RCM October02 Perspective

Capitulation? That’s what July seemed like. Fifty two billion dollars was withdrawn from mutual funds alone. No telling how much more selling was done by foreign sources, individual account managers, and individuals. July was a continuation of the late June sell-off, prompted by the news of massive fraud at WorldCom. July 24^th seemed climactic with huge volume and reversal from a vicious down 213 to up 479 points. Was this the bottom?

Unfortunately, the August rebound was on lighter volume than one would expect after July, indicating that many investors were not yet ready to commit new funds. In September the market fell back, re-testing the July lows. Although the corporate governance issues and accounting risks had been mostly factored into the markets, a new risk came to the forefront: war.

This risk also is being factored into both the bond and equity markets. When on September 17, Iraq seemed to acquiesce to inspections, the market was ready to explode to the upside until it became obvious that events would not be resolved so easily.

The talk of war has frozen many longer-term investors from making decisions, thus leaving market participation primarily to speculators and professional traders. Many corporate decisions about future investments also have been put on hold. This has been the recurring theme this year, one event after another, which cumulatively have delayed and muted a normal economic and market recovery.

Over the summer, the recovery hit a speed bump. We are seeing the consequences of that in the increased corporate earnings warnings this quarter. The question before us is whether this is a lagging indicator or a sign of more to come.

Our best guess is that the third quarter was an interruption in the recovery brought about by reaction to corporate scandals, the on-going war on terrorism, and concern about the prospect of war with Iraq. Corporate spending certainly was put on hold and even the consumer seemed to grow more cautious.

The only sectors that did well were autos and housing. Apparently many see the zero percent financing for autos and the low interest rates for homes as a rare opportunity, not to be missed. However, beyond these two sectors, consumer caution seemed evident.

Almost unnoticed are the Fed.’s moves to boost money supply, home refinancing liquidity, improving trade balance, and government spending. In short, the economy probably still grew by 3.5-4.0% in the third quarter. Profits for the average S&P 500 company in the third quarter most likely increased by between 5-10%. Our best guess is that as these positive factors eventually kick in, economic growth should broaden beyond autos and housing.

The reaction in the market to negative news is far worse than warranted. Good news hardly gets play. Equity markets remain thin, with mostly speculators and market makers the primary participants. That’s why daily moves often can approach a significant portion of an entire typical year’s return. Analysts unfortunately almost never see change coming, just like the bear market most of them missed. Many can now only extrapolate current conditions.

Volatility usually signals that change is coming. If we are correct in assuming that the economic recovery will get back on track in the fourth quarter, then equities should follow. Equity performance is generally now concurrent with or lagging the actual performance of the companies they represent. Today’s investor wants to see proof of performance before new funds are committed.

After two years of a bear market, historical precedence had pointed to good returns this year. However, that now seems unlikely, although some recovery is possible. The best we can hope for is that the end of this bear is at hand and a new upturn is near. Historically, initial returns after severe downturns usually are very impressive. Obviously, geo-political events (such as the potential for war with Iraq) play into the scenario; that the fear engendered by these unknown risks makes investors unwilling to participate in what otherwise should be a favorable market.

We can not estimate the probabilities of war with Iraq or the course of such a war. However, the last one marked the bottom of the ‘91-92 bear market and the beginning of the bull market of the 1990s. Uncertainty is what is holding things back today.

U.S. Treasury obligations continued to benefit from the fall-out from the equity markets and the prospects for war. They are very expensive. Five-year yields are under 3% and ten-year under 4%. We believe that commitments to such returns will later be viewed as poor decisions. Also reinforcing the notion that fear is driving the process: the spreads between the available yields on treasury obligations and those of other fixed income instruments widened. Fear is driving money into these instruments, not rational expectations for the future.

We have not changed our strategy of being invested for economic recovery. Even though the corporate scandals and new accounting certifications froze corporate decision-makers over the summer, signs are evident that things are improving. Capital spending has stabilized and is showing signs of improvement in certain categories. The consumer liquefied with home refinancing proceeds and lower interest rates, is likely to continue to power an economic upturn. If the conflict with Iraq is resolved quickly or without war, markets are poised for impressive recoveries.

The cash we raised in many portfolios earlier in the year has not yet all been reapplied. We expect to have this opportunity in the not too distant future. In the meantime, we are closely monitoring events, looking for opportunities.

We continue our cautious policy to new commitments toward fixed income investments. Core inflation is now tracking at about 2.7%; up from about 1.8% last year, so concern about future interest rate rises seems warranted. Because corporate bonds remain severely under-priced relative to treasuries, we have added a few short maturity issues to some accounts. Cash reserves, however, remain a priority.

The scandals, accounting issues, and prospects for war only have postponed a correction in the bond market back to higher yields, not eliminated it.

What is your investment horizon? It’s probably a lot longer than you think. Most investors will have holdings for the rest of their lives. These holdings may provide a legacy for the next generation and/or charitable activities.

The primary purpose for most investors is to provide for their retirement. Since the 1980s, most companies in America retreated from the traditional pension funding for workers and instead turned over the responsibility for retirement funding to each employee --- sometimes with a promise to merely help in the process by setting up certain contributory plans and, perhaps, making some limited contribution.

Employees, with the help of professionals, were expected to set up allocations based upon their own risk tolerances and preferences. When times were good, everyone seemed to be satisfied with this arrangement. However, today, after 30 months of downturn, many are having doubts and expressing concern.

Virtually all investors are aware of the historical long-term returns that equities and fixed income markets provide. And all mature people know that over a long period of time, results will vary: sometimes good, sometimes bad. Knowing this, how should investors respond to today’s market?

Obviously some have sold. Realistically, however, it would seem that downturns provide opportunities. Since most of us will be investing for a long-term horizon, even if retired, why not view cheap stocks as potential bargains, an opportunity to add to one’s future portfolio growth rate? Obviously, each individual’s circumstances and current needs are important considerations, but the logic of buying cheap is compelling. Corporate insiders now are buying at a very bullish rate and even Warren Buffet is finding some bargains.

Why, then, the sudden fixation with short-term results? Why sell a good company that missed some analyst’s expectations by a few cents? Part of the reason is that an entire industry has grown up around the need to serve transactions. The financial media (print, audio, and visual) bombard the investing public every day with learned opinions, undue concentration on minutiae, and the immediate sensation. There are times a position needs to be sold, such as when business outlook changes and becomes unfavorable for an extended period or when management has failed in a significant way. However, these situations arise far less frequently than a transaction minded industry would have us think.

Diversification and balance are key ingredients to weathering significant downturns. Every investment will not work out, but enough will, to provide solid returns. We at Riverplace Capital can not foretell the future, but we believe the past has been a good guide. We are optimistic. Talk with Us.

Notice

Riverplace Capital, Inc. (RCM) is proud to announce the establishment of its West Coast office in Anaheim Hills, California. The two principals of this office are Patrick D. Powers, Vice President and Managing Director, and Christine Blanchard. Both Pat and Christine are Certified Financial Analysts (CFAs), and Pat has also earned Certified Financial Planner and CPA designations. With nearly 27 years of combined investment experience, Pat and Christine will perform analytical research and portfolio management services for RCM’s clients. They are members of RCM’s Investment Management Committee. We look forward to their contributions to our investment process and continued growth.