HOFFMAN, WHITE & KAELBER FINANCIAL SERVICES,
LLC
Investment
managers & Financial Advisors
May 3, 2004
This is the May 2004
monthly Wealth Management newsletter from Hoffman, White & Kaelber
Financial Services, LLC. If you do not
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Alternatively, any of your friends or colleagues may receive this on a
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it useful. Thanks for your interest and I hope you enjoy the letter.
Which way is the stock market going? Which way are bonds going? Commodities?
Real estate? Where should I
invest?
“Would
you tell me please, which way I ought to go from here?”
“Oh, you’re sure to do that,” said the Cat, “if you
only walk long enough.“
---Lewis Carroll,
As mentioned in our prior newsletters, we strive to provide
articles on various aspects of wealth management to assist your understanding
of why planning for the present and for your future has importance. Yes, we also promote our services; yet, you
will find that we always seek to present thought provoking topics that are
relevant to our wide audience. (This
month we delve into some of the more technical aspects of investing. Please let me know if this level of
discussion is helpful or not. Keep those
referrals coming! We love it!)
Successful investing for the next several years will require you to think
very differently than most investors have in the last twenty years. We started the last bull market with high
interest rates, very high inflation and low stock market valuations. All elements were in place to launch the
greatest bull market in history. Now,
we’re in the opposite environment.
Potential run-away inflation is knocking at the door, the stock market
has high valuations, interest rates have nowhere to go but up, the dollar is
dropping all with budget and trade deficits staring us in the face.
In this letter, we will discuss our
view and strategy in navigating through these market trends and, as always, we
finish with an update on our investment activities.
Which
way is the stock market going? Which way
are bonds going? Commodities? Real estate?
Where should I invest?
Both stockbrokers and mutual fund sales people
will tell you, “Now is the time to buy stocks!
You can’t time the markets, so you should buy and hold for the long term
and not worry about the short term drops.”
This advice has been the same year in and year out and has been wrong
about half of the time.
My favorite economic analyst, John Mauldin, whose work
contributed significantly to this newsletter, reflects that “there are long
periods of time when stock markets go up or sideways and long periods of time
when markets go down or sideways. These
cycles are called secular bull and bear markets.” By secular, Mauldin means ten to
twenty year’s time. “Each cycle favors
different types of investing opportunities.”
Mauldin believes, and I agree, “We are currently in the beginning of a
secular bear market.” The problem is
that the products stockbrokers and mutual fund sales people sell do not do well
in secular bear markets.
In secular bull markets, risk taking is more easily
rewarded and many adventuresome investors focus on investments that offer relative
returns. By that I mean they look
for investment opportunities that offer the potential of performing better than
the market averages. If you can
consistently beat the market averages you are doing well.
In secular bear markets that same strategy can be a
prescription for disaster. If the market
goes down 20% and you go down only 15%, Wall Street proclaims your performance
to be “winning”. However, you are still
down 15%. For years 2000, 2001 and 2002
the average annual return was down 15%.
And, during that time, most adventuresome “stock market only” investors
saw their portfolios cut in half or worse.
In markets like those we face today, the focus should
be on absolute returns. Your
benchmark is a money market fund.
Success should be measured in terms of how much you make above Treasury
Bills. In secular bear markets, success
is all about controlling risk and carefully and methodically compounding your
asset returns.
Inflation
is defined as a sustained rise in overall price levels. As the economy grows, businesses and
consumers spend more money on goods and services. In the growth stage of an economic cycle,
demand typically outstrips the supply of goods, and producers can raise their
prices. As a result, the rate of
inflation increases. If economic growth
accelerates very rapidly, demand grows even faster and producers continually
raise prices.
In the
Rising
commodity prices are perhaps the most visible inflationary force because when
commodities rise in price, the cost of basic goods and services generally
increases. Higher oil prices, in
particular, can have the most pervasive impact on an economy. Higher oil prices mean first, that gasoline
prices will rise. This, in turn, means
that the prices of all goods and services that are transported to their markets
by truck, rail or ship will also rise.
At the same time, jet fuel prices go up, raising the prices of airline
tickets and air transport; heating oil prices also rise, hurting both consumers
and businesses.
By causing price increases throughout an economy, rising oil prices
take money out of the pockets of consumers and businesses. Economists therefore
view oil price hikes as a “tax,” in effect, that can depress an already weak
economy. Surges in oil prices were followed by recessions or stagflation – a period of inflation
combined with low growth and high unemployment – in the 1970s, 1980s and early
1990s.
How Does Inflation Affect Investment Returns?
Inflation poses a “stealth” threat to investors because it chips
away at real savings and investment returns.
Most investors aim to increase their long-term purchasing power. And, inflation puts this goal at risk because
investment returns must first keep up with the rate of inflation in order to
increase real purchasing power. For
example, an investment that returns 2% before inflation in an environment of 3%
inflation will actually produce a loss of 1% when adjusted for inflation.
If investors do not protect their portfolios, inflation can be
harmful to fixed-income returns, in particular.
Many investors buy fixed-income securities because they want a stable
income stream, which comes in the form of interest payments. However, because the rate of interest on most
fixed-income securities remains the same until maturity, the purchasing power
of the interest payments declines as inflation rises.
Inflation can adversely affect fixed-income investments in another
way. When inflation rises, interest
rates also tend to rise either due to market expectations of higher inflation
or because the Federal Reserve has raised interest rates in an attempt to fight
inflation. When interest rates rise,
bond prices fall. Thus, inflation may
lead to a fall in bond prices, potentially reducing total returns on bonds.
Unlike bonds, common stocks have often been a good investment relative
to inflation over the very long term, only if companies are able to raise
prices for their products when their costs increase. Higher prices may translate into higher
earnings. Yet, over shorter time periods,
stocks have often shown a negative correlation to inflation and can be
especially hurt by unexpected inflation.
When inflation rises suddenly or unexpectedly, it can heighten
uncertainty about the economy, leading to lower earnings forecasts for companies
and lower equity prices.
So far this year, the CPI (Consumer Price Index)
showed a 0.5% growth in inflation for January, 0.5% growth in February and 0.6%
growth in March. The markets immediately
seemed to multiply that information and project 6% to 7% inflation for the
remainder of this year. The amusing part
of this is 1) year over year inflation is still below 2%; 2) the first quarter
of 2003 started off similarly before growth tapered off; and 3) much of the
rise in inflation this year was from sources like apparel that are unlikely to
be big sources for inflation in the future because there is significantly more
capacity than being utilized.
Two weeks ago, Fed Chairman Greenspan provided his most
optimistic assessment yet on the
Most
people are aware that there is a government body that acts as a guardian over
the economy - an economic sentinel who implements policies designed to keep the
country operating smoothly.
Unfortunately, most investors do not understand how or why the government
involves itself in the economy. In the
Morgan Stanley Chief Economist Stephen Roach thinks
the Fed should raise rates by 2%. Many
economists are calling for the Fed to raise rates this week or in June,
allowing rates to rise to a more “Natural” range of 3% to 3.5%. Recent Fed governor speeches seem to agree
with this line of thinking. They suggest
this, as the natural rate, because they feel interest rates should be at least
1% above inflation, which seems to be approaching 2% and rising (in terms of
CPI).
While it is difficult to determine how and when the
Fed will react, the recently released Kiplinger Letter forecasts that the Fed
will raise rates in August or September.
They say, “Look for a quarter percentage point increase in the benchmark
federal funds rate, a move likely to be duplicated in December. Both moves will bring the rate to 1.5% by
year-end from 1% now. In 2005, the Fed
will keep ratcheting upward, about one hike every two months. That’ll put the rate at about 4% by the
middle of 2006.”
Michael Santoli, at Barron’s, writes, “Bullish market
analysts have been busily crafting arguments that stocks need not suffer as
interest rates rise. A rough consensus
among strategists seems to be that higher stock prices can coexist with rising
rates. However, history is rather clear,
though, in its verdict that stocks are at a disadvantage as monetary conditions
tighten…
Bear Stearns strategist Francois Trahan noted that
the vast majority of all stock market appreciation since 1970 has occurred while
market interest rates were falling. In
months when rates were declining, the S&P 500 rose at an annualized rate of
6.9%. Whereas, in months when rates were
climbing, that annualized return slipped to 1.4%…
The potential sting of higher rates, by one way of
thinking, could be more intense this time around due to the all-time high
proportion of financial shares in the broad stock market indices… Financial stock profits are reliably slowed
down by higher rates... Financials make
up about 22% of the S&P 500’s market capitalization, compared to about 15%
in 1994, the last time the Fed embarked on a tightening cycle. Yet, there’s always a chance that the widely
expected rise in rates will be forestalled, or that the adverse effect of
tighter money won’t exert a downward pull on stocks for some time.”
Aside from interest rates, however, there’s a
separate concern for equity investors.
The pace of economic acceleration and profit growth both appears to be
cresting for the time being. The
middling reaction to the acceleration on job growth and to generally stellar
first-quarter earnings reports also prompts questions about whether the market
has taken full account of this bounty and is preparing for less impressive
results.
As stated earlier, “In markets like those we face
today,
where potential run-away inflation is knocking at the door, the stock market
has high valuations, interest rates have nowhere to go but up, the dollar is
dropping all with budget and trade deficits staring us in the face, the focus should be on absolute returns. Your benchmark is a money market fund. Success should be measured in terms of how
much you make above Treasury Bills.
Success is all about controlling risk and carefully and methodically
compounding your asset returns.
Hoffman, White & Kaelber Financial Services Investment
Performance Update
This was an extremely
interesting month! All market sectors
posted negative returns for the month and hardest hit were long and
intermediate-term bond and REIT (real estate investment trust) sectors. All but S&P500 and MSCI EAFE indices were
below their beginning of the year values and US Treasury Bonds and REIT sectors
exhibited 2 to 4.5 times their normal volatility. The markets, this past month, were very ugly
indeed!
For the month ended April
30, 2004, our one-month performance is down 6.24% (our first down month), our
three-month return is down 4.51%, our one-year return is up 12.87%, and our
average annualized return since inception is up 13.50%. Our (since inception) risk profile has
increased to +/-8.07%, which remains low relative to the volatility exhibited
by all market indices over the same time periods except for Short-Term US
Treasury Notes. As we have not increased
our targeted risk, we expect this measure to steadily rebound lower in
subsequent months. As well, this
increased volatility experience impacted our Sharpe Ratio by bringing it down
to a very respectable 1.55. Given, the
extreme recent volatility in the markets, we continue to be very proud of our
risk/reward record!
Investment
pros borrow a tool from the statisticians—standard deviation—to measure
investment risk. It shows the range of returns that investments are
likely to earn over a given period of time and it has two sides, the
out-performance and the under-performance of an average rate of return.
For
example, let’s look at the S&P 500 Stock Index1 and consider the
average rate of return 12.1% and standard deviation +/-19% for 100 years. The
standard deviation tells us that a relatively bad year for the Large Cap market
overall would have been negative -6.9% and a relatively good year would have
yielded a higher positive return 31.1%.
The range from -6.9% to 31.1% corresponds to outcomes within one standard
deviation of the 12.1% average. It
captures 68 of the total 100 observations.
If the trend of this previous century carries into the next, we might
expect that 2/3 of the time; this collection of stocks will provide a return
within this range.
The Sharpe Ratio is a commonly used measure of portfolio earnings quality. In short, the Sharpe Ratio is a measure of return achieved per risk taken. Sharpe ratios can be better than just looking at performance because it incorporates the issue of risk. Some would say it is a measure of a manager’s ability to perform consistently. The number by itself, however, is hard for many to understand without comparing it to something.
Let’s take a look at the
S&P 500 Index for a quick comparison.
The Standard & Poor's 500 Index is usually considered the benchmark
for
Are you familiar with
Morningstar, Inc.? They are a
Chicago-based, global investment research firm, providing information, data,
and analysis on the mutual fund industry. They say that a Sharpe Ratio of over
1.0 is "pretty good" and outstanding funds achieve something over
2.0. Using this “yardstick”, we are more
than pleased with our accomplishment to date.
For most investors, the Sharpe makes good intuitive
sense because they not only hate to lose money but they often compare the
returns to risk free investing. You owe
it to yourself to understand and consider this measure when making investment
decisions.
Is a comfortable retirement or preservation of wealth
important to you?
Want better long-term results from your investments?
Choose Us As Your
Investment Manager!
Research us on the
web at www.hwkfs.com