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:: April 2004| Page 2 of
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The eventual increase in interest rates is a cause for concern for both the stock and bond markets. In 1981 the ten-year U.S. Treasury bond offered a yield of 16%. Since that time rates have moved down to a low of 3.07% set last June. The yield rose to 4.6% in September and has since fallen to 3.7%. Even if the Federal Reserve does not plan to raise rates for some time economic growth and the weak dollar could put upward pressure on rates. The bulging federal deficit also requires many new treasury securities to be absorbed in the market. Not only would a general rise in the level of interest rates tend to slow the economic recovery, but consumers who have taken on a record high amount of debt would be squeezed, and the valuation equation for stocks and real estate would be negative.
The stock market enjoyed a strong recovery from March 2003, without a decline of 5% until recently. A correction began in January for the NASDAQ stocks that had had the strongest gains last year. It then reached the broader markets in March erasing the earlier gains. The quarter closed with the S&P 500 up a bit over 1% for the year-to-date. One can never be sure if a pull back is a normal healthy correction until it is over, but analysts report that the average duration and magnitude of a correction during the first two years of a recovery is eleven weeks and 10%. During this correction the Dow Jones Industrial Average was down about 4% from its peak in early March.
The economic recovery and rising earnings should support a further advance in the months ahead. Earnings estimates for the S&P 500 have been rising steadily. The first quarter is expected to show a gain of over 16%, and the full year is projected at 13%. Forecasts call for further, but slower gains moving into 2005. Valuations have become a bit more attractive due to rising earnings and lower stock prices. The S&P 500 now sells at 17.6 times estimated 2004 earnings which is reasonable in the context of very low inflation and interest rates. Several new names have been added to portfolios during the first quarter as some trimming has been done in older holdings. From this point, a rotation into more stable, dividend paying stocks seems likely.
There are numerous risks to consider including terrorism, rising interest rates, unfavorable changes to the tax laws for investors, and higher energy costs to name a few. Nevertheless, strongly rising earnings, low interest rates and low inflation offer a favorable environment for stocks in the near term.
Sincerely,
John L. Simpson, CFA
Chief Investment Officer
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