Client Update – April 2006

Rising interest rates, fear that the housing market may be starting to roll over, a growing current-account deficit, volatile commodity prices, ongoing turmoil in the Middle East—all of these concerns have been on investors’ minds lately. Looking past short-term noise is important in making good investment decisions; but many of these issues are more than noise, and require that we evaluate and try to put them in an investment context.

Given an almost endless list of positives and negatives to consider, our goal is to make a realistic assessment that weighs optimism and pessimism fairly. We give more weight to factors that are material and knowable, and then try to evaluate how they might relate to a clear argument for making a move in your portfolio. Therefore, over the past several years we have made many strategic changes to portfolios due to opportunities and threats created by ever-changing geopolitical and economic events.

There are problems on the horizon. The current-account deficit, the impact of a slowdown in housing prices, and other macro-level risks could all create scenarios where earnings could decline significantly (e.g., a weak dollar would lead to higher interest rates and a recession; lower housing prices could hurt consumer spending, etc.). Earnings growth is still quite good at the moment, but profit margins are near all-time highs, which leaves little room for improvement. All these variables—as well as others—contribute to our belief that the market is fairly valued at this time.

Though there are still plenty of risks in the outlook, and the U.S. and global economies remain volatile, we continue to find opportunities to take advantage of the market and its volatility. We seek opportunities where others see problems. For example, as the dollar falls in value, foreign stocks and bonds reap the benefit. Thus we are inclined to stay with a positive view and will continue to find investments that add value and minimize risk.

Client Update – June 2005

As of this writing, we believe the S&P 500 is roughly 10% below fair value. This surely doesn’t qualify the market as vastly undervalued, especially in light of the significant risks that are out there, but it does provide some cushion.

For us, our analysis always comes back to valuations. There is never a shortage of things to worry about (see our “media” article on the back), but understanding the extent to which those risks are already being reflected in market prices is the key to making good investment decisions.

A very simplistic analysis of return expectations goes something like this: assuming that valuations return to “fair,” that we collect about 2% per year in dividends, and that earnings grow at 3% on average (a conservative number, which is about half their long-term average growth rate), we’d be looking at returns of roughly 7% for the S&P. These valuations also tell us that some level of pessimism is already priced into stocks, so the market is discounting a less-than-rosy outcome. And even if returns end up being only modest, we’d expect our investments to be able to add a bit of extra return above what the market provides.

What’s an investor to do in such an environment? As our natural bias is to err on the side of conservatism rather than exuberance, we are, for the time being, content to hold slightly below-average positions in high-quality bonds and neutral weightings in stocks. This is not exactly an exciting strategy but we are not inclined to take on more portfolio risk until the Fed’s monetary tightening cycle (raising interest rates) is closer to a peak.

Our obligation to you, as always, is to understand the risks associated with your portfolio, and select the investments that best reflect your tolerance for risk and the realities of your financial situation. Further, due to the ever-changing nature of world economic conditions and political events, we continue to do this on an ongoing basis.

Client Update – June 2004

Rising interest rates, fear that the housing market may be starting to roll over, a growing current-account deficit, volatile commodity prices, ongoing turmoil in the Middle East—all of these concerns have been on investors’ minds lately. Looking past short-term noise is important in making good investment decisions; but many of these issues are more than noise, and require that we evaluate and try to put them in an investment context.

Given an almost endless list of positives and negatives to consider, our goal is to make a realistic assessment that weighs optimism and pessimism fairly. We give more weight to factors that are material and knowable, and then try to evaluate how they might relate to a clear argument for making a move in your portfolio. Therefore, over the past several years we have made many strategic changes to portfolios due to opportunities and threats created by ever-changing geopolitical and economic events.

There are problems on the horizon. The current-account deficit, the impact of a slowdown in housing prices, and other macro-level risks could all create scenarios where earnings could decline significantly (e.g., a weak dollar would lead to higher interest rates and a recession; lower housing prices could hurt consumer spending, etc.). Earnings growth is still quite good at the moment, but profit margins are near all-time highs, which leaves little room for improvement. All these variables—as well as others—contribute to our belief that the market is fairly valued at this time.

Though there are still plenty of risks in the outlook, and the U.S. and global economies remain volatile, we continue to find opportunities to take advantage of the market and its volatility. We seek opportunities where others see problems. For example, as the dollar falls in value, foreign stocks and bonds reap the benefit. Thus we are inclined to stay with a positive view and will continue to find investments that add value and minimize risk.

What Should I Do Now?

Taking Control of Your Investments in Turbulent Times

As the investment markets have dropped significantly from their March 2000 highs, you most likely have watched your portfolio value drop unnecessarily. But at the same time a more worrisome drop may have occurred—a drop in your confidence as an investor, a drop caused by both the severity of the declines and a lack of guidance and direction regarding how best to get back on track toward your long-term goals.

Investor “Red Flags”
If that’s your situation, you should know that the key to regaining control over your investing future lies in asking yourself some basic questions:

Has it been a while since you and your advisor reviewed your strategy?
Are you paying large tax bills, even though your investment portfolio has dropped in value?
Most importantly, are you not getting sufficient advice and guidance from your financial advisor on reducing losses and enhancing your chances of regaining lost ground?

Back to the Basics
If you are experiencing any of these “Red Flags,” then this could be an indication that your investment strategy doesn’t accurately reflect your current personal situation. For example, your portfolio now could:

Have become too concentrated in certain industries or types of securities (such as technology stocks) in an attempt to capitalize on short-term market trends;
Contain more risk than you may find comfortable in today’s environment;
Be poorly designed—or not at all designed—to consider after-tax returns;
Be generating significant costs and expenses without providing personalized service and guidance in return.

The best way to correct this situation and take back control of your investing process is a thorough, objective analysis of your portfolio and strategy. This “financial checkup” is one way to ensure that your portfolio is properly managed and your strategy still suitable. A comprehensive portfolio assessment should include not only your individual securities holdings, but also an assessment of your goals and risk tolerance, your tax status and potential liabilities, and a cost/benefit analysis of the fees and expenses you are paying.

Next Steps
If you want to take back control of your investments then you should get this financial review. This checkup could simply reconfirm that you should “stay the course” with your current strategy. More likely, it will help identify if changes are necessary to better reflect your current concerns and needs. A “financial checkup” can help you regain control of your investment strategy and provide a lifetime of benefits for you and your family. What should you do now? Please take the time now to find the right answer for you.

Published in Westlake Magazine – April 2004

Market Update

There are three problems currently facing the economy and markets. First, too much credit was created for individuals, corporations, and government and it needs to be unwound. Individuals and corporations have begun that process and it will continue for several years. Second, the U.S. economy’s recession began near the start of 2008. Even though government statistics masked its existence, it was evident through common sense observation. Recessions are a natural part of the business cycle and need not be feared. They generally last 12-16 months, causing stock markets returns to be low or slightly negative for a few months and bond prices to rise, offsetting some of the stock market’s return. However, the third factor, the recent credit freeze, has caused a powerful flight from risk pushing virtually all security prices much lower. This, in turn, makes the first two problems worse.

The credit freeze is much like a financial heart attack. It does not matter what other illnesses the patient may have, because they become irrelevant if the heart cannot be restarted. If credit does not flow through the economy’s veins, then business will come to a halt. Every week that conditions were frozen will likely add one month to the patient’s recovery. Thus, we expect that the four weeks from mid-September to mid-October will add four months to our recession, taking us out to mid-2009 before conditions begin to look better. The stock market, however, will anticipate the recovery and begin to move higher before the news media can report improving conditions.

Carpe Annum

As you read the newspaper or listen to the evening news, you hear a litany of reasons explaining our turbulent stock market: the economic recovery has stalled; earnings have disappointed; oil prices are high; deflation seems just around the corner. And to further complicate our nation’s economic situation, the threat of war with Iraq looms on the horizon. It makes a certain amount of sense that the market should be encountering instability as a result of these concerns. But they don’t adequately explain the sharp deterioration in confidence that has gripped not just our nation, but countries around the globe.

It is the combination of all of these factors which has led U.S. investors to what has become a crisis of confidence. Confidence is indeed depressed but the question is why has the result been so unusually harsh? Though our situation seems grim, we must remember that oil prices have been high in the past; the pace of economic growth, while somewhat disappointing, is still positive; deflation is under the control of the Fed; and earnings are up. But upon further inspection, one can see that our market seems to be falling into a cycle. The economy is weak because the market has drained consumer confidence. This crisis of confidence leads to lower market growth and this lower growth means fewer profits. This further drains consumer confidence, the economy weakens further and thus the cycle continues…

There is, however, a light at the end of this tunnel. The cycle can be broken when investors examine the facts and focus on the reality that the U.S. economy, for all the disappointments it’s delivered, is not in bad shape. GDP growth is positive and productivity is rising sharply. The unemployment rate remains near 6%; job growth is positive, if slow; consumer durables and housing are strong; and inflation and interest rates are low. It’s easy for us to lose sight of these fundamental supports when growth doesn’t necessarily meet expectations.

In the short-term, stray factors can influence stock prices and cause valuations to deviate from fair value. Sometimes these deviations can be rather large and last for quite some time, as we saw in the late ‘90s. But eventually the fundamental principles of capitalism will overcome, and the market will reflect a fair price that’s based on real earnings growth. In every market environment, good or bad, there are always opportunities and risks. A good investor will find some of the opportunities and avoid most of the risks. In 2003, most investors will once again be surprised by the market - missing the best opportunities. What will you do?

Published in Westlake Magazine – February 2003

Client Update – January 10, 2003

While the fourth quarter was strong for stocks and high-yield bonds, it was small consolation in a tough year. For the year, every S&P industry sector was down and eight of the ten experienced double-digit loss. It has been sixty years since the market has fallen three straight years, and 2002 was the worst single year since 1974.

In our opinion, there are a number of factors that contributed to the bear market, but without question the biggest was the stock market’s tech bubble. Terrorism and war fears didn’t help, but these only contributed at the margin to the magnitude and length of the bear market. Corporate shenanigans also hurt, but were not the driver—just another outgrowth of the environment of bubble-driven greed.

It is almost a tradition for investment professionals and the media to issue a forecast at the beginning of each year. But in any particular year there are many factors that play out differently than expected (e.g. Enron & Worldcom), and other potential issues that simply can’t be foreseen (e.g. 9/11). This makes accurate forecasting very difficult. Instead, to achieve long-term investment success we believe it is essential that we base our strategies only on analysis that we are highly confident in, not hope or speculation. This necessitates a relatively long-term time horizon, since we have a much higher level of confidence in our ability to assess long-term factors.

As we look out over the next five years we are optimistic and believe financial markets are likely to deliver decent returns relative to inflation. There remains a lot of cash sitting on the sidelines waiting to enter, corporate valuations are moderate, and interest rates and inflation are low. While we won’t be seeing anything like the 1990’s Bull for many years, we don’t expect to be visited by the Bear anytime soon either.