Broker Check

Quarterly Newsletter October 2004

Quarterly Investment Commentary | October 2004


September was a solid month for equity markets and, generally, a very strong month for our mutual funds. For the full quarter, however, equity markets were under water. Concerns about oil prices, geopolitics, the election, employment, and earnings all contributed to equities’ weakness while fueling a bond rally. For 2004, small caps and foreign funds continued to be strong performers and contributed significantly to our portfolios’ outperformance.


Let’s Be Rational

For optimists and pessimists, their views can influence what they see. For rationalists, what they see determines their views. Our job is to weigh the arguments put forth by both optimists and pessimists and assess them rationally and without bias. The optimists might argue (some of these points are specific points made by bullish investors I know and respect):  


The economy is healthy  

Global economic growth is likely to come in at a 30-year high in 2004.

Unemployment claims are low enough to be consistent with a growing, fairly healthy economy.

Credit card delinquency rates have been declining for over a year.

The consumer is in better shape than many think, if you take into account household assets, rather than just debt levels. Asset levels have increased significantly so that consumer balance sheets are solid.

With all the talk of the heavily indebted U.S. consumer, debt as a percentage of disposable income is actually quite a bit lower than it is in either the U.K. or Japan.

Productivity growth remains encouraging. 


Corporations are flush with cash 

Corporate earnings have surged and as a result, cash on balance sheets is extremely high. In fact, for the S&P 500 companies it is roughly double the level it was at the end of 1999. This bodes well for spending (hiring and investment) though the private sector has been cautious in the expansion to this point.


Valuations are quite reasonable

With stock prices down slightly and earnings up this year, valuations are much improved and quite reasonable with P/E multiples in the mid-teens on a forward basis. Multiples haven’t been this low in over seven years. 


Fear can result in excessive pessimism and missed opportunities. There are always things to be afraid of. Investors become paralyzed and miss out on the benefits of long-term economic growth if they allow themselves to be frightened by non-quantifiable, big-picture risks. There is a good chance that this will be a benign cycle, with interest rates and inflation moving higher but still staying low enough to be accommodative. That, coupled with slowing but still strong productivity growth, will contribute to a reasonably attractive investment backdrop. The short interest ratio (this compares short sales to total stock market volume) is extremely high and suggests excessive pessimism on the part of investors. 


On the other hand the pessimists might say:  


The economy has improved but continues to have serious and dangerous structural problems. The economy is walking a tightrope between inflation and deflation. If easy monetary policy ignites inflation, interest rates will rise, possibly leading to a sharp slowdown in consumption. A competitive global economy that still suffers from overcapacity could, ironically, eventually result in deflation—not a healthy scenario for stocks or other equity-type assets. There is great pressure on the Fed to make sure interest rate levels are “just right.”


Household debt levels are high. If interest rates reverse their 20-year downtrend, consumption could slow because of a reluctance to use higher-cost debt. Even though household balance sheets look healthy enough, higher interest rates could cause house prices to decline along with stocks, possibly inflicting damage to household finances. The current account/trade deficit remains huge, at around 5% of GDP and nearing $600 billion (annualized). Asian central banks can’t support the dollar forever. There is risk of a dollar crash that could result in a global recession.

The growing budget deficit is troubling. Budget deficits usually lead to inflation.


Stocks don’t have much upside and there is little margin of safety.

Stock multiples may be low when compared to the latter half of the 1990s but they are still high relative to the rest of history. And given the recent generational bear market, investors are not likely to feel comfortable with valuations that are much higher than today’s levels. If true, stock-market returns will be capped at a rather modest level. And it also suggests that if anything goes wrong stocks are not priced with much margin of safety.

On a long-term basis, earnings are now above their trend line and therefore are likely to grow at a below-average rate, on average, over an extended time period. Profits growth is still okay but is already slowing sharply.  

The geopolitical situation amounts to a security tax at best and a potential economic shock at worst.


Terrorism is an ongoing risk that won’t go away soon. The mere existence of the threat imposes costs to our economy that are the equivalent of a security tax. And at some point an economically damaging terrorist attack seems inevitable. In the meantime, the costs of U.S. involvement in Iraqand Afghanistan add to the budget deficit. The sharp rise in oil prices is equivalent to a tax on oil consumers. And while it’s true that oil prices are not high on an inflation-adjusted basis relative to past peaks, the percentage increase compared to the recent past has been sharp and does result in a marginal drag on the economy. Some of the price rise reflects a geopolitical risk premium. It’s hard to know how long that will stick—but it’s the risk-premium portion that has pushed prices to a level where they really have some economic bite. Some of the increase is also demand-driven (China) and so prices are unlikely to return soon to levels of the last decade.  




Macroeconomic and geopolitical developments are extremely difficult to confidently and accurately assess. So they are not primary drivers of any asset-allocation strategy. I am most comfortable (as always) assessing valuations. At present, based on analyses I respect, equity-type asset classes are generally in a fair-value range, neither overvalued nor undervalued. That suggests that a normal level of risk is reflected in stock prices. For the most part bonds look a bit pricey. Stocks of large companies in the U.S. (large-caps) are in a fair-value range. Some valuation work suggests five-year returns could be as high as 11%, while other metrics suggest mid-single-digit returns in a base-case scenario.

Stocks of small companies (small-caps) are priced in line with large-caps. In other words, they appear neither cheap nor expensive compared to large-caps or on an absolute basis. With respect to value stocks and growth stocks, I have no clear favorite. Most of the analysis I look at shows that they are in a fair-value range relative to one another.


Looking overseas, many countries don’t have the structural imbalances the U.S. has (huge trade deficit, low savings rate, and high debt levels). Foreign stocks look undervalued relative to U.S.stocks. However, they often (usually in the case of Europe) sell at a discount to the U.S. and outperformance has not always followed periods when the discount was wide. There is less confidence in the quality of the data available on foreign stock-market valuations.

REITs have surged this year. They are no longer undervalued and by most metrics they appear to be a bit pricey, although probably still within a fair-value range. Increasing interest rates could adversely impact REITs.

High-yield bonds are no bargain.  With yields below 8% and a narrow interest-rate differential (spread) vs. 10-year Treasuries, high-yield bonds don’t have much price upside. Total return should approximate the coupon. Investment-grade bonds are priced at very low yields. For example, the 10-year Treasury yield is about 4.1%.

Compared to inflation, yields are below their long-term average and this suggests that investors are somewhat pessimistic about the economy. Looking out over the next few years it wouldn’t be surprising to see interest rates drift higher, resulting in low single-digit returns for bonds. (Indeed, modestly higher rates would be welcome because they would go hand-in-hand with a healthy recovery.)

Foreign bonds also continue to offer low yields on average. However, inflation pressures are more muted in Europe and thus there is a good chance that European bond markets will outperform markets. In addition, if the dollar weakens on a long-term basis, as seems likely to me given the huge current account/trade deficit, currency gains would add to returns from foreign bond funds.


A fairly benign cycle still seems a quite-possible outcome. Probabilities are hard to accurately assess but I believe a fairly supportive inflation/interest-rate environment and continued gradual growth is the most likely outcome. My view is influenced by healthy levels of cash on corporate balance sheets, muted inflation, and consumer spending that remains solid though there has been some slowing.  

The one thing I can say with certainty is that opportunities will come. The world will always be a volatile place and at some point something will cause investors to act irrationally. So we must be willing to be patient for however long it takes. While we are patient, if the environment is benign, returns may be just fine. And of course I have enormous confidence in our mutual funds and my disciplined investment process which keeps portfolios invested in the best mutual funds in the best asset classes.  


Every month, I analyze over 50 world wide asset classes for both return and risk.  Foreign equities and smaller companies look attractive in the equity world. In the fixed income arena, bank loans, multisector bonds, high yield and emerging market bond funds are strong performers and not necessarily affected by rising US interest rates. Exposure to at least some of these asset classes is required for good risk adjusted returns.   


Please contact me if you would like to discuss your specific portfolio or if your financial situation has changed.


Thank you for your trust and confidence. I welcome your comments and questions.


Mike Durant, October 8, 2004,,   617-489-0040