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Quarterly Letter to Clients

January, 2005

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

Dow Jones Industrials: 10,783.01 4Q'04 +6.97% YTD +3.14%

Standard & Poor's 500: 1,211.92 4Q'04 +8.73% YTD +9.01%

A recent cartoon shows a dollar bill, with Washington’s picture blank. The space where George’s head should be has a caption: “Help! I’ve fallen and I can’t get up!”

The fourth quarter was a mildly exciting terminus to an otherwise dull year. The indices were essentially flat for nine months until the election, after which the markets rallied nicely. The move up seemed to be capped in the general area of Dow 10,500 until the final two weeks, when that venerable index added 300 points. When all was said and done, we finished with low-single-digit positive numbers in the Dow, and a few percentage points better in the S&P.

Overall, it was basically a dull year for stocks and bonds, but even a small plus is better than a minus.

Everyone knows what was weighing on the markets: Iraq; the declining dollar; the trade and budget deficits; inflation; higher oil prices; higher interest rates; it’s a wonder that the market went up at all.

The Fed raised rates twice during the quarter, for a total of five bumps up in 2004. General interest rates are only just beginning to feel the upward pressure that is part of the larger economic picture. We can expect further rises in 2005. By some miracle, bonds held their ground, confounding all informed observers, yours truly included. How much longer these prices can be sustained is anyone’s guess, but it is certainly difficult to make new commitments at these levels.

Oil, which earlier in the year seriously threatened to broach $60 per barrel (on the upside), looked ready to fall through $40 by mid-December. This was, not coincidentally, about the time that the U. S. Strategic Petroleum Reserve was finally filled. By year-end the price seemed to find equilibrium in the mid-to-low 40s, a level that our government and the Saudis would like for us to grow accustomed to. Let’s hope we don’t have to get used to any significantly higher price.

It seems to be a stark reality that we are at an inflection point in the dollar and the economy.

The decline of the dollar versus the world’s major currencies is the method that our government is using in the hope of reducing our trade deficit. The strategy has far-reaching implications, including higher prices for all imported goods, higher interest rates, and inflation. Much is also being written about the consequences of the withdrawal of foreign support of the dollar. The ending of the story has yet to be written.

It would be easy to draw a doomsday scenario related to this, but it is not entirely clear to me that such a view would be accurate. One of the main reasons is that a lower dollar should lead to an increase in U. S. exports. American goods and services should become more competitive around the globe, and more attractive here at home. Of course, we cannot, and should not, think that we will ever be able to supplant cheap foreign labor. Our competitive edge must come from a technological advantage.

This will not unfold overnight; thus it will take quite some time and a very sharp eye before we can ascertain whether the stimulation in exports is in fact enough to offset the higher prices that we American consumers will pay for those goods that we continue to import.

As for our twin deficits, trade and budget, I could easily write a much-too-long discourse on these problems. But to sum it up; the lower dollar may eventually help our trade balances; while our budget problems can only be solved by raising taxes and cutting spending. The latter does not seem to be in the cards, but must eventually be addressed.

I find myself moderately positive on the prospects for stocks for the year 2005; my outlook for bonds is less sanguine. As always, I remain vigilant and will do my utmost to protect your capital and to make it grow in a conservative manner.

I wish you a Happy, Healthy and Prosperous New Year.

Jim Pappas