RCM October03 Perspective

Surprise, surprise! The third quarter has typically been a difficult quarter, this year it was good. It just goes to show “you can never tell”. The gain for the quarter by the broader market as measured by the S&P 500 was approximately 2.5%. The year-to-date gain is about 13%.

The market advance was broad with most investment styles and company sizes participating. Early in the quarter, smaller companies did better than large ones and the growth style did better than value. By the end of the quarter, however, the differences were not large and a more mixed picture emerged.

Second quarter earnings reports, announced in July, on average were better than expected. We now await the results for the third quarter-- most companies will report these in October. The ratio of negative to positive pre-announcements is as low as it has been in a long time. It looks like another good quarter for earnings is in the offing.

The bond market was the biggest story during the quarter. In July, interest rates took as big a jump in a short period of time as we ever have seen. As it became obvious that economic growth was accelerating, interest rates for the ten-year Treasury bond jumped from under 4% to over 4.5% in one week. It was quite a shock to many and fixed income managers had to scramble to respond.

Along with higher interest rates, investors also contended with a falling dollar. Other currencies, especially the yen and the euro, appreciated significantly against the dollar. A cheaper dollar makes imports more expensive, but in turn makes our exports more competitive to foreign buyers. The impact of these fluctuations varies from company to company, but this could help exporters.

As Riverplace predicted last quarter, economic growth has accelerated. The third quarter’s growth rate is estimated to be over 4 %, up from the second quarter rate of 3.3%. We expect fourth quarter growth to be over 3.5%.

The most heartening factor about the better growth is that it spread across a fairly wide spectrum of sectors. The consumer sector continues to do well and corporate investment is improving and helping capital equipment suppliers.

Although the acceleration is welcomed, growth is still below rates that are typical of rebounds from other recessions. In past recoveries five to seven percent increases for several quarters have not been unusual. Two factors are different this time. First, the recession was shallow (although it did not feel like it to investors). Second, imported goods are meeting more incremental demand. Some services now are also being provided from offshore sources. (Examples of this phenomenon are call centers being located in India and engineering services provided from China.)

Imports and offshore outsourcing create structural challenges for our economy. (Even though we may all appreciate the opportunity to buy cheaper imported goods and services, we do need a job to provide the income to make those purchases.) A better, but uneven and still-choppy recovery is what we predict. Because these structural problems are likely to persist, unemployment also should remain at higher levels than occurred during past recoveries. These factors may continue to dampen this recovery as compared to recoveries in the past.

Cost cutting helped a number of businesses improve their profits. For many companies, that effort has gone about as far as it can. Increased sales, not cost cutting is now the key to increased profits; fortunately we are starting to see evidence of that.

This environment will not be easy for many firms. What used to be a 12-inch pie for many industries may now be 8 inches. (Remember the structural challenges mentioned earlier.) Every company in the same business can not get back the same slice it used to have. As we wrote last quarter, competition is severe. Only a few firms in each category can do really well.

Thankfully, Riverplace Capital has been successful in identifying many of these.

As mentioned earlier, interest rates have risen. In April of this year, the interest rate on ten-year treasuries reached a low of approximately 3.10%. Those rates are now about 4%. That is about a one-third back up in rates.

As we wrote last quarter, the trend for interest rates has changed from down to up. We expect pauses along the way. We are in one such pause now, but the forces for higher rates are considerable: a better economy, higher government deficits, a weak dollar, and high rate of money supply growth.

A better economy usually is accompanied by more business borrowing. Right now, there is a current high level of consumer loan demand. Additional business demand for credit should lead to higher cost for money and higher interest rates. Increased government borrowing adds to demand for credit and pushes rates higher too. Because we are a debtor nation, we may need higher interest rates to attract foreign investment to fund our debts so modestly higher rates are not necessarily bad. The money supply now is growing far faster than the economy, which means that there are more dollars being created than goods and services. This usually leads to greater inflation also leading to higher interest rates. Still higher rates are in our future.

Picking the right stock is our focus. As we wrote last quarter, this is more important than sector weightings at present. Current corporate performance is key, not promises of future success. Today’s winners within the highly competitive business environment are likely to be stock market winners as well.

Investment themes are likely to be choppy and short-lived. Therefore, we are reducing the size of successful stock positions more quickly taking some profits along the way. We consider this as prudent in these uncertain times. Sell high, buy low!

With the back up in interest rates, we recently made some new commitments. We have limited these bond purchases to ones that mature within 2 ½ years in order to capture better yields as we wait for better opportunities. It also lets us avoid the fall in prices of longer maturity bonds as interest rates rise.

Treasury notes have been our preference. We want the option to sell these early in case higher rates come about sooner than we foresee. Treasuries are the most liquid of bonds and can be traded with less cost than most other obligations.

After many years in the investment business, one learns a lot. Many lessons are about human nature, which really never changes. One learns a great deal more about a person’s character during a short period of tough times than years of good ones.

Others lessons re-learned are those investment principles which have stood many tests and continue to help deal with the confusion of the immediate.

Hindsight always is perfect. It is the decision we have to make today about tomorrow that is so difficult. Here are a few observations that may ring true to you and be helpful.

Investing is hard. Most individuals today are responsible for their own financial security and retirement. Every decision won’t work out. You only need to bat .500 to have excellent returns. Try to recognize your tolerance to risk and what makes good long-term financial sense for you.

It’s never all or nothing. Change is usually best if it is made incrementally. It is also easier to make a change when each step is small. Irresistible pressure to make a dramatic shift in strategy usually occurs late. It may result from not making smaller adjustments along the way.

Most people are honest. Overwhelmingly, business leaders work very hard and try to deliver good results for their owners. Over-reacting to the disappointing behavior of some is not a reason to be out of the market. Doing nothing is not an option. There are always many reasons for inaction. Most individuals today are responsible for their own financial security and retirement. Investing is essential.

Be an early investor. If an investment trend has been missed, don’t worry. At some point every trend gets to the “greater fool stage.” The values long have been overplayed. Look for something new or be patient. Other opportunities will come along. And when they do, don’t expect a lot of confirmation from analysts or the press. If you are truly early, you may feel very much alone.

All investments are not equal. Decide which investments are worth your time and which are not. You have a choice. Have high standards, but don’t become too impatient so long as you have good reason to believe in a good result. Investments all develop on different schedules.

Think long term. Most people over-estimate what can be achieved over the short run and under-estimate the same over the long-term. Consistency, perseverance, and discipline are what count. You will be investing for the rest of your life. Think that way. You can not maniacally day trade for the next 20-30 years. (It won’t take nearly that long for you to lose all your money this way.) Set up a process that will still work 10 years from now. That’s what we do.

If you would like to have a long-term partner with generations of experience, we would be happy to help you. Talk with Us.

Notice

This quarter we celebrate the first year anniversary of our West Coast office in Anaheim Hills, California. This office has been the smoothest expansion we have made. It is a tribute to our fabulous partners there, Patrick Powers, Christine Blanchard, and Matt Herr. The office is off to a strong start.