RCM July03 Perspective

It’s a bull. What we described as stealthy last quarter, now is obvious. The equity markets are recovering. The broad market as measured by the S&P 500 is up over 10% this year and the NASDAQ around 20%. It’s a big move in a short period of time. (It usually is off a bottom.)

The recovery of stock prices has been broad based. All categories of domestic equities have participated. Perhaps these markets are anticipating better times. However, this quarter the stocks of smaller companies led over those of larger ones. This is reverse of the pattern of the first quarter.

The technology and healthcare sectors are the leading sectors again as they have been all year. Industrials, consumer, utility, finance, and energy are also performing well. In fact the only lagging sectors are materials, staples, energy, and telecommunications.

Bonds also did exceedingly well. The ten-year Treasury bond yield fell to under 3.5%. Everything that could go right did. The war with Iraq ended quickly, with minimal losses, inflation remained low, the dollar declined, taxes were cut, and the Fed lowered short-term interest rates for the thirteenth time.

Interestingly, Japan may have helped the recent drop in interest rates. For some time now, the Japanese have worried that a cheaper dollar and more expensive yen would make their products less competitive. In order to keep their currency from appreciating too much, Japan effectively propped up our dollar by buying over $90 billion during April and May and placing the funds in US Treasury securities. (That buying pushed up the prices on the bonds, which lowered their yield.)

Short-term rates are at 45-year lows. The overnight rate for banks is now pegged at 1% and the prime rate is 4%. However, long-term rates have begun to creep back up. Perhaps the boost from Japanese buying is over and investors are concerned that a stronger economy in the future would reverse the recent fall in rates.

The big question is where do we go from here? The initial adjustment from the extreme selling pressure at the end of the bear market is over. (Remember markets go to extremes both at the top and at the bottom.) Now economic growth and better earnings have to come through for even higher stock prices.

Economic growth should begin accelerating. Lower taxes, low interest rates, increasing money supply, and cheaper dollars are the fuel. To what extent and for how long are open questions, but a positive effect is not in doubt. Last quarter we predicted that for the entire year, GDP growth should average between 2.5% - 3.5%. That still looks like a good prediction.

So far this past year and throughout the recent recession, the consumer has been carrying the economy. The consumer should continue to spend, but incremental growth will need to come from corporate spending and investment. That is coming.

Corporate investment has been sub-par for three years. By now, there are needs that haven’t been met for some time and equipment that needs to be upgraded or replaced.

At the very least, old equipment needs to be replaced even if there is not a full scale revamping. Capital spending should begin accelerating soon.

Even though we believe economic growth will improve, we now believe it will be erratic and subdued for several reasons: (1) Unemployment may stay higher than we would like to see; (2) Competition will continue to be intense; and (3) unanticipated events, such as terrorism, or events in Korea or the Middle East, may set progress back periodically.

In short a better environment, but not good enough to help everyone and every business. The successful will thrive, while weak competitors will continue to whither.

Two similar businesses can produce vastly different results in the economy we foresee. Since we believe competition will continue to be severe, only a select few in each category will be able to do really well. (These are the ones we look for.) Growth will exist; it just won’t be so easy to find. Therefore stock selection will be more important than investing in broad categories.

Investment trends are likely to be choppy and shorter lived. Market moves will be very quick; just like the one we have just had.

As mentioned earlier, interest rates took another dip in spring. Japanese buying of US Treasury bonds in April and May, most likely was a major contributor. However, rates for longer-term bond maturities already are creeping up. Once the Fed has confidence in the economic recovery, it will also raise short-term rates.

Interest rates most likely have already bottomed. We expect rates for five year obligations and longer to rise only modestly at first, but to pick-up when more vigorous economic growth emerges.

We are fully invested. We remain modestly over-weighted in technology and healthcare companies. However, our emphasis is not so much on sector weightings, as on the individual holdings. We believe this is where performance will come from. (The few winners in each category we referred to earlier.) Company size or investment style also will not matter much, only corporate performance.

We have made several changes during the past quarter to replace lack-luster performers with much better candidates. As a result our account activity has increased. We are not changing our bias toward long holding periods; we are responding to significant changes in the environment. Changes may come in spurts.

With interest rates having turned upward, we are pleased that we have limited new commitments to short-term obligations. It will be some time before we commit to longer maturity bonds. We can be patient. Our stock holdings are producing excellent returns and carrying performance.

We took some profits in some of the appreciated bonds in our clients’ portfolios. The seeds of future inflation and higher interest rates are being sown today.

Last quarter we wrote of the proposed tax law changes and how they might affect investments. Now we have a law and the changes are profound.

- The old rate on long-term (12 month) capital gains was 20%; new rate is 15 %. Taxpayers in the 10 and 15% tax brackets will pay only 5%.

- These changes in rates on dividends and capital gains are scheduled to run through the end of 2008 only. Then, who knows what will happen?

- Interest will still be taxed as ordinary income, i.e., up to 35% so fixed income securities such as bonds, money market funds, and CD’s will face a steep hurdle.

- Most preferred shares won’t qualify for the 15% rate on dividends because their payouts are deemed to be more like interest than dividends.

- Real estate investment trust (REIT’s) dividends don’t qualify for 15% treatment either because their income is not taxed at the corporate level. Master limited partnership (MLP) dividends may be in the same boat.

- A dividend wrinkle – to qualify for the 15% rate the shareholder must have held the security for 60 days during a 120 stretch beginning 60 days before the ex-dividend date.

- If you have a non-deductible IRA or an after tax 401(k), it would take you 36 years to breakeven in an account returning 8% per year in dividends and capital gains vs. investing the same amount in a taxable account and paying the 15% tax on earnings each year. You would pay 35% tax on earnings in the retirement account, in this case, upon withdrawal of earnings. Therefore, anyone over 45 should generally not invest in these types of accounts.

- You still want to invest in deductible IRA’s and pre-tax 401(k’s). But use these accounts for the fixed income portion of your portfolio and also REIT’s, CD’s, GIC’s, preferred stocks that are taxed like interest, and for short term trading.

- Dependent Children, if 14 or over, will pay 5% on dividends and capital gains if their taxable income is $47,450 or less. If under 14, the first $750 of gains each year are tax-free and the next $750 are taxed at the parent’s rate.

- The new maximum ordinary income tax rate is 35%; all other bracket rates are decreased by 2%.

- Many more taxpayers will be caught by the alternative minimum tax (AMT). AMT results in a 26% tax rate. You will need to check with your tax advisor.

- Variable annuities are much less attractive. There is no tax deduction for your contributions, costs are usually high, and you pay income tax at ordinary income rates on your withdrawals. (See the explanation for non-deductible IRA’s.) Variable annuities are now best suited for holding high yield bonds, REIT’s, and other fixed income securities.

- Coverdell education savings accounts and College 529 Savings accounts are still a good bet as they grow tax free if used for education. However, you give up some flexibility with 529 plans, they often have surprisingly steep costs, and their tax-free status is scheduled to expire in 2011. Coverdell’s are cheaper but contributions are limited to $2000 each year.

- Foreign stocks – dividends will still be taxed at ordinary income rates unless the company is listed on a US exchange (ADR).

We can help you make the most of the new tax-law changes in your investment program, so please, Talk with Us.

Notice

Riverplace Capital now is taking the responsibility to vote the proxies on behalf of our clients. We intend to exercise these votes to promote good governance and fair treatment of shareholders. We hope that more investment management firms will do the same.