War. The shoe finally dropped. Few guessed that the market would take off posting the best one-week return in twenty years. In fact, the market averages began rising days before the official start to hostilities. (The old market adage, "don’t sell a war," held true.)

However, economic activity slowed dramatically in the weeks leading up to the war. Travel dropped off significantly, the consumer paused, and business investment again got put on hold. In spite of record low interest rates and aggressive fiscal policy, the economy just won’t accelerate. Confidence is the missing ingredient. Since 9/11, our country has lost its swagger. Many believe that success in Iraq and a short-term conflict may allow some of this confidence to return.

Remarkably, in spite of the economy and global concerns, equity markets have performed reasonably well. Though they have been volatile. The year started with a strong rally. After three down years, investors believed that odds favor some recovery. Then as the prospects for war increased, the markets sank again. As war became imminent, markets recovered; quite a yo-yo.

Technology and the healthcare sectors have been leading market performance. As a whole, large company stocks have been performing better than those of smaller companies, and ones with growth characteristics are doing better than those categorized as value. The market seems to be anticipating broad-based recovery. At the end of the quarter, equities traded based upon war news and rumors. Military success helps restore confidence and setbacks bring fears of a Vietnam War experience.

Concerns of endemic accounting irregularities and corporate governance seem to be receding into the background. Individual examples still emerge, but seem to be handled on a case by case basis. Today regulatory oversight is much stronger and will continue to be improved.

The big question that can not yet be answered is how long will the war last, and what the aftermath will entail for the U.S. government and its budget? Much of our immediate economic future depends on the answer to these questions. Riverplace Capital is paying close attention to the short-term risks without losing sight of the long-term potential.

Growth was better than expected for the fourth quarter of last year. GDP grew at approximately 1.4%. For the first quarter of this year, we are expecting an increase of approximately 2%. The second quarter will be affected by the severity and duration of the war, but should show a similar rate of growth. For the entire year we believe growth will average between 2.5 – 3.5%.

The economy has been growing since the third quarter of 2001. No second dip into recession is expected. Capital spending is in the early stages of recovery. Consumer spending has leveled off, but remains healthy. Once the Iraq war begins to wind down, we expect economic growth to accelerate. Our innate American optimism should begin to return.

The big surprise this past quarter was the good performance of equity markets in the face of war with Iraq. We believe this good performance is likely to continue and carry the popular averages considerably higher by the end of the year. Gains, greater than most expect, would not surprise us.

However, volatility certainly will continue. On a near term basis this seems exasperating, but simply masks the fact that stocks can be purchased with far less risk than in many years. Prices already reflect the known risks. These are many, but in our estimation, not permanent.

A stealth bull market already has begun; perhaps not evident from casual observation, but certain sectors are up (considerably) from last summer’s lows. Even within strong sectors, performance is very specific, with only certain companies’ stocks being bid up. By the time this process becomes evident to a larger audience, much of the available returns may have already occurred.

Higher interest rates are coming. In fact, rates already have begun to creep up, first affecting treasury obligations. In time, other fixed income securities will decline in price, to adjust their values in order to provide higher rates.

The one category of bonds that should benefit is high-yield. This asset class should respond to a better economy as investors become more confident in the issuers’ ability to meet their obligations. However, we consider high-yield bonds equity substitutes, not true fixed income instruments.

We include fixed income instruments in portfolios to reduce the risk from equities. Therefore our emphasis is on high quality obligations.

For the past two quarters growth has outperformed value and large-cap has outperformed small-cap. Since we focus on large-cap growth stocks, we are well positioned.

We have over-weighted the technology, industrial and healthcare sectors. We remain under-weighted in the financial and communication sectors. All other sectors are essentially equal to present market weights. The over emphasis is in sectors where we see opportunity and conversely the under-weighting is where we believe there is diminishing potential.

Our fixed income policy remains the same. The maturity target for new commitments is within a range of two to three years. Our preference is to buy corporate bonds because they still offer the best value and should continue to benefit from increased confidence in their credit worthiness as the economy continues to grow.

Cash reserves remain important, as well.

Be careful what you wish for!

A seemingly popular demand by investors for more emphasis on dividends from corporations may have unintended consequences. Tax policy is being examined and changes are recommended to facilitate more dividends being paid.

Dividends now get taxed twice. Companies that pay them must first pay tax on the earnings before the dividend is paid. The recipient, if it is a tax paying investor, then pays tax on them as well. Many see this as unfair.

Issuing stock is one way for a company to raise capital. Another is to borrow money. The company that borrows must pay interest on the outstanding balance. That interest is tax deductible to the firm. One argument goes that paying a dividend is part of the required return to entice investors to invest in a company through stock ownership, so why not make it deductible as well? That would reduce the bias at the corporate level to use more debt because of its deductibility. This would help all investors by allowing firms that pay dividends to reduce their tax and therefore have higher after tax earnings. Presumably these stocks would rise in price because of this increased profitability.

Another proposal is to allow investors to exempt a greater portion of dividends from taxes. This would make it more desirable for investors and they would put pressure on company management to pay earnings out rather than retain them in the company to fund future growth. Of course this only applies to stock held in taxable accounts. This would not benefit tax-favored accounts such as IRA’s, 401(k)’s, traditional pension plans, foundations, endowments, etc.

Today many investors, especially those in high tax brackets, would rather the company keep all the earnings and use it to grow value. Therefore the investor could allow that growth to continue if additional income was not needed. The investor could sell a portion of the appreciated stock if funds were needed and pay a capital gains tax on the gain, rather than the higher income tax would be paid on dividends.

Growth requires investment. Companies grow their own businesses through ongoing investment and often provide risk capital to promote new products or services. With less money retained by companies, this driver of growth may be diminished. Another argument goes that individual investors may then provide more of this risk capital. That may be true, but in a more conservative atmosphere of getting a return now, not in the future, this probably wont make up the difference. The result is a less dynamic and slower growing economy. Risk taking is necessary for growth.

The desire to have more earnings paid out in dividends is understandable after the past couple of years. Investors have less confidence that reported earnings are really accurate and would like to verify them by having more paid out. (The old adage is that earnings are an opinion, cash is a fact.) Also management ability to reinvest earnings is being called into question. However, the unintended consequence may be less future growth.

Obviously, if either of these proposals come about, it will effect how Riverplace applies capital. We are considering the implications of the various proposals. If you want to work with a firm that is evaluating issues in advance, Talk with Us.

We are proud to announce the appointment of C. Ronald Belton as Executive Vice President of Riverplace Capital Management Co. Ron helped found Riverplace Capital and has been an integral partner in its growth and development.

Large Cap Stocks (S&P 500) -3.60%

Dow Jones Industrial Average -4.19%

Mid Cap Stocks (S&P 400) -4.73%

NASDAQ Composite 0.42%

Small Cap Stocks (Russell 2000) -4.84%

MSCI EAFE -8.83%

Lehman Corp. Bond Index 1.64%

Inflation 2.50%

(Equity indices are three-month returns excluding dividends)