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October 2003 Newsletter | Print Friendly Format

Dear Clients and Friends,

After three straight years of stock market declines, it appears that, finally, 2003 could record positive returns.   The market low touched in March this year was made with a confluence of bad news about the economy and the impending war with Iraq.   Following the quick military successes, and fueled by bountiful liquidity courtesy of the Federal Reserve, stock prices rallied strongly.   The S&P 500 rose 15.4% while the NASDAQ Composite climbed 21.3% in the second quarter; in the third quarter the indexes were up 2.7% and 10.1% respectively.   The largest gains during this period have been recorded by some of the most speculative technology stocks.   Rising confidence has lured some investors back into the same types of issues that burned them so badly only three years ago.  

It seems that the Federal Reserve has engineered another "bubble" in technology stock prices.   Day traders that survived are back, and borrowing to buy stocks on margin has skyrocketed.   Stock analysts have been ratcheting up their price targets to rationalize purchase recommendations.   Investor psychology has turned 180 degrees since March, when fear drove some out of the market.   Now the call is for the latest "story stock" to get back into the game.

For those of us who rely on fundamental valuation for stock selection, it has become increasingly difficult to find attractive issues.   As stock prices have moved higher and reached targets based on next year's estimated earnings, the value discipline is suggesting such stocks be sold, which may result in a temporary increase in cash reserves above normal allocations.   Experience has shown that at times like these it is important to protect gains if possible, and be ready to add to holdings as prices pull back to more favorable levels.

THE ECONOMY

The last recession officially ended in November 2001.   Investors have anticipated a recovery in the second half of 2001 and 2002, only to be disappointed.   Several indicators now seem to point to realization of these hopes this year, but concerns remain about the durability and magnitude of the expansion.  

The index of leading economic indicators has been rising, inventories are low, and industrial production has picked up.   Consumers have been supporting the economy for some time now, but finally spending by business is growing too.   Economists have revised upward their numbers for third quarter growth in Gross Domestic Product to about 4.5%.   Employment remains the soft spot in the recovery.   Jobholders peaked at 132 million in February 2001; in August of 2003 the number was a bit over 129 million, down 2.1%.   The unemployment rate moved up to 6.1% as the economy was able to grow with fewer workers.   Job creation has become the major topic for Presidential hopefuls; the administration is doing everything possible to improve the situation before the election next year using low interest rates, increased liquidity in the financial system, tax cuts and deficit spending.

The latest maneuver is to push the value of the dollar down against foreign currencies to boost exports and slow imports. It seems to be a risky move that may have unintended negative consequences as outlined below.   The consensus outlook calls for a gradual recovery into 2004 with housing and auto production easing back as business spending picks up, profit margins rise, companies begin adding workers, and profits increase.   If this scenario proves correct, a great deal of the good news has already been discounted in stock prices.

Bonds have been anything but boring during the past two years.   Interest rates have been in a generally declining trend since 1982.    As measured by the yield on the ten-year U.S. Treasury note, a multi-decade low was recorded this summer at 3.11%.   This level coincided with the Federal Reserve authorities voicing concerns about deflation, implying strongly that they would do whatever is necessary to avoid the problem including the purchase of Treasury securities on the open market.   Subsequent developments eroded the over-enthusiasm of bond investors as stronger economic numbers lessened the threat of deflation.   Interest rates on the ten-year note rebounded to 4.6% in one of the sharpest moves in memory.   Currently, the note is yielding about 4%; interest rates remain near historic lows.

Federal Reserve spokesmen have repeatedly stated that there is no reason for them to raise rates for a considerable period, but history would suggest that an uptrend in rates is more likely than a decline within the next year or so.   This outlook would steer investors to place their fixed income assets in shorter maturities, under five years, rather than locking in low rates for longer periods.

One of the driving forces holding down interest rates this year has been the large persistent purchases of U.S. government securities by the central banks of China and Japan.   The transition to a global economy has had a significant and possibly worrisome impact on investment markets.   The quantity of goods imported from China has soared in recent years with their value far exceeding the value of goods and services imported from the U.S.   China thus ends up with a huge sum of U.S. dollars, which they have invested in U.S. Treasury securities.   Their purchases have helped keep interest rates lower than they would otherwise have been.   Japan has been feeling the competition from China, which has much lower labor costs.   The Japanese central bank has been selling yen and buying U.S. dollars which they invest in U.S. Treasuries absorbing more of the supply.   U.S. consumers get inexpensive goods from the Asian countries, which obligingly recycle the money into our government securities.

Toward the end of September, at the urging of U.S. Treasury Secretary Snow, an international agreement was reached to allow the value of world currencies, excluding China, to trade at levels determined by the market rather than have them held at an artificial level as Japan had been doing.   The administration's goal (some would say political goal) was to allow the value of the dollar to drop, making U.S. goods more attractive and imports more expensive.   The manufacturing sector in this country has been rapidly losing jobs, and encouraging a decline in the dollar is one of the last options available to provide further stimulus to the economy, but it is a risky one.   Foreigners are owners of a large amount of U.S. government and agency securities (36% of U.S. Treasuries outstanding), and as noted above their purchases have helped hold down interest rates with a positive impact on the economy.

If, for example, a Japanese investor came to fear that the value of the dollar would drop significantly versus the yen, the value of his holdings translated into yen would fall, more than offsetting the meager amount of interest earned.   He would likely stop buying, and could sell the securities he already owns.   Under such a scenario, U.S. interest rates would need to rise substantially to induce foreigners to purchase our securities, which, in turn, would put the brakes on the economic recovery.   Investors have yet to fully discount this possibility, and, at the same time, the projected rise in business activity would tend to push interest rates up in competition with the government's need to borrow to fund a $500 billion anticipated budget deficit.   The impact on both stocks and bonds would be unpleasant to say the least, which leads us to lean to the side of caution in this environment.

Your thoughts and comments are always welcome.

Sincerely,

John L. Simpson
Senior Vice President, Chief Investment Officer