Perspectives
Number 28
Second Quarter 2005
2004 all over again? Last year all of the gains came in the last four months, this year might be similar. Last year the election was the focal point for investors, this year it is the Fed. Investors are fixated: When will the Fed conclude this round of interest rate hikes? We believe that it will be soon. In the mean time, investors need patience.
Dramatic moves do occasionally occur and the stock market moves toward the top or bottom of its trading range. These moves are usually driven by news that lends credence to a more positive or negative economic view of the future. Will the economy cave in under the pressure of higher interest rates and more expensive energy, or merely decelerate to a moderate but sustainable rate of growth? A definitive resolution of the debate eludes investors.
Obviously the more time that goes by with the economy still healthy, the more likely the optimists are correct. All that is left is for most investors to recognize and act upon that fact. Riverplace Capital believes this is the most likely prospect. We are optimistic and believe a large breakout move to the upside is coming.
This past quarter, bond yields dropped to the low end of their recent trading range. Some stock investors point to this as evidence that the bond market is predicting more than a slight deceleration in economic growth, perhaps a recession. We believe otherwise. RCM believes that the bond market is a less reliable predictor of economic activity than it has been in the past. There is an incredible demand for longer term U.S. bonds for a wide variety of reasons. (We discussed these issues in past Perspectives.)
This year has been a tough one so far. Market averages have done little or nothing. It is difficult for an investment manager to show much absolute out-performance in such an environment. Nevertheless, RCM has done so, with many of our accounts considerably higher than market indices for the year. We are proud of our performance.
Forecast
Economy
Growth is moderating, but still solid. A year ago the economy was growing at over 4%; it has now decelerated to about 3%. The evidence so far is that the current rate of growth is likely to persist. (In fact there is reason to believe that growth could re-accelerate next year. By then, the Fed should have short-term rates where they want them and some central banks around the world actually may be easing rates. European stock markets recently have reached new highs on expectation of interest rate cuts.) Money supply is growing again and businesses are increasing their capital investments.
The real unknown is the course of real estate activity. Should increasing real estate prices suddenly decline; the economy will surely enter into recession. If on the other hand, prices and activity merely slow or level-off and begin to diffuse slowly, then the impact may be modest. (RCM believes the latter is most likely as demand still looks solid and interest rates are unlikely to reach levels that strangle activity.) Other investment alternatives, especially stocks, could benefit from a real estate slowdown.
Energy prices are also a factor. However, those prices have not had much impact yet. Energy, however, is self-correcting. If prices climb too high and begin to restrain world economic growth, then energy prices will fall in anticipation of weakening demand.
Equities
As earnings gains continue to exceed the improvement in stock prices, stocks become cheaper; an ongoing process for over two years now. The P/E ratio for the market has declined from over 20 to about 16. This ratio is well within historical experience meaning that it is neither cheap nor expensive and should have a neutral effect upon determining future stock values. Earnings gains now should be the main driving force for increases in stock prices. (If earnings increase for a particular company, then so should its stock price.)
Earnings gains so far this year have exceeded general expectations. First quarter earnings gains were 12% greater than the same period the previous year. (The expectation at the beginning of 2005 was for an increase of around 5-7%.) Second quarter earnings will be reported soon. Current expectations for this quarter’s earnings are at about a 7% increase. RCM, however, believes the actual reported second quarter increases will exceed this expectation.
Certainly earnings gains are decelerating from the over 20% rate recorded for the past couple of years. This is inevitable, but a mature economy such as ours can sustain earnings growth (albeit not at 20%) and we are optimistic about resulting stock price increases. Pressure continues to build for an upside breakout. We expect it to occur in the second half of this year, or perhaps early next year.
Fixed Income
Low rates persist for fixed income instruments. Along with many other investment managers, we have been expecting higher interest rates for some time now. Instead of going up, most intermediate and long-term rates have actually gone down. When asked why this has happened, the Fed Chairman did not have an answer and called it a conundrum. Only very short-term rates have risen as a result of Fed policy.
Some factors we have pointed to in past Perspectives that explain the lack of rate increase, are substantial buying of U.S. treasury bonds by foreign central banks, continuing risk aversion by investors, and underlying deflationary pressure from new global competitors in manufactured goods.
Although manufactured goods from countries like China place competitive pressure on prices on the same goods made here, the effect of rising demand is that raw material prices are increasing. As more and more of the world industrializes that pressure will continue. This means our economy is affected by both deflationary and inflationary forces at the same time. Cheap labor, cheap currency, and productivity increases are what produce the deflationary forces in manufactured goods. These forces will moderate as exchange rates adjust over time and labor in the developing world gradually becomes more expensive.
Investment Strategy
Equities
RCM is fully invested. However, we have balanced our portfolios to weather the sometimes violent moves within the trading range we have been experiencing, including more defensive positions. These are stocks in the staples, healthcare, and utility sectors. Service companies have been included in some of the more business cycle sensitive sectors also to provide stability. We closely monitor the risk inherent in each of our holdings and have eliminated a couple of positions where the risks tipped to unacceptable levels.
Over the past two years, RCM sought out companies that we believe can provide consistent growth. We gladly have accepted a trade-off between consistency and higher growth rates. We lowered our hurdle rate of growth to 12% from 15%. So far we are pleased with the results. We have consistently beaten the returns of our benchmarks with less volatility.
Fixed Income
The difference between short-term and long-term interest rates is about as narrow as we have seen in years. The result is that by investing in shorter term maturities, an investor gives up little potential yield. Our risk-adverse fixed income strategy of staying short-term remains prudent.
Because the spread between corporate bonds and Treasury yields has widened, we again are beginning to buy some corporate bonds. Investors now are being adequately compensated for the somewhat greater credit risk in these bonds.
Talk With Us
Clients sometimes are asked about their expectations for investment management services through industry surveys. When asked to rank those expectations, typically they prioritize as follows: integrity, service, and then performance.
Integrity is a given, and the fundamental starting point. Any client or prospective client must believe that their interests are being served. Information must be reliable. They must believe that their advisor’s opinions and strategies are formed through intellectually honest processes and honed by experience. They want the benefit of experience and intellect as well as the ability to adapt to new information as it becomes available.
No endeavor that seeks to position present actions for future rewards always will be correct in every aspect. Most clients know this. Riverplace Capital has assembled an outstanding group of individuals of unquestioned integrity. The firm’s culture reinforces their values and promotes intellectual rigor and curiosity. RCM has created and adheres to a code of ethics.
Service implies that clients’ assets are handled properly with accurate accounting. When a client has a particular need, the expectation is that it will be handled expeditiously without error. Excellent and consistent service is the hallmark of a well-run investment firm.
RCM’s standards require that any client servicing need will be handled within twenty-four hours. Most issues are handled and resolved immediately. Some complicated issues like account transfers and consolidations take a little longer. Our staff takes pride in the service they provide. All have extensive industry experience.
Performance is the bottom line. It ultimately is what makes investment management worth paying for. However, performance has to be measured against the client’s stated goals and criteria. Clients differ in the risk they want to accept. Some may have income needs, a liquidity criteria, or particular preferences. Good managers adjust their approach to meet the criteria of each client.
There are some standards that can provide broad comparison. RCM measures its performance for each client against the most appropriate measure for their portfolio. RCM also aggregates individual performance measures to determine how the firm is performing as a whole. RCM’s goal is to perform in the top 25% of its peer group on a consistent basis. Thankfully this mostly has been the case. We are proud of the results we have produced for our clients over the past difficult investment period. RCM continues to adapt and adjust its investment processes to further enhance its performance.
If you are looking for integrity, excellent service, and top tier performance, Talk with Us.
Major Indices as of 6/30/2005
Large Cap Stocks (S&P 500) -1.70
Dow Jones Industrial Average -4.71
Mid Cap Stocks (S&P 400) 3.26
NASDAQ Composite -5.45
Small Cap Stocks (Russell 2000) -1.83
MSCI EAFE -2.76
Lehman Corp. Bond Index 1.72
Inflation 2.8
(Equity indices are six-month returns excluding dividends)