10.10.20042004-Third Quarter Client Letter Economic Update: Continued Slow Growth The economic slow down continues as real GDP growth in the 2nd Quarter was 3.3%, down from 3.9% in the 1st quarter 2004 and 4.1% in the 4th quarter 2003. Projected economic growth, as the chart depicts, has flat lined. Future growth, eight months from now, is projected to be zero percent. Higher oil prices, election uncertainty, and the temporary rise in interest rates are contributing factors. Market Update: Negative “When everyone thinks alike, everyone is likely to be wrong." By Humphrey Neill, The Art of Contrary Thinking. The financial markets have an amazing ability to fool investors. When the majority of investors are convinced economic conditions are conducive for positive equity gains, as they were at peak of the dot.com bubble in early 2000, the market quickly moved in the opposite direction. When economic conditions seem most bleak, as they did in the fall of 1998 during the Asian crisis or the fall of 2002, the stock market soared. Why is this? Theoretically, when investors’ capital is fully invested in the market, they have few additional resources to purchase additional equities. They can only sell. When selling exceeds buying, the market will go lower. Likewise, when investors are so negative with many of their investments in cash, they can’t sell anymore, they can only buy. When there is more buying than selling, prices will go higher. Where are we today….fully invested or in cash? Are investors optimistic or pessimistic? Most investors are optimistic and fully invested. One measurement of investor optimism or pessimism is the volatility index (VIX), a gauge of investor’s confidence or lack of confidence in the market conditions. The VIX measures the price investors are willing to pay for puts, or insurance on their portfolio of stocks. A put option is a contract that gives the owner (of the put) the right to sell an underlying security to the seller of the put at a specified price up to a specified date. The following two charts illustrate the VIX and the S&P500 over the past year. Note whenever the VIX is high, the S&P500 rallies and vice versa. In September 2003, March 2004, May 2004, and August 2004, the VIX peaked at higher levels. At these higher levels, investors are paying more for insurance, because they are pessimistic about the market. Subsequent to these VIX peaks, the S&P500 rallied. Likewise, a low VIX usually spells trouble for equities. Low VIX readings occurred in February 2004, April 2004, July 2004, and now. Each VIX low was followed by equity declines. Currently, the VIX is at the low end of its recent trading range and the S&P500 is at the high end of its trading range. Just because the VIX is low does not mean it can’t go lower. If the market goes higher, the VIX will go even lower. As discussed, a low VIX is not good for the market. Therefore, we believe the optimism, as represented by the low VIX, will limit any market advance. We believe “everyone is thinking alike” and the market has more risk (of a sell off) than reward (of a rally). Portfolio Update: Caution The weakest sectors in the second quarter were the strongest sectors in the third quarter. The conservative and hedging-oriented investments such as government and high yield bonds and gold had positive returns, while the equity markets were negative. We have successfully avoided the US Large Capitalization sector. We continue to hold higher levels of cash/money market investments. Instead of investing in bonds with low interest rates, we are beginning to purchase high dividend paying preferred stocks. These more conservative stocks are paying annual dividends between 4-8%. On a risk-adjusted basis, we believe these will provide some upside, with limited downside, during this uncertain period. Due to investor optimism, we would rather be safe than sorry. We continue to expect the market to become more volatile and directional after the election, regardless of who wins. Moreover, if Kerry wins the election, we anticipate additional equity weakness. We believe a Kerry victory could be accompanied by an increase in the capital gains income tax rate from 15% to 20%. This would encourage investors to realize capital gains by selling equities at the current lower long-term capital gains rates. Announcements: New Associates We are pleased to announce our newest professional staff members: Nick Blasi and Marcy Lewis. Nick interned with us in the past spring during his final semester at the University of Kansas. Nick earned a Business Administration degree and joined us full-time in June. His responsibilities include client relationship management and financial planning. Marcy joins us this month as our Office Manager. Marcy comes to us with broad experiences in the marketing and healthcare industries. She is excited to assist our clients, as well as oversee administrative functions within the office. Thank you for your continued trust, support, and patience! Trevor K. Holsinger, CFP