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Past Commentaries

Current Commentary, Review and Outlook
June 29th, 2004

To My Clients, Friends & Observers:

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 will occur.

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.

Current Strategy

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.

Best regards,