In the pursuit of excellence, some ruminations on truth and reality:
“If you lack sincerity in your quest for truth, you will
only find what you want to find, whether it’s true or not.”
Mark T. Shirey
“Dispel, O Lord of all creatures, the conceit of knowledge
which proceeds from ignorance.” Hindu prayer
“A man who does not know his ignorance will be misled by
his knowledge.” Anon
“A man goes to knowledge as he goes to war: with fear,
respect, and absolute assurance.” Carlos Casteneda
These are uncertain times to navigate but times
have always been uncertain, and in fact without uncertainty there
would be no speculation from which to profit. Our composite underperformed
the S&P 500 Index in the first quarter, the result of an asset
allocation over 50% in fixed income securities and cash and a reversal
in the bond market, which is expected to continue. I do not like underperforming
the S&P, even if our composite is radically different in composition.
Furthermore, it is frustrating to observe some of our equity selections
struggle to eke out price advances or decline without sound fundamental
basis. I know that clients too can get frustrated, and maybe more
than I. Shouldn’t their portfolios be growing faster, regardless
of the indexes? Isn’t that what BHI gets paid to do? And why
isn’t the market doing better than it is?
The asset allocation models we construct to mitigate portfolio drawdowns
in bad markets will also inhibit performance in advancing markets.
Consequently we may lag the broader indexes. We allocate according
to client-indicated risk tolerance and with an appreciation for the
very real risks the markets face. Within the last 60 days U.S. intelligence
has warned us of an imminent terrorist attack. I am comfortable lagging
the indexes on the upside if it means lagging on the downside as well.
With regard to fees, they are insignificant compared to any other
investment program considering the individual attention given each
client portfolio. I would hold our fee-adjusted performance up for
comparison against any mutual fund over various periods.
Why isn’t the present value of the market higher? Are future
cash flows in jeopardy? The answer is “Yes, possibly.”
There is uncertainty and there is certainty. It is certain that interest
rates will rise. It is uncertain how much and what the effect will
be on long rates. It is certain, according to our government, that
we are going to suffer another major terrorist attack in the foreseeable
future. It is uncertain exactly where or when. It is certain that
when it happens our financial markets will take another hit. It is
uncertain how much and for how long. It is certain, to me, that excessive
growth in the Chinese economy will run aground and the financial shock
will be felt worldwide. It is uncertain when and in what fashion it
We can toss and turn every night with worry and achieve nothing but
anxiety and distraction. It is better to be optimistic and constructive.
We’ve lived through similar and worse uncertainties for every
year of the quarter century I’ve been investing. If we were
to presently choose the security of insured bank certificates to market
returns we would be assured of 2.3% for one year, 3.2% for two years
and 3.65% for three years. But we would be sacrificing the opportunity
for an average annual return of 7% or more over the next three years
and current portfolio yields that meet or exceed CD rates. (The 7%
return is not a bad estimate in my opinion.)
The economy is chugging along close to a 4% annualized GDP rate,
swimming upstream against high oil prices and the promise of higher
interest rates. According to the BLS Consumer Price Index, energy
related costs have increased at a 70.4% rate for the first five months
of 2004. Fortunately oil has dropped from $42 a barrel on June 1 to
$36 as I write this. Let’s hope this is a trend. A significantly
weaker dollar might have put some foreign investment at risk but the
anticipation of higher interest rates are already driving the dollar
back up. The unemployment rate is a low 5.6%. Over 70% of corporate
earnings reports beat estimates in the first quarter and we expect
a strong second quarter as well.
Consider all the forces at work against the U.S. economy. In May
ten new countries were admitted to the European Union: the Baltic
states, other former east block countries including Poland and Hungary,
and Cyprus and Malta. These countries have nearly nothing European
about them other than a loosely shared map. The Europeans have learned
the importance of trading not just products but cash flows and the
EU is seeking to replace the dollar as the world’s reserve currency.
That would hurt the U.S. Losing the war in Iraq would contribute to
the dollar’s demise, and indeed, there seems no winning there.
There is no political entity other than Japan or England perhaps that
wants to see the U.S. pull off a clear victory in Iraq. Iraq, by the
way, had been trading its oil in Euros instead of dollars before the
war, the only OPEC nation to do so. The EU has little motivation to
assist the U.S. economically or politically. American consumers are
resented if not hated, though they keep the world economy turning.
The Russian bear to the east is no longer a threat. The U.S. military
is neither needed nor welcome in Europe.
The Euro has little to recommend it for the world reserve currency,
a store of value with the acceptability of gold. The European Union
is an unprincipled, bloated bureaucracy that cannot get out of its
own way. Despite encouraging signs that the EU’s two largest
members, Germany and France, have executed some pro-growth measures
of tax-relief and deregulation, growth in both countries is still
anemic and 10% unemployment seems endemic. And the EU machinery in
Brussels has hardly begun to regulate. The continent needs paint and
the Muslims who were last turned back at Vienna may yet dominate Europe
within 30 years by virtue of their immigration and birth rates. Though
there are many fine companies in Europe, most could not withstand
the accounting scrutiny we apply to domestic corporations. Quite simply
I can find no compelling reasons for investment in the EU.
As rates rise we extend fixed income durations. Munis are very good
value, particularly for those of us who fear being taxed to death
in the future. Regardless of the outcome of the November election
Washington will likely pick away at the last round of tax cuts. There
seems to be no consensus for making them permanent, unfortunately.
We have been screening stocks extensively during the first half. The
results are not impressive. The market appears thoroughly picked over
and overvalued still.
By how much? If in fact the S&P 500 is trading at 17 times expected
2004 earnings, and 22 times trailing 12 months earnings, then we could
say that the market is about a year ahead of itself, all other things
remaining equal. The market seems to be discounting a rough year in
2005. Still, the investor who can withstand average market risk is
better off in the market than in a 2.3% CD. Corporate balance sheets
and valuations are better than they have been in years. The yield
curve is positive enough to withstand a 2% hike by the Fed and the
money supply has been suitably accommodative and not excessive. Because
price movements in the market can happen dramatically we choose to
maintain significant equity exposure. We want to be on board when
the next bullish train leaves the station.