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Quarterly Letter to Clients

April, 2004

Indices at quarter-end (March 31, 2004):

Dow Jones Industrials: 10,357.70 1Q'04 -0.92% YTD -0.92%

Standard & Poor's 500: 1,126.21 1Q'04 +1.29% YTD +1.29%

The hottest new issues of the market this quarter were Chinese internet stocks. Does this tell you anything?

The year started off just fine, initially adding a little to the healthy gains recorded in 2003. But at the end of the quarter, ostensibly because of the terrorism incident in Madrid, the markets seemed to hit a wall. It’s a little too soon to be worried—the first quarter of 2003 was negative, remember, and that year turned out just fine.

But there must be a reason that it was the Greeks that invented worry beads, because it seems to be in my genes to always be under a cloud of concern.

From the highs reached in February, stocks slipped some 5% or 6% before bouncing back in the final few days of the period, finally finishing essentially flat. The markets seem to be marking time, waiting for direction from interest rates and/or the economy. So far they are not getting any clear signals. What is clear is that oil and its derivatives (gasoline, heating fuel, plastics) are impacting the economy again. Two quarters ago I was almost alone in scoffing at the financial headlines that predicted deflation. Today there is almost no one left in the deflationary camp.

Interest rates remain at uncomfortably low levels. Longer-dated bonds, while not impossible to buy, have become an imprudent purchase at these prices. With elections coming up in November, there are very few pundits willing to predict rising rates for the balance of this year. In my opinion, regardless of the election outcome, the Fed will be pressured to keep rates low. But it does seem to be a given that rates will rise at some point in the future—after all, they can’t go much lower. And in a rising rate environment, you do not want to be holding long-dated paper for which you paid a premium. (Note that I do not mind holding bonds that were purchased at lower prices, even if the market value of those bonds declines, because I bought them for their cash flow, not for their appreciation.)

Meanwhile, housing prices remain at uncomfortably high levels. The whole world, by which I mean a goodly number of the people that I talk to, are anticipating that the real-estate market will tumble in the not-too-distant future. Personally, for various reasons, I am not particularly worried about housing prices.

But stock prices are another matter. Many observers are waiting for a “correction” in stocks. The implication of the term is that you are just jiggling the wheel a little, trying to stay on a straight course. The desired direction is always up.

If we do get a correction of any consequence I would be a buyer of good-quality equities. For my fixed-income accounts I have recently begun buying certain utility stocks. While this is by no means a perfect hedge, my thrust is to preserve principal and generate an income stream. At this moment, utilities seem to be a logical choice.

In Berkshire Hathaway’s latest annual report, Warren Buffett mentions what he calls “gin rummy management”, wherein you dump your weakest businesses at each turn. He is not of that school, nor am I. Over time I have found that it is much more profitable to hold stocks for very long periods. This mean that in times of decline you give up market value. But it also means that when markets turn up you remain invested and do not miss the turn. Since market declines are historically shorter in duration than market advances, it is logical to me to hold my positions through the high points and the lows.

This strategy further rewards me by the fact that I do not have to predict the precise timing of a stock’s move. I can simply select a good business and patiently wait for the market to agree with my assessment. If you add to this the regular buying of securities during declines, you have a recipe for long-term market success. It may not be exciting, but it works.

Jim Pappas