Fourth Quarter, 2004

With the year 2004 now over, it’s fascinating to note how investment markets failed to behave in accordance with a variety of conventional wisdoms. Here are three examples:

Intermediate- and long-term interest rates were widely expected to increase during the year causing both the stock and bond markets to have low or negative returns. The logic behind rising rates was so irrefutable that Alan Greenspan commented in a recent speech that people not heeding the warning signs and the Fed’s cautionary comments regarding rising interest rates were simply wishing to lose their money. It didn’t happen! Intermediate- and long-term interest rates ended the year at the same levels observed at the beginning of the year, and rising short-term interest rates had no negative effect on the stock market or the economy. The tug of war between global inflationary and deflationary forces continues.

Second, withering Chinese competition was expected to wreak further havoc on our domestic economy especially in the manufacturing sector, causing more stock market pain, job losses, etc. It didn’t happen. Stock market performance by year’s end was much stronger than anything we thought possible. And the year concluded with solid economic growth that is gaining momentum as the new year gets under way. One surprising news item we saw was from the U.S. Labor Department which recently reported that the manufacturing sector of the economy increased its employment in 2004 for its first annual gain since 1997.

Finally, the dollar’s continuing decline during the past year was expected to give a positive boost to gold and gold mining stocks. It didn’t happen. Gold and gold-related investments generated modest investment returns for the year. What we believe we are witnessing is that global investment markets are so complex and interwoven that it is simply impossible for any mere mortal to get their arms around a clear cause and effect relationship between economic and political events and investment market behavior.

As the old saying goes, things aren’t a problem until they are a problem. We are reminded of this almost on a daily basis as long-term interest rates hold steady and domestic and global stock markets continue to move higher in the face of major domestic financial inbalances, over-leveraged consumers and over-valued markets.

We continue to witness an amazing degree of investor complacency in markets, both domestically and globally. For example, emerging market and high-yield debt now offer some of the lowest yield premiums to treasuries seen in the last ten years. Stock market volatility is at the lowest level since these records began to be kept. Emerging market equities now trade at comparable valuation levels to those of developed markets.

We began 2004 as ‘nervous-nellie’ investment managers, and we have ended the year in the same fashion. Our nervousness has not, however, interfered with our success in generating strong portfolio returns as set forth elsewhere in our communications. During the year, our domestic stock markets have moved towards less excessive levels of valuation due to strong earnings growth. However, overall market valuations still remain high by historic standards. As a result of improving valuations, we have modestly increased stock market exposure during 2004 with various securities that met our selection criteria. Part of our equity strategy called for maintaining a high level of dividend yield of your stock portfolio and we continue this practice in the new year. Compounding income is vitally important to successful long-term wealth accumulation.

Another strategy carried out throughout the year was to increase diversification in client portfolios. Investments in foreign stocks and bonds have been increased. A hedge fund has been added. Gold mining companies, and recently an investment in a fund which holds gold bullion, have been added.

The net effect of all our actions is to smooth out the magnitude of fluctuations that client portfolios have experienced in the past. This is a good thing, especially for people who remove cash from their portfolio on a periodic basis.

Presently, we believe the major trends which continue to affect U.S. investors include:

1. The ongoing decline of the dollar vis-a-vis other currencies;
2. The continuing explosive growth in the economies of China, India and the developing block of Asian nations;
3. A higher "floor" price level for oil caused by growing competition for reserves from Asian nations as well as continued terrorist attacks on sources of supply;
4. Continued growth of the U.S. and world economies. A wide variety of economic indicators are moving higher. The result is widespread investor complacency and a lack of undervalued markets anywhere!

Recently, various Federal Reserve governors have begun spreading the word of their growing concern about the prospects for inflation and the rising global disenchantment with the declining dollar. They are hinting that the Fed may raise short-term interest rates more rapidly this year than last. We will continue to closely monitor the reaction of the longer-term bond markets to Federal Reserve pronouncements and actions for clues regarding the future health of the economy.

Our strategies during this period of enormous conflicts and crosscurrents have remained clear and unwavering. They include:

1. Extremely broad diversification, domestically and internationally in equities and fixed income securities;
2. Continued emphasis on energy stocks;
3. Continued focus on maximizing portfolio yield. Cash flow leads to growth in your portfolio through compounding, while hoped-for capital gains are much more problematic;
4. The China card—China is the global economic giant absorbing increasing quantities of world resources. As a theme we are focusing on companies and countries that benefit from China’s rapid economic growth.