4th Quarter 2004: A Soft Patch?

Fourth Quarter 2004
Market Commentary

A Soft Patch?

As we begin the final quarter of the year, we look back on the first nine months of 2004, and reflect upon what has been an essentially flat market - both in stocks and bonds.

For the first nine months, the Dow Jones 30 was down -3 %, the S&P 500 down under
-1%, the Nasdaq down -5%. It has been a stock pickers market, with selected stocks doing well, but with the indices themselves treading water.

Energy has been the strongest sector in the market, with oil stocks generally recording double-digit gains for the year, buoyed by oil prices now hovering above $50.00 a barrel.

Next in line - for lack of a better label - are dividend paying stocks. We have maintained for some time that the thrust of the market is, and will continue to be oriented towards income producing securities, as investors come to grips with a money market that is just now bouncing off 40 year lows in interest rates.

That said, we believe one of the more significant developments in Q3 (third quarter) was the fact that the Federal Reserve has chosen to back away from their accommodative stance on interest rates; and have begun a slow process of tightening.

On June 29th of this year, the Fed raised the discount (overnight) lending rate from 1% (a 40 year low), to 1¼%. Of interest to us was the fact that the ten year US Treasury bond, selling at 4¾ % before the Fed announcement, dropped to 4 ½% immediately afterwards. Further, when the Fed raised the discount rate for a second time on August 9th from 1¼% to 1½%, the ten-year treasury yield dropped again to 4¼%. The Fed then raised the discount rate a third time in September, from 1½% to 1¾%. This action coincided with the ten-year treasury yield falling further to 4%, and for a brief time, just under 4%. (It currently stands at 4.00%).

These capital market responses to the Fed's actions underscore our belief that deflation, not inflation, is a more serious thrust for the intermediate and longer term, and is in line with previous comments we have made to have an increasing income component to your portfolio; and that over the next market cycle, income returns will probably provide a larger percent of total return than in recent years.

To this end, we are taking a fresh look at the Utility sector, a good number of which have dividend yields in the 4% plus range. Again, if we combine a 4% dividend with an 85% tax exclusion we are looking at an approximate 7½% pre-tax - apples to apples - return. When viewed against short-term 100% taxable money market rates in the 1½% area, this becomes compelling.

Supporting this point of view is a recent Business Week article that pointed out that the average dividend paying stocks on the NYSE were up close to 3% for the year, while non-dividend paying stocks were down 8%. We think this trend will continue for the foreseeable future, particularly when juxtaposed against a flattening yield curve. Moreover, this is a flattening yield curve in the early stages of Fed tightening.

Some have argued that the current bond market - which has been rising (with lower yields) is merely a reflection of an economy which is slipping and losing its foothold. Federal Reserve Chief Alan Greenspan doesn't see it this way, as he repeatedly has stated that the economy is in an expansionary mode, and that we have just passed through a "soft patch". In his words, the economy is "regaining momentum" and that "the underlying structure of the recovery is still there." He alluded to high oil prices as the chief culprit of the slowdown, but felt strong enough about the economy and its underlying strength to initiate the three interest rate hikes referred to earlier.*


It's true though, that a number of economic indicators slowed in the third quarter. Some of the developments include the following:

a) Lower profit growth. After four consecutive quarters of 20% plus profit
growth, the third quarter of 2004 appears likely to drop. It will still grow,
but at a decreasing rate. First call, (which is a composite of leading
brokers), estimates 14.3% growth for the S&P 500 for the quarter , with
similar numbers in the fourth quarter.
b) Consumer Confidence. Consumers account for 2/3 of all US economic activity. On 9/28 the (National Industrial) Conference Board released a consumer confidence reading of this index of 96.8 for August, down from 105.7 in July; but still up significantly from March 2003, when it hit a low of 64.
c) Leading Economic Indicators. The Conference Board, on Sept 24th also released numbers indicating a 0.3% decline in August. This on top of another 0.3% decline in July, and a 0.1% decline in June.

d) Job growth. The US Labor Dept. announced job growth of 144 thousand new jobs in the month of August, up from June and July; but still well below the growth registered in the first and second quarters of the year.
e) Oil. The expectation of October prices declining after the usually strong summer season demands for gasoline has not occurred. In fact, it has continued to rise in price, driven by large Chinese purchases, as well as disruptions in the supply of petroleum products due to Hurricane Ivan, shortages in natural gas, seasonal maintenance of certain refineries leading to downtime in both California and Alaska, and low inventories of heating oil.

We also believe that the politically charged election cycle has tended to hold back consumer confidence, and the divisiveness of it has had a negative impact on our markets as well. Beyond the November election, however, we see things slowly returning back to normal; which would generally imply an uptrending market. As of now - that would also be our bet, but we are by no means in a mode of clear sailing.

There are still a number of factors "out there" overhanging the market that we think will continue to play a major role in determining the direction of this very choppy market, most of which we have touched upon in previous commentaries. Here's an update with our current thoughts.

Twin Deficits

The first two of our concerns are our twin deficits.

a) Trade Deficit - Earlier this year in our first quarter 2004 commentary, we noted that our international balance of trade was then running at close to a $500 billion per year deficit. We also commented, however, that the U.S. "was the only locomotive powerful enough to turn up the world economy" at that time. Running a trade deficit when you're coming out of recession can help to keep inflation low; and thus co-incidentally to help keep interest rates low - while the fiscal and monetary stimulus generated over the previous year was given a chance to work.

In fact, this has happened. But now, we are well into a recovery cycle; further stimulus seems both unwarranted and unlikely; and yet the trade deficit, now running at more than $50 billion per month, has gotten worse rather than better.

Part of this can be directly attributed to the high price of oil, as we still import over half our needs. Nonetheless, oil prices are expected to remain high for some time; and in fact, have risen $10.00 per barrel since our last report in July.

Both of these developments lead us to believe we are approaching an important inflection point in world trade, (with the U.S. dollar vis-à-vis other currencies) wherein any further material increase in our trade deficit will in turn trigger a drop in the international value of the dollar. On a trade - weighted basis, the dollar has already fallen 13 % since its peak in early 2002, and more if it is compared to the Euro during that same time period.

The problem here is that if these conditions worsen, and the dollar drops another notch, it may then force the Federal Reserve's hand to accelerate raising interest rates - not to slow down rate of growth in the economy as is its usual activity; but rather to keep and attract foreign investment.

b) Budget Deficit - Why do we need foreign investment? The answer here is a function of the other half of our twin deficits - namely the Budget deficit. We are currently running close to a $500 billion annual deficit in our internal finances. There's an old axiom that says you can't spend more than you take in. The cause of this deficit can be dissected, broken down and debated; and will be for some time. It's true that a good part of this arises from our response to 9/11 and our involvement in Iraq. The President's tax cuts, which have been part of the economic stimulus program, also has the result of adding to the deficit; particularly in the short run.

However you slice and dice it, the bottom line is that we have to borrow the difference of what we spend versus what we take in, and we issue debt for the difference. Someone has to buy that debt, and increasingly it has been foreign governments who have benefited from the surplus of dollars flowing into their countries from our ongoing rush to buy their products. Foreign holdings of U.S. Treasury securities now total $1.75 trillion. This accounts for approximately 41% of debt owed by the public.

The primary foreign holders of U.S. debt as of August 2004 appear below:

Country 2004, August

Japan $721.9 billion
Mainland China $172.3 billion
United Kingdom $134.8 billion
Caribbean Banking Centers 2/ $91.3 billion
Korea $63.4 billion
Taiwan $56.4 billion
Hong Kong $49.4 billion

Apart from Great Britain and Caribbean Banking centers (which include tax-free zones), all holders in excess of $50 billion are from the far East. Further, in the case of both Japan and China, approximately half of their holdings have arisen in the last three years.

The correlation between the two deficits can be illustrated by the fact that our trade deficit with China alone is in excess of $120 billion annually; and it appears that much of our dollars going overseas to China (and others) winds up in the form of those countries holding our debt.

This becomes problematic, in that it gives these countries some degree of leverage over our economy, and may have the impact of affecting our government's decisions on various issues when we interact with the outside world.

c) Next in line is Iraq. Irrespective of the election outcome, we are likely to be bogged down in Iraq for some time. Insofar as it pertains to the market, our thought is that the market sees it the same way, so that the daily occurrences we see and read in the evening and morning news is already pretty well discounted in the market. That tells us that any positive news, such as successful elections in January, or a surrender or capture of either of the al Sadr or Zarqawi militant sects, will be met with considerable enthusiasm.


Where does this leave us? Without trying to duck the issue, we see more of the same - a continued choppy market environment.

The Good news is that economic numbers are strong. More important, corporate earnings are rising and are historically high. Of all the variables affecting common stock prices, we believe (and have statistics to support this belief), that rising earnings have historically had a strong positive correlation to stock prices. So we see the domestic underpinnings of the market as quite good.

Having said that, we are becoming increasingly concerned that our debt situation could worsen and lead to currency movements that would undoubtedly have a negative impact on the bond market, and on interest rates.

As of now, we see these opposing forces as being fairly balanced; and all other things being equal, should lead us into an environment where sector and stock selection becomes increasingly important, as does the asset mix of a portfolio.

We also believe things will become a bit clearer after the election, irrespective of the outcome. Further, seasonal money flows and traditional year-end price patterns cause us to believe that in the near term equity markets may respond more favorably to the underlying economic news and earnings reports, and carry us to slightly higher levels by year end.

As always, we will try to keep you posted on any changes in our thinking and invite any questions you might have.

Best wishes to you and your families for a happy Thanksgiving, and a blessed Christmas and holiday season.



Bill Schnieders
Jim Schnieders, CFA

*Please call the office at 626-584-6168 for a copy of the graphs.

1. See 3rd quarter 2004 Commentary "A Glass Half Full"
2. See 2nd quarter 2004 Commentary "The 3 faces of Jobs"
3. See 1st quarter 2003 Commentary "Dividends Matter"
4. LA Times 9/9/04
5. Investor's Business Daily dated 9/23/04
6. Investor's Business Daily 10/15/04
7. U.S.Treasury, August 2004

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