7.23.20042004 Second Quarter Client Letter Economic Update: Slower Growth Ahead On June 13, 2003, the yield on the 10-Year Note was 3.1%. On May 19, 2004, the yield had increased to 4.9%. This represents a 58% rise in the interest rate. Historically, when the 10-Year Treasury Note yield increases more than 50%, the growth rate of the economy is cut in half within a year. I often hear investor concerns about Federal Reserve actions and the effect on their portfolio and mortgage rates. This rise in the 10-Year Treasury occurred prior to the Federal Reserve raising the Fed Funds rate ¼ percent on June 30th. The bond market is efficient and usually moves prior to Federal Reserve actions. The economic slow down has begun. In the 1st quarter 2004, Gross Domestic Product grew at an annual real rate of 3.9%, down from 4.1% in the 4th quarter 2003. The following chart predicts economic growth continuing to slow. Market Update Last quarter, I commented that the stock market’s volatility in the 4th year of a presidential term is normally 33% lower than average. In actuality, this year the volatility has been 65% lower than normal, with a standard deviation of only 6% instead of historically 20%. The S&P500 has closed between 1100 and 1150 over 89% of the all trading days this year. Election years have shown dramatically different results from August to November, depending on the results of the election. If the incumbent wins, the market goes up dramatically. If the incumbent loses the market sells off. My short-term concerns for the market are investors’ extreme optimism for the stock market and the slowing economy. As we have mentioned before, if investors are too optimistic and are fully committed to the market, the market will go lower. Investors’ enthusiasm for equities and the pending economic slowdown has limited the stock market’s advance. On the positive side, the Price to Earnings (P/E) ratio has been falling and record levels of cash are sitting in money market accounts. These savings deposits have increased from $1.9 trillion in 2001 to $3.4 trillion today. This represents a tremendous amount of future buying power. P/E ratios are falling, because corporate earnings are rising. If earnings projections are met, the P/E ratio of the S&P500 will be 18. The historical average of this ratio is 16. This is the lowest the P/E ratio has been since September 1995. Why is the stock market not going up if earnings are increasing? Stock prices are based on discounting future earnings. As interest rates increase, the discount rate of future earnings increases. For stock prices to increase, earnings must increase faster than interest rates. Portfolio Update We are frustrated and disappointed with this quarter’s performance. The conservative and hedging-oriented investments such as government and high yield bonds, merger arbitrage, and gold all had negative returns, while the equity market was slightly positive. In addition, in April, China decided to stop artificially financing their robust economy. As a result, commodity prices quickly adjusted to the slower future growth in the world’s most populous country. Commodities in the short-term will have limited upside, but long-term appear they are still in a bull market. We chose to reduce our commodity allocation for the time being. During the quarter, we sold some US equities as the market began to disappoint. As a result of these sales, we are holding higher levels of cash/money market investments. Money market rates of 1% less taxes and inflation make their real rate of return -2%. The unattractiveness of this is still better than making less attractive equity investments. Therefore, we will remain more heavily weighted in cash until the investing environment becomes more appealing. Directionless markets are difficult for making money. During this range bound market, buying for short periods and quickly selling market rallies is the predominant method to make money. We don’t believe this is a prudent long-term investment philosophy because these periods don’t last longer than a couple of quarters. We expect the market to become more volatile and directional as the election approaches. When range-bound markets break out of their range, their break outs are generally violent in nature. The market could move quickly higher or lower. In either case, we will be prepared for such a move. Thank you for your continued trust, support, and patience! Trevor K. Holsinger, CFP