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Quarterly Letter to Clients

April, 2005

Indices at quarter-end (March 31, 2005):

Dow Jones Industrials: 10,503.76 1Q'05 -2.59% YTD -2.59%

Standard & Poor's 500: 1,180.58 1Q'05 -2.59% YTD -2.59%

A recent cartoon shows a broker saying to his client, “Do you prefer highfliers that crash, or beaten-up equities that languish?” I guess I fall into the languish camp.

Here, verbatim, is an actual headline from the Wall Street Journal of March 1: “After Some Ups and Downs Stocks Are About Flat With Level at Start of Year”. Four weeks later, at the end of the quarter, flat was looking good, as stocks had slipped into the minus column by a few percentage points. Just as the first nine months of 2004 were dull as dishwater, so have been the first three months of this year. I’m not the only one languishing. These last couple of years it has been difficult to make any money at all in the markets.

But why are stocks and bonds so lifeless? Earnings have been fair, not explosive perhaps, but generally OK. P/E’s have come down, so the values look a little more appealing. Dividends have been rising, which should bring more people into stocks. What is the problem here?

While you could tick off a list of positives, it is hard to see any development that might drive prices higher. And the nagging list of negatives just won’t go away. Rising oil prices and interest rates, and an endless war conspire to hold prices down. The fear of inflation doesn’t help, nor does a slumping dollar.

Alan Greenspan recently described the Federal budget deficit as a “huge” problem. He has also let it be known that he will raise interest rates at every meeting this year. My comment on the Federal budget: don’t try it at home.

But the market has so far ignored Mr. Greenspan’s words and actions. Long-term rates remain abnormally low, while short-term rates have risen only slightly. I must echo my earlier comment; that the bond market looks like a stretched rubber band. When it finally snaps there will be pain, and not just in bonds.

Real estate is showing all the hallmarks of a bubble market. A friend in the real estate business recently told me that real estate always goes up. I pointed out that in 2004 Japanese realty prices went down—for the fourteenth year in a row. And that real estate prices in New England topped in 1987-88 and then took ten years to recover. Also, don’t forget what happened to Texas real estate in the 1980’s. There’s no such thing as a sure bet—if there was, it wouldn’t be a bet at all.

Oil stocks have been big winners, and here’s the contrarian view: I’m beginning to think that oil might also be a bubble in the making (though it probably needs a good spike to the upside before it bursts). If they would stop pumping it into the ground to fill the Strategic Petroleum Reserve we would surely have lower prices. Some conservation methods would also help. As a nation we are energy hogs. Our lifestyles entail getting in our cars and going places. I’m as guilty as anyone, and I don’t see a convenient way to change my habits. But given the right circumstances, I’m open to reducing my consumption, and I'll bet you are too.

If it happened that oil prices were to come back down, even a little, both stocks and bonds would probably get a good lift. It certainly doesn’t appear likely at the moment, but watch for a big spike upward. If it does happen, it just might mark the top.

With all of the problems, the economy remains fairly vibrant. We all would like to see less dependence on imported oil, but the higher prices seem so far to be absorbed without too much pain. Employment levels are good, as is profitability. I think you have to be a buyer on dips; but you also have to be prepared to wait out further declines. Volatility is a given.

Jim Pappas