What's going on here? There is now an old economy and a new economy. We have record point increases and record point declines. Blue chips collapse and hot concepts, without much substance, rise. Everyday, it seems investors wake up and change their minds. One day the Dow is collapsing, the next it is recovering. Many times the NASDAQ goes in the opposite direction.

Underneath record-breaking volatility the broad market went through a correction. Companies deemed to be hurt by rising interest rates declined significantly. By early March, the decline approached 20% from its high in early January (as measured by the Dow Jones Industrial Average which includes many of these stocks).

On the other hand, the NASDAQ marched on to one new record high after another. (This is because this index includes many companies that are considered immune from increasing interest rates. In many cases these companies are believed to benefit from many other companies' need to find ways to become more efficient in the face of both rising interest rates and other cost pressures.) By early March, the NASDAQ posted a gain of 24% for the year. Then in mid March, this index corrected over 10% in a matter of days. After a brief recovery, the NASDAQ suffered another sell-off during the last week of the month. It was the worst one-week point loss ever recorded by this index.

"Bifurcation" became the new buzzword to explain the difference in performance between Dow and NASDAQ stocks. Companies offering solutions to other companies, engaging in new businesses or finding new ways of doing business were deemed part of the "new economy." All others were grouped as being a part of the "old economy."

A driving force behind this bifurcation was the Open Market Committee of the Federal Reserve Board. The Fed raised the Fed Funds Target Rate and the discount rate 1/4 % in February, then did it again in March. This last increase was the fifth one for the Fed Funds Target and the fourth for the discount rate since June of last year. Market participants realize that the Fed is determined to slow the economy from torrid growth in the 5-6 % or even 7% range to a pace near 3%.

The Chairman of the Federal Reserve Board, Alan Greenspan, counseled that this was necessary to prevent inflationary pressures from building. In the meantime, oil prices have risen, although the core inflation rate continues to be tame, measuring about 2%. Last year’s core CPI increased 1.9% and the core PPI a miniscule .5%.

By February the Bond Market began taking this process in stride. It appears that interest rates for intermediate and longer maturity bonds actually peaked in late January and early February. In our last Perspectives we predicted that this might happen. The peak was forced by the Fed’s need to extract the extra liquidity that it provided the economy at the end of last year.

By late March, both the bond and stock markets began major rallies. The Long Term Treasury bond’s yield slipped to under 6%. Both the Dow and NASDAQ approached their early January highs. However, technologies suffered yet another setback at the end of March. During the quarter, the NASDAQ suffered four separate declines of 10% or more and the Dow declined over 1900 points and recovered 1100.

So whatever is going on here, it’s the new normality. We simply need to get used to it.

By February of this year the United States economy had been expanding for the longest time period in our recorded history, 107 months and counting. In past issues of this letter we have listed the reasons to expect that this expansion would continue. Most of these factors still exist, such as a good business environment in the U.S. with low inflation and surprisingly strong productivity gains. There is economic recovery in Asia, accelerating growth in Europe, and improvement in Latin America. The consumer is still spending and personal wealth is at record levels.

However, we have forecasted a slowing in the growth rate of our economy and we are beginning to see some evidence in this regard. The pace of home sales, both new and existing, is declining. In January this decline was 10.7%. Durable good orders were off in both January and February. The money supply is contracting. The bond yield curve is flat to negative, which usually portends at least a slowing. Real interest rates (the actual rate minus the inflation rate) are now at levels that never failed to slow the economy in the past.

The statistical evidence of slowing usually becomes known at least a quarter after the fact, so we will have to wait and see if these initial indications are correct. The good news is that, for now, a recession is not in sight.

As noted earlier, volatility is now an everyday occurrence. We are all getting used to it. We should mostly consider it "noise." It doesn’t tell us much about underlying corporate performance.

Besides interest rates, the other driver of the general level of stock prices is earnings.

Lately, the estimates for earnings growth this year have increased. They now average an increase of 14-17%. If all other conditions remain favorable, stock price increases ought to reflect this rise in earnings. We believe they will. So we are forecasting yet another year of good returns from our equity holdings.

Although technology stocks provided market leadership during the first quarter, by late March, many other sectors began to perform better. Perhaps we are beginning to see the broadening of the market we have forecasted. Financials, energy, drugs, and retailers all finished the quarter on an up-note. "Techs" wrecked again.

Bond yields peaked in late January and early February. Treasury obligations peaked before corporates and municipals. Short-term yields have been forced up by Fed policy, but long-term yields are declining in anticipation of economic slowing. Barring any unforeseen jolts, we have probably already seen the highs in long term rates for this cycle.

In our last Perspectives we expected to get reasonable returns from bonds this year and had begun moving out targets for duration and average life. We are now at 6-8 years for these targets.

Equities: Present weightings for equity sectors are being maintained. We know every year we will be surprised by poor results from one or more companies in our model of 50 stocks. In the first quarter we had two such surprises. We have since upgraded these holdings with two new candidates that have been on our watch list for some time. We like to avoid turnover. However, we want to avoid poor performance even more. The environment for equities has been especially tricky. Our approach has been to keep a steady course with a balanced portfolio. So far, this discipline has rewarded us well and we are pleased with our results.

Fixed Income: Our fixed income policy remains the same as it has since the beginning of the year. Our preference is for high quality issues, targeting an average life of 6-8 years for each portfolio. We are pleased with the results in this sector as well.

Many prospective clients ask us what portfolio structure is appropriate for them. Obviously, this is dependent upon individual circumstances. Those clients who can accept greater near-term volatility for long-term rewards generally have a higher proportion of their assets in equities. This is because equities have the greatest expected reward over time. (Historically equities have averaged increases about 10-12% per year. This is a long-term average and one-year periods show highly variable returns.)

Equities or stocks have the greatest volatility among the major asset classes (stocks, bonds and cash.) To reduce this volatility, fixed income or bonds are added to the portfolio mix. This asset class often has its own cycle, which may counter that of stocks.

For instance, in times of financial shock, such as the Russian debt default in August of 1998, high quality bonds move higher in value just when stocks are collapsing. (This is because high quality bonds are perceived as a safer investment and money flows into them during such times. Lower quality bonds do not offer this same protection, but respond more like equities.) Another example is that stocks may go down due to recession or economic slowing. At the same time bonds may go up as interest rates decline.

Most large pools of money, such as pension funds, larger foundations and endowments, gravitate to a mix of about 60% equities and 40% in fixed income assets. Cash is also used to adjust risk, but is usually used only to provide current operating funds. (The long-term return on cash is even less than that of bonds.) As the proportion of equity rises, volatility increases faster than the expected return. The 60/40 mix is the optimum balance between the two.

For those who can accept greater volatility than a 60/40 mix, the extra reward may still be worth it. What is right depends on you. To get the benefit of this analysis, Talk With Us.

Large Cap Stocks (S&P 500) 2.0%

Dow Jones Industrial Average -5.0%

Mid Cap Stocks (S&P 400) 12.4%

NASDAQ Composite 12.4%

Small Cap Stocks (Russell 2000) 6.8%

MSCI EAFE 0.39%

Lehman Corp. Bond Index 1.43%

Consumer Price Index Annual Rate 2.9%

(Equity indices are three-month returns excluding dividends)