.

Quarterly Investment Commentary

September was a solid month for equity markets and, generally, a very strong month for our active managers. Small-cap stocks, foreign stocks, and growth stocks were particularly strong. For the full quarter, however, equity markets were under water. Concerns about oil prices, geopolitics, the election, employment, and earnings all contributed to equities’ weakness while fueling a bond rally. Our portfolios outperformed by a wide margin in September, after underperforming in July and August. For the year, we are in line with our benchmarks after four straight years of outperforming.

With the end of 2004 in sight we continue to have only lukewarm enthusiasm toward the available investment options. Nothing comes close to catching our fancy, so like Barry Bonds, we must stay disciplined and refrain from swinging at pitches not to our liking (I know — yet another baseball analogy! But wait…there is more!) Or put another way, in the words of another superstar, the great Warren Buffett, “the stock market is a no-called-strike game. You don’t have to swing at a questionable strike—you can wait for your pitch. The problem when you’re a money manager is that the crowd keeps yelling, ‘Swing, you bum!’”

For us, waiting for our next pitch means sticking to our neutral allocation and for the most part, we are there now. Only our fixed-income allocation is postured differently from neutral, as it has been for a number of months.


Why We Are Rationalists

For optimists and pessimists, their views can influence what they see. For rationalists, what they see determines their views. Our job is to weigh the arguments put forth by both optimists and pessimists and to assess them rationally and without bias.

In light of our refusal to “swing,” the optimists might argue:

The economy is healthy.
  • Global economic growth is likely to come in at a 30-year high in 2004.
  • Unemployment claims are modest.
  • The U.S. consumer is in better shape than many think. Asset levels have increased significantly so that consumer balance sheets are solid, and credit card delinquency rates have been declining. Debt as a percentage of disposable income is actually quite a bit lower than it is in either the U.K. or Japan.
  • Productivity growth remains encouraging.
Corporations are flush with cash.
  • Corporate earnings have surged and as a result, cash on balance sheets is extremely high. This bodes well for spending (hiring and investment), though the private sector has been cautious in the expansion to this point.
Valuations are quite reasonable.
  • Valuations are much improved and quite reasonable, with P/E multiples in the mid-teens on a forward basis. Multiples haven’t been this low in over seven years.
There is always fear, but it can result in excessive pessimism and missed opportunities.
  • Investors can become paralyzed and miss out on the benefits of long-term economic growth if they allow themselves to be frightened by non-quantifiable, big-picture risks.
  • The high ratio of short sales to total stock market volume suggests excessive pessimism.

On the other hand the pessimists might say:

The economy has improved but continues to have serious and dangerous structural problems.
  • The economy is walking a tightrope between inflation and deflation. If easy monetary policy ignites inflation, interest rates will rise, possibly leading to a sharp slowdown in consumption. A competitive global economy that still suffers from overcapacity could, ironically, eventually result in deflation—not a healthy scenario for stocks or other equity-type assets.
  • Household debt levels are high. If interest rates reverse their 20-year downtrend, consumption could slow because of a reluctance to use higher-cost debt. Even though household balance sheets look healthy enough, higher interest rates could cause house prices to decline along with stocks, possibly inflicting severe damage to household finances.
  • The current account/trade deficit remains huge, and Asian central banks can’t support the dollar forever. There is risk of a dollar crash that could result in a severe global recession.
  • The growing budget deficit is troubling. Budget deficits usually lead to inflation.
Stocks don’t have much upside and there is little margin of safety.
  • Stock multiples are still high historically, and after the recent bear market, investors are not likely to feel comfortable with high valuations. This could cap return potential and also suggests that stocks are not priced with much margin of safety.
  • After a strong rebound from depressed levels, earnings are likely to grow at a below-average rate, on average, over an extended time period. Profits growth is already slowing.
The geopolitical situation amounts to a security tax at best and a potential economic shock at worst.
  • Terrorism is an ongoing risk. Aside from the possibility of an economically damaging attack, the mere existence of the threat imposes costs to our economy that are the equivalent of a security tax and that add to our deficit.
  • The sharp rise in oil prices is equivalent to a tax on oil consumers. Some of the price rise reflects a geopolitical risk premium. It’s hard to know how long that will stick—but it’s the risk-premium portion that has pushed prices to a level where they really have some economic bite. Some of the increase is also demand-driven (China) and so prices are unlikely to return soon to levels of the last decade.

Whew! The optimists and the pessimists can have at each other. We are paid to be rationalists. Rationality requires us to recognize what we can confidently assess and what we can’t. As a general rule it is easier for us to assess the optimists argument than the pessimists. And for those things that we can’t assess we must determine if they have the potential to undermine our ability to meet our portfolio objectives. With respect to these issues, our views and conclusions have held constant throughout 2004:

We are most comfortable (as always) assessing valuations

Our analysis tells us that equity-type asset classes are generally in a fair-value range. That suggests that a normal level of risk is reflected in stock prices. For the most part bonds look a bit pricey. A number of the managers we respect tell us that stocks of high-quality companies with some growth characteristics are selling at very reasonable prices—not fat-pitch cheap—but definitely attractive. We have exposure to this part of the market through a number of stock pickers including Tom Marsico (Marsico Focus), Louis Navellier (Navellier Mid Cap Growth) Bill Nygren (Oakmark), and Dave Yucius (Aurora).

Looking overseas, many countries don’t have the structural imbalances the U.S. has (huge trade deficit, low savings rate, and high debt levels). And based on most metrics, foreign stocks look undervalued relative to U.S. stocks. However, they often (usually in the case of Europe) sell at a discount to the U.S. Yes, we like foreign stocks, but not enough to have a large overweight.

Investment-grade bonds are priced at very low yields. For example, the 10-year Treasury yield is about 4% as we write this. Compared to inflation, yields are below their long-term average and this suggests that investors are somewhat pessimistic about the economy. Looking out over the next few years it wouldn’t be surprising to see interest rates drift higher, resulting in low single-digit returns for bonds. (Indeed, modestly higher rates would be welcome because they would go hand-in-hand with a healthy recovery.)

Foreign bonds also continue to offer low yields on average. However, inflation pressures are more muted in Europe and thus there is a good chance that European bond markets will outperform U.S. bond markets. In addition, if the dollar weakens on a long-term basis, as seems likely to us given the huge current account/trade deficit, currency gains would add to returns from the foreign bond funds we hold.


Fairly valued equities suggest that stock-market investors are not placing a high probability on the troubling structural imbalance risks. As a result, the margin of safety in stock prices seems no better than average. At the end of the day we are concerned enough about the structural imbalances that we are not willing to overweight equity-type securities vs. bonds, even though bonds are somewhat overvalued. Our view is influenced by healthy levels of cash on corporate balance sheets, muted inflation, and consumer spending that remains solid though there has been some slowing.

So we remain at our neutral allocation, postured neither overly aggressively nor ultra-conservatively. And while it’s frustrating to stand in at the plate with the bat on our shoulder, the one thing we can say with certainty is that opportunities will come. The world will always be a volatile place and at some point something will cause investors to act irrationally. So we must be willing to be patient for however long it takes. While we are patient, if the environment is benign, returns may be just fine. And of course we have enormous confidence in the stock pickers we rely on, though that confidence is high over the long-term (periods of at least three years) but always lower in the short-term. Again, patience is essential now.

As always, we thank you for the confidence you have placed in JPH Advisory Group and myself.

Best Regards,

Jon Houk, CFP®