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Past Commentaries

Current Commentary, Review and Outlook
January 15th, 2004

To My Clients, Friends & Observers:

Another year is laid to rest and with it the bear market of 2000 to 2002, the third worst in history. The S&P 500 Index closed up 26.38% for the year. The five year total return for the index is still -9.54%. The market has a lot in its favor going forward. Since 1900, presidential election years have yielded positive returns 70% of the time. Since 1960 they are positive 82% of the time. We should be in the second year of a bull market although the second year rarely outperforms the first. The best performing index this year should be the S&P 500 as we see a rotation out of techs and into large cap growth stocks. I’m targeting 1195 for the year-end S&P 500 price, a mere 5% away from where we are now.

The dollar lost some 20% of its value in 2003. It is oversold but I would rather it stabilized here than return to its level of 18 months ago. The cheaper dollar helps U.S. exports and is a shot in the arm to a global economy that buys its oil in U.S. dollars. Oil is recalcitrant at $35 a barrel and is a real drag on the economy. We would be booming with $20 oil but that does not seem imminent. Everything in America, particularly our equities and our real estate, is cheaper for foreigners, and they are buying. It’s estimated that as much as 30% of our real estate markets may be immigrant driven. America's for sale. The weaker dollar will drive our longer term bond rates up, though when I hesitate to predict. Better to be positioned for them rather than moving in anticipation. Roll with the changes.

We've come to the housing party late but it is a trend strong enough to warrant participation still. We do so with builders Pulte Homes and Dominion Homes and with Fidelity National Financial, a title insurer and provider of real estate systems support. REITs are suspect as commercial real estate vacancy rates are high, markets are overdeveloped, and rents are slipping.

Did we miss the trend in gold which was up 20% in '03? Deliberately so. One did better in the S&P 500 as above and the gold miners are way overpriced. When we participate it will be in exchange-traded gold bullion funds which are soon to be introduced to the U.S. It's been said gold is God's control of the money supply. I like the sentiment but it seems antedeluvian in a world awash in freely floating currencies. If the supply of gold is finite it is also permanent. The first ounce of gold ever mined in human history still exists, refined, somewhere. It's scarce but not scarce. Then consider oil and its price potential.

I'm looking for corporate profits to increase 17% in '04, a bit higher than most estimates. I'd expect the S&P 500 P/E to stay around 27. The dividend yield, presently 1.6%, I'd expect to see closer to 1.8%. These are all healthy numbers even if we factor in another 1% additional annual inflation over the next several years. The Fed has been fighting deflation and a small dose of inflation, properly controlled, is stimulative.

Arthur Andersen, Martha Stewart, Imclone, Enron, Healthsouth, Worldcom, Tyco, Mutual Funds, and many more…Accountants, Corporations & Mutual Funds

Left unresolved in 2003 are the scandals. Stealing is nothing new. If a starving man steals a loaf of bread he's committed a crime but not a sin. (Now there's a passé concept. What's new is the discarding of the concept of sin.) If the man backs up a trailer truck and cleans out the bakery he's committed a crime and a sin. There are measures of proportionality. When I hear federal regulators state that "new regulations will be forthcoming" to address these scandals I can't help thinking of Judge Roy Moore in Alabama. He already had the appropriate regulation carved in stone outside his courtroom, to wit: Thou Shalt Not Steal. He was thrown off the Alabama Supreme Court bench by a Federal Court last August.

These scandals aren't garden variety thefts. They are symptomatic of deeper pathologies.

If the concept of "security" is removed from the securities industry there will be much less of the industry in the future. Investments are based on confidence in fair trade practices supported by laws uniformly enforced. Consider three parts of the problem: corporations, accountants, and mutual funds.

The corporations

This current crop of corporate suspects would have done what they may have done for one reason: they felt they could. It's a simple exercise of power. I would want to congratulate Healthsouth for fraudulently constructing its financial statements for as much as ten years, if true as alleged. It's amazing that they could get away with it for so long, if in fact they did. They had high-priced, independent analysts studying their every quarter. They had high-priced accountants, some of the best in the country, advising them. They had audits! They had investors throwing money at them. I suppose all this combined toadying would be enough to camouflage ten long years of "fudging." Hubris could seduce management into thinking they could get away with it. Winston Churchill said it so well: "The truth is incontrovertible. Malice may attack it, ignorance may deride it, but in the end, there it is."

The accountants

One of the worst trends of the last ten years is the death of accounting as we used to know it. The "count" in accounting is misleading because they do little or none of it. In fact bookkeeping is, in the words of my own accountant, a dying art. The accounting industry is necessarily a political beast as evidenced by the composition of the Financial Accounting Foundation (FAF) and the Financial Accounting Standards Board (FASB). Look at the sheer number and complexity of FASB statements. Accountants are legal interpreters of the tax laws and of the principles and reporting practices generated by its own industry and peddled in Washington by willing donors to the politicians who ordain them in return. Everybody gets paid. In a further reach for revenue the industry has insinuated itself into the investment business. This is a Pandora's Box of conflicts of interest and larcenous temptations. In its metamorphosis to "full service" the accounting industry is sacrificing accountability. Accountants should be outlawed from the investment business. Doing both, they do both poorly, to the detriment of the public welfare.

Mutual Funds

They are less "mutual" than ever if the name is to connote some "mutual benefit." Some say the government can't legislate morality. It certainly legislates immorality. Thus the present loophole allowing insiders of mutual investment companies to profit from inside dealings. The market timing issue best falls under Judge Moore's preferred regulations. It is stealing, plain and simple. More and more sophisticated investors are eschewing mutual funds for private, independent money managers like yours truly.

Case study

Perhaps the following true story best illustrates the deficiencies of the current investment securities/accounting/mutual fund business.

A client referred a woman to me for a portfolio review and some advice. The woman had inherited a legacy of about $600,000. On the advice of her CPA, who had recently become a registered investment adviser, she put the money with another adviser who manages portfolios of mutual funds for a fee. The CPA, acting as an investment adviser representative, got paid a fee from the portfolio manager. The portfolio manager was paid an annualized fee of .4% of the client's assets under management. The mutual funds in which the client became invested also charged fees and expenses, ranging from .22% to 1.08%. So, the CPA was paid, the portfolio manager was paid and the mutual fund companies were paid. So what did the client buy for her payments?

When she came to my office in February 2001, her portfolio had declined over 40% in value, to around $350,000. Mind you the S&P 500 had declined over 10% in 2000, but the real blow-off was about to begin in earnest in April, 2001. The woman was scared, skeptical and suspicious. I explained my system. To her I sounded a lot like "the other guy." She didn't understand much of it. She was seeing me at the urging of a mutual friend, but then that's what had got her into the mess she was in—seeing a portfolio manager on the advice of another trusted friend, her CPA.

Faced with her stasis, I agreed to review her portfolio of mutual funds and render an opinion on them, no charge. And herein lies the real story. They were all no-load funds. Almost all of these funds were big household names. Five of the eight funds had Cisco Systems and GE in their top five holdings. I calculated that the woman's total portfolio was approximately 8% in GE and 11% in Cisco, big over-concentrations in both. Cisco Systems had never doubled its revenues or earnings year over year in the prior ten years and was priced at roughly 30 times expected earnings five years away. GE had clearly stopped growing from manufacturing and was morphing into a financial services giant which would not have the earnings to support its valuation. And Jack Welch was retiring. He knew when to leave. Both Cisco and GE, among many others, had significant and growing contributions to earnings in '99 and 2000 from market investments. This clearly could not last. Those earnings were going away and when they did the market would implode.

One huge fund had Enron as its second largest holding. Another fund had as its objective "to buy and hold stocks of quality companies for the long term." The average annual portfolio turnover: 45%. How long term is that? Or did 45% of the fund's companies go from "quality" to "low-quality" in one year?

But the real lulu was a utilities fund, a fund meant to pay regular dividends, presumably suitable for widows and orphans, run by one of the biggest, most common names in the mutual fund industry. Herewith were its top five holdings in year 2000: Voicestream Wireless, Nextel Communications, Qwest Communications Intl, Sprint PCS Group, and AES. They totaled 31.5% of the total fund assets. According to the Morningstar report on the fund, the fund manager was adding to positions in these stocks as of 7/31/2000, right as the tech bubble was peaking. None of these companies paid dividends. This group of stocks lost 80% of its value from July 2000 to December 2002. This is a utilities fund? Talk about style creep!

Not knowing who to trust and thoroughly spooked by the markets this woman decided to do nothing and "wait it out," convinced—probably by her CPA—that "it'll come back."

One year later her portfolio value was $214,000. It didn't and it hasn't "come back." This is only one case of dozens, all with the same fact pattern.

The accountant gave his client bad, unqualified, investment advice. The accountant spends most of his time interpreting tax laws and their applications. The accountant didn't read the financial statements of the companies in the mutual funds. Neither did the mutual fund managers nor the portfolio manager. They all should have if they're holding themselves out as investment professionals. They were being paid.

To all who choose to participate in the securities markets, where, truly, animal instincts prevail, caveat emptor. Beware! Regulatory authorities were created to give investors some protections but who can you trust? It's enough to make you want to shout, "There oughta' be a law!" But there already is a law. Judge Roy Moore could tell you.

Best regards,