RCM April04 Perspective

“In like a lion, out like a lamb;” that was the first quarter 2004 stock market. The market suffered a correction, after almost one-year of steady increases. In late January the correction started as loss of momentum, then a series of rolling setbacks, moving from sector to sector and finally culminating in a broad retreat in March.

Catalysts for the broad retreat included concern for security after the Madrid train bombings, political uncertainty, Iraq, and lack of confidence in the durability of the economic recovery. In other words, things are getting back to normal after a one-year uninterrupted bull run. (There is plenty to worry about in every era.) By the end of the quarter, the market seemed to be stabilizing.

Bonds benefited in this environment, continuing to be seen as a safe haven. Treasury bonds did best. High yield bonds actually declined in value as investors lost some confidence in their creditworthiness given the waning of confidence in future economic performance.

While current economic strength is almost seen as a given, the outlook for the latter part of this year and next year causes anxiety among many investors. Corporate leaders also seem to lack confidence. For this reason, inventories are being rebuilt slowly and investment in expansion and new ventures is modest. Instead, most firms are focused on costs and profitability.

Despite this, it should be kept in mind that the collective profitability for the companies of the S&P 500 hit a record last year. This year should extend that record level by another 12-15%. This is why RCM remains optimistic for stock market returns this year.

Episodes of terrorism and the war in Iraq periodically give the market a case of jitters. However, investors’ focus reverts back to the excellent market fundamentals rather quickly. Although we hope for the best, we are managing accounts with the assumption that geopolitical concerns could interrupt domestic economics. This sobering possibility guides us in how we construct portfolios.

So far, our earlier prediction of better than 4% economic growth this year looks to be solid. We do not share the prevailing concerns about slowing late this year and next. We believe this pace is sustainable for some time to come. World recovery is still just beginning and corporate investment likely will accelerate. Lagging domestic employment growth should also pick up.

Economic progress most likely will be irregular; variability quarter to quarter should not be alarming. The underlying forces of fiscal stimulus, low interest rates, and good money supply growth are key.

Momentum in the economy is gradually shifting from the consumer sectors to the producer sectors. Producers are benefiting from cost cutting (including lower head-counts), a cheaper dollar, and better worldwide demand. Shifts in the economy like this usually last for periods measured in years, not months.

We believe that returns this year will be better than 8-10%, because profits are expected to grow at a pace faster than this historical average stock return. In addition, momentum should carry through the latter part of this year as investors begin anticipating further profit growth next year.

Price-earnings ratios, however, should come down over time, especially as interest rates rise, but profit growth still looks to be strong enough to provide the predicted above average return. (Remember, price-earnings ratios are normally higher with low interest rates than with higher rates.)

The desperate attempt by investors to find reliable current income is leading more and more of them to take on unwarranted risks. In many cases, these investors do not understand these risks. When interest rates begin rising in earnest, losses will mount. What was presumed to be safe may prove very risky.

Rates are taking longer than we expected to begin a sustained rise. However, don’t doubt that it will happen. Pressures continue to mount. One example is commodities. The CRB Commodity index is up over 10% so far this year. Commodities are inputs into other products. This increase will have to be passed through to many final product prices sooner or later, which will have an inflationary effect leading to higher interest rates. We think the actual rate of inflation is higher than reported numbers and that this will be reflected in rising interest rates soon.

We have been carefully reviewing every stock position. Ones that do not appear to have the characteristics to perform well are being removed. In addition we have been very busy adding candidates to our watch list. If a change is warranted, we want to have the best available candidates as replacements from this list.

We have placed modest emphasis on the industrial, technology, and health care sectors. Less emphasis is being placed on consumer staples, financial, and utility sectors. All other sector weightings are equivalent to the current market weights. Nonetheless, we believe that this year individual selections will prove to be far more important to performance than sector weightings.

During the first quarter, we have purchased Treasury notes in the one-to-three year maturity range. We see few other fixed income opportunities that meet our risk profile at this time. We will remain defensive until interest rates move higher.

The Presidential election will have ramifications on the market to be sure. Investing is our business at RCM, not political handicapping. We have no better insight into the outcome of this year’s contest than most of the rest of America. In our estimation, this election will be close, so as to give very little time to prepare for the various contingencies. We can, however, evaluate the effects of various outcomes and begin to reduce obvious risks in portfolios

In general a switch of party control of the White House, brings immediate uncertainty. This affects markets in the short-term. After some time, markets assess the likely changes and respond to business fundamentals. Investors make adjustments and shift capital. Some businesses may gain and others may lose.

One obvious concern to investors is where the parties have widely differing policies that could have material effect on the profitability of their stocks. One such sector is the pharmaceutical industry. There are similar concerns about certain defense companies and financial service firms. With regard to pharmaceuticals, the Democrats and Republicans clearly differ on public policy toward drug pricing; with regard to defense certain large weapons systems might not get as readily funded if the Presidency shifts. If Senator Kerry is elected, tax policy affecting investment activity also could change.

Even if there is a change in the Presidency, radical shifts are highly unlikely. The executive branch can not act unilaterally. It is constrained by both the legislative and judicial bodies. Even if we should experience a change at the White House, it is unlikely that power in both houses of congress would also shift. So, under that scenario, split government would be the result, making sudden changes in policy even more difficult.

Granted, if Senator Kerry were elected, certain emphases and priorities might indeed shift, but these take time to impact the economic environment. In the meantime, businesses adapt. And remember: stock markets historically have actually fared better under Democrat administrations than under Republican ones.

So RCM’s approach is to evaluate each investment as to how it might be affected by a political shift. Where there is obvious risk, we already have made changes or will soon. A large majority of investments will not be directly affected and should they be there are plenty of excellent alternatives to choose from. (RCM already has done this for investments most detrimentally affected by terrorism.) So if you want to work with a firm that anticipates and evaluates the ramifications of potential change, Talk with Us.

Riverplace Capital Management

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