Quarterly Commentary:
October 2004

Departure from Conventional Wisdom

Financial planners and the Wall Street brokerage community have established and marketed an investment methodology for the “prudent, long-term investor.” A diversified portfolio of equity and fixed income securities is established, based on the client’s risk profile and time horizon. The asset allocation will vary somewhat: perhaps 40-50% equities for the conservative investor, often 70-80% equities allocation for aggressive or long-term positions. In all but the most short-term accounts, a substantial and permanent percentage of the portfolio is allocated to the stock market. The portfolio is then regularly rebalanced to maintain the original proportions.

The prudent investor is counseled to stay the course. Attempting to alter the allocation, buy low or sell high, or otherwise react to prevailing market dynamics is considered day trading, market timing, or some other pejorative and, by implication, not prudent.

Then there’s Warren Buffet. In 1969, Warren was so bearish on equities that he cashed out entirely and gave investors back their money (recommending municipal bonds). In 1979, he was so excited about the stock market, he “felt like an oversexed man in a harem” (his quote, not ours). Warren is not particularly concerned about diversification, having made his fortune through highly concentrated holdings. Warren actually violates many of the principals marketed today as prudent investing.

Modern portfolio theory is a statistical model. It requires future asset class performance estimates and forecasts, often derived from an analysis of historical data. It is true that equities have provided superior returns over long periods of time. It is also true that equities have performed poorly or even disastrously for decades. For very wealthy individuals, pension funds, and foundations, the law of large numbers applies. The rest of us cannot afford to be so sanguine.

From 1964-1981, GNP grew by 373%, and yet the Dow Jones only increased from 874.12 to 875. The patient, buy-and-hold investor earned a compounded return of one-tenth of one percent over this seventeen-year period. Why did stocks perform so poorly for so long? Among the factors, rising interest rates. In December, 1964, long-term government bonds yielded 4.20%; in 1981, 13.65%.

Over-adherence to a static asset allocation model, as practiced by most of Wall Street, provides a false sense of control. It is not only unwise, it is dangerous.

Relative value: We are not predisposed or obligated to invest at any time in stocks, bonds, or any particular investment vehicle. We do operate within specified risk/reward parameters, established individually with each client. We do not short sell, invest in options or futures contracts, or buy on margin. Other than that, everything is fair game. Sometimes, as is the nature of markets, investments perceived to be riskiest are actually the safest. If market conditions suggest that we hold cash, we hold cash.

Risk: We look down before we look up. We prefer to avoid a loss, rather than overstay a risky market in fear of missing a profit opportunity. This is not because we are particularly conservative; it is because of the math. We are paid to grow your money over time, and one bad year makes a mess of our compounding.

Will we make a bad trade? Absolutely. Will we, at times, lose money or underperform in certain markets? Without a doubt. However, we always have a theme, reason, or set of arguments upon which we base our investment decisions. We refuse to invest in an asset class simply out of some ideological insistence for diversification.

Hedge funds: Groucho Marx is quoted as saying he would never join a country club that would accept him for a member. That’s how we feel about hedge funds.

Hedge funds were traditionally a vehicle in which a highly successful money manager allowed a few of his closest and richest friends to participate. In our opinion, these are the only hedge funds truly worth investing in. If you travel in these circles, you know who you are, and you don’t need any help from us.

Hedge funds are the new fashion. Many have been created by mediocre managers, with mediocre performance, and outrageous fees. We are still looking.

The Quarter in Review

Oil prices, terrorism, and an uncertain presidential election kept a lot of investors on the sidelines, or in cash. Contrary economic statistics over the summer suggest the economic recovery may not be so certain. The wholesale flight from the bond market in the second quarter reversed itself as interest rates declined back down to forty-year lows.

Equity prices were a manifestation of low interest rates and expectations of a robust recovery. As the Federal Reserve changed course, and forthcoming economic data offered less optimism, we became increasingly bearish over the summer. We set stop-loss limits for our primary domestic (SPY) and international (EFA) equity positions. These limits triggered in July, reducing our maximum equity exposure in some accounts to about 40% of total assets. These funds were reallocated to adjustable-rate bond funds.

• Standard & Poor’s 500 Index, third quarter: -2.3

Fixed-income declined so precipitously in the second quarter, we felt there was little additional price risk. As described in our second-quarter Commentary, we took a contrarian approach and bought yield.

We collected those high coupons and, as interest rates declined again, realized capital gains as bond prices soared. Our Nuveen Quality Preferred Income Fund (JPS) position yields 8-9.5% (depending on purchase price), and appreciated almost 9 % for the quarter. Our other primary position was leveraged, adjustable-rate bond funds. These exchange-traded funds offer about 5.5% yields with a substantial degree of price stability. We used these instead of traditional short-term funds or money market instruments.

• iShares Lehman Aggregate Bond Index, third quarter: +3.75%

The Markets: Inflation and interest rates

The markets are chanting for the Holy Grail of steady economic growth with low inflation. Low inflation implies continued low interest rates. Low interest rates will not necessarily ensure a bull market, but rising interest rates, in response to rising inflation, will likely kill it.

The Federal Reserve clearly sees the economic glass as half-full, and is committed to increase the short-term federal funds rate. The bond market, interpreting the same data, sees the glass as half-empty, as long-term rates decline back down to March lows.

Something has to give.

We just hope the glass isn’t broken. Three years of cheap and easy money, tax cuts, and massive fiscal spending appear to be a “Reaganomics” attempt to outgrow mounting economic problems. Instead, it has created ballooning federal and trade deficits, a falling dollar, and a liquidity bubble that has extended the speculative insanity of the 1990’s. Such conditions must ultimately dominate the credit markets and push interest rates higher. A lot higher. Unless, of course, the bond market is forecasting an economy that is about to seriously weaken. Our overleveraged economy will have little resilience to either significant interest rate shock, or a relapse into recession.

We do not understand how these conditions establish the foundation for a sustained economic recovery, or the resumption of a bull market.

But then again, we could be wrong.

As investors, it is not necessary to always accurately forecast the economic future. It is important to watch market reaction to unfolding economic changes, look for relative value, and manage our risk.

Strategy for Fourth Quarter

The markets are directionless and contradictory. This may continue until after the November election, and probably until the New Year. We expect potentially severe volatility as market perceptions shift. We see little opportunity for capital gains. Our emphasis is on yield, but only with manageable safety of principal. Our overall strategy is to remain liquid and flexible.

Asset allocation: No more than about 40% in equities, and maybe less by selling into market strength. The bulk of our new fixed-income purchases will be adjustable-rate bond funds that provide a degree of price stability, and yield about 5.5%.

Equities: There may be a post-election rally. We will not chase it. We have heard no argument, or can imagine no scenario, in which to favorably view stocks at current price levels. Certainly, we are not comfortable with a buy-and-hold strategy. Should a major correction occur and prices become more attractive, we may change our opinion.

Fixed-income: The yield curve is flattening, as short-term rates increase and long-term rates decrease. This cannot persist. We believe the Fed will not change course, and that the odds are against long-term interest rates remaining so extremely low. We will reduce our long-term positions in market rallies, and reallocate to adjustable-rate funds.

REITS have very interesting qualities. They are valuable yield-bearing instruments, but will arguably participate in an economic recovery as property values and rental payments increase. REITs have exploded in popularity and volume, and prices have certainly behaved like bonds during the declining interest rate market of the last few years. Indeed, most analysts often categorize REIT price risk as comparable to long-term bonds.

We’re not so sure. In fact, we are not sure the market will know how to accurately value REITs in a rising interest rate market. There may be opportunity.

Commodities and oil stocks are essentially a bet on inflation. As long-term rates fall, inflationary pressures have arguably subsided. We are not sure we understand the dynamics of this market, but suspect if there was an opportunity, we probably missed it.

Tactics for Fourth Quarter

It bears repeating: we limit reallocation to about once a quarter, but permit trades if an opportunity presents itself. Active trading often leads to over-reaction to market and current events, and we start to make mistakes.

Current Equity positions are the remainder of our third-quarter allocation:

Diamonds (DVY) – dividend-paying Dow Stocks	15% (total portfolio)
iShares Europe (EZU)	7.5%
iShares Japan (EWJ)	7.5%
iShares Russell 2000 (IWM)– small blend	6%
iShares Russell Mid-Cap (IWR)	6%

Fixed-income does not appear to be always efficient. Several bond funds we watch have almost identical characteristics, and yet will trade differently or contrary on the same day. Consequently, we will spread our positions among several funds in each category, and occasionally re-allocate to manage our risk.

Short-term, price stability

• iShares Lehman 1-3 year Treasury bond fund (SHY). Yields about 1.5%, yet still declined about 1.75%. Sterile money. We have been selling this fund and reallocating to the adjustable rate funds to increase yield.
• Nuveen, Pimco adjustable senior lien notes (NSL, JFR, PFL). Exchange-traded funds, invests in corporate senior lien loans, leveraged by about 30% to enhance yield. Loan rates adjust annually, so price fluctuation in a rising interest rate market should be minimal. Currently yields about 5.5%.

Higher yield, more price volatility

• Nuveen Quality Preferred Income Fund (JPS). A closed-end preferred stock fund, leveraged by about 30% to enhance the yield. Leveraging works as long as there is a positive slope to the yield curve (short rates low, long rates high). Yield ranges from 7.5% – 9.5%, depending on purchase price.
  We are in no hurry, but will gradually sell this fund in market rallies, for some accounts. Our capital gains will melt away as interest rates rise. Reallocating to the adjustable rate funds will maintain yield and reduce price volatility.
• Kensington REIT. Yields about 6.5%, depending on purchase price. Again, may sell in market rallies. There are better REITs available, with comparable yields and greater opportunities for price appreciation. REIT prices will be volatile as interest rates fluctuate, so timing will be important.
• Van Kampen Strategic Sector Municipal Trust (VKS). Closed-end municipal bond fund for our individual clients in taxable accounts. Yields about 7.5% tax-exempt interest, 11.6% taxable equivalent. Price has been surprisingly stable.

Interest rate hedge, mutual fund

• Rydex Juno fund (RYJUX). It is almost impossible to hedge against, or profit from, rising interest rates, without selling short Treasury bonds or otherwise incurring unacceptable investment risk. And yet rising interest rates will have a disproportionately negative effect on both the stock and bond markets.
  The Rydex Juno fund is a highly specialized mutual fund, designed to hedge against such a fundamental risk. The price moves in the opposite direction of the price of the thirty-year Treasury bond. As such, this fund will appreciate in value as interest rates rise, and as the price of all other fixed-income securities decline. This fund is expensive, and is not a long-term holding. As with such funds, timing is everything. The price is currently at an all-time low. We will allocate about 5% of total assets for our larger accounts.