RCM October04 Perspective

More of the same. The trading range we described in the second quarter’s “Perspectives” continued. Although the stock market was down in July and August before recovering in September, that trading range held.

The big concern over the summer months was the rising price of oil and the impact it could have on the economy. Oil recently has exceeded $50 per barrel. Oil stocks did well, but most everything else suffered. (The oil sector seems to do well at the expense of the rest of the economy and market.) Consumer stocks, such as retailers, were particularly hard hit as investors surmised that higher gasoline prices reduced consumers’ discretionary dollars.

Because the economy was seen to suffer from the high energy prices, inflationary concerns were suppressed, leading to a rally in the bond market. Bond yields dropped from about 5% on the ten-year Treasury bond to about 4%. That is quite a rally and a good demonstration of the importance of having a disciplined, diversified portfolio.

Besides oil, the general environment was affected by the deteriorating situation in Iraq and ongoing concerns about terrorism. This kept investors in a cautious mood, in spite of generally excellent business results. Earnings for the second quarter, reported in July, were more than 20% above the same quarter of the previous year, for the fourth quarter in a row. Total earnings for the S&P 500 companies hit yet another record.

Third quarter earnings also are expected to show an excellent increase. Most of these will be reported in October. However, it is unlikely that they will exceed a 20 percent gain; 15 percent is a more realistic estimate. Earnings gains are decelerating but should remain healthy. This moderation is inevitable as the economic recovery matures.

The political uncertainty of the presidential election will be resolved soon. The Iraq war will continue and so will the threat of terrorism. It is important to keep in mind that markets always have concerns: just look back at the tumultuous 20th century. It is the course of the economy and the profitability of companies that always emerge as the important factors in setting the value for companies.

In the third quarter, the economy drifted into a soft patch, which may have been precipitated by having to absorb higher energy costs. The worry was whether this was a slight deceleration in the rate of economic growth or a sign that the economy was starting a new and protracted downturn.

Economic measures (such as consumer confidence, GDP, and employment measures) are more mixed than in the recent past, but still indicate continued growth, just at a slightly slower pace. Higher energy costs have acted like a tax, in that it results in taking money away from other purchases.

At the beginning of the year, Riverplace Capital predicted that economic progress this year likely was to be irregular and that has been the case. However, we thought that the result would be growth at 4% or better. That might now be too high. Total growth of 3.5 – 4% is probably a more realistic estimate; slightly less, but still a very healthy rate of expansion. It should be noted that the estimate of GDP growth for the second quarter has recently been raised from 2.8% to 3.3%. As a result, we believe that the third quarter GDP growth may come in higher than expected too.

Except for a brief sell-off during the summer months, stock prices have been in a trading range all year. Riverplace Capital earlier predicted that the eventual breakout from this trading range would be to the upside. The underlying case for this prediction is our belief that the economy would continue to expand and profits continue to grow. So far this year profits growth has exceeded expectations and the economy’s outlook is for continued expansion at a healthy rate.

Corporate operating earnings per share for the S&P 500 companies are projected to rise to $63.25 from $54.34 last year. This has resulted in a substantial decrease in the market price-earnings ratio. The result is that the market is much more affordable now than it was at the beginning of the year. Therefore Riverplace Capital reiterates its prediction for an upside breakout and respectable year-end returns.

This past quarter the Fed raised its Fed Funds Rate twice. Since the first of the year this rate has been raised three times. In each case the increase was a quarter of a percent. The Fed Funds Rate is now 1 ¾%. We expect that the Fed will continue raising rates at this pace through next year.

Inflationary concerns, general investor caution and the impact of foreign central banks attempting to manage their exchange rates have affected longer-term interest rates. (See the Talk With Us section for an in-depth discussion of this.)

We continue to predict higher interest rates. Economics will win out over attempts to manage currencies, under reporting of inflation by the Labor Department, and current investor caution. Economic forces always win out over the long-term.

Riverplace Capital positioned portfolios to benefit from the expanding economy. We have replaced positions that could be unusually adversely affected by either terrorism or change of leadership in the White House. Our portfolios are defensive in down markets and are outperforming in up markets.

Finding and owning companies that will grow consistently over the next few years is our goal. There is a very strong relationship between the increase in a company’s profits and the increase in the price of its stock. Other factors, such as terrorism, may affect this relationship for short periods, but over the long-term stock price is all about profits.

Because of the hurricanes in Florida, some insurance companies are selling some of their corporate bond portfolios in order to finance the settlement of claims. We are finding some short and intermediate term corporate bonds that are attractively priced. For the most part, Riverplace Capital continues to be cautious in committing to any but short-term obligations.

Our bias towards short-term bonds has hurt us a little over the past year as longer-term interest rates have fallen, in spite of the Fed Fund Rate increases. The trend in longer-term rates is in the process of changing now, so our strategy will serve us well in the coming year.

For certain accounts, Riverplace Capital is allocating a portion of fixed income portfolios to high quality international bonds, largely because international interest rates are more attractive than those in the U.S.

Recent trends in the bond market have been puzzling to many. The ten-year Treasury bond recently has declined from almost 5% to about 4% while at the same time the Fed has raised short-term rates from 1% to 1 ¾%. The paradox of rising short-term rates and falling longer-term rates may be explained by a coincidence of four factors.

Firstly, several far-eastern governments are reinvesting the dollars that they are accumulating from their trade surpluses with the U.S. into Treasury bonds. (They do this by first buying dollars and then buying the bonds.) This buying helps keep their currency exchange rates at present levels, ensuring that their currencies are cheap relative to the U.S. dollar, which in turn makes their exports attractive to us. Maintaining these exports and having a competitive advantage is more important to the foreign economies than the return they get by investing these surplus dollars in our Treasury bonds. Their surpluses are large; hence purchases of our bonds are helping push interest rates down.

Second, the domestic bond market is not currently concerned about inflation. Reported inflation is running around 2%. Many investors judge that this rate will stay low because of global competitive pressures. We believe significant measurement problems exist in the methodology used to calculate consumer inflation, which in turn has resulted in under-reporting of this index. One example is that housing costs are calculated by tracking rents. (Rents are considered a good way to track housing costs because they are generally paid under short-term contracts and can adjust to conditions fairly rapidly.) However, rents have been depressed because many would-be renters have been able to buy their own home with low mortgage interest rates. Therefore rents are not accurately reflecting the rise in housing costs as experienced by a large segment of consumers. There are other such examples.

Third, after the recent bear market in stocks, many investors have a more cautious attitude, more inclined to accept less return for the promise of safety. Terrorism and other geo-political concerns have reinforced this predilection. Their willingness to buy bonds at rates, which provide little to no real return, also has helped keep rates low.

Lastly, corporations in the U.S. are accumulating cash. Instead of borrowing to fund their operations, they are paying down their debts. Municipalities also are not increasing their borrowing significantly. For the most part their activities are confined to refinancing existing debt. Thus foreigners are willing to finance our trade and budget deficits for their own purpose of maintaining a favorable exchange rate. There is greater investor acceptance of lower rates. Demand from the corporate and municipal sectors is low. There is less concern about reported inflation. Therefore, it is not surprising that long-term rates have declined in the face of the Fed raising short-term rates.

The implications of this phenomenon are that investors are not receiving a fair return for investments in longer-term bonds. Therefore Riverplace Capital has had to adjust its fixed income approach. We are doing this while still maintaining our criteria for safety.

If you would like to work with a firm that prizes research and analysis in order to produce results, Talk With Us.

Riverplace Capital would like to acknowledge the devastation inflicted on Floridians by the recent hurricanes. Our thoughts and prayers go out to those whom have suffered from great personal loss. We also want to recognize and appreciate the selfless and compassionate efforts provided by our police, fire and public employees who have tirelessly endeavored to help those in need.