Back to Quarterly Letters

Back to Quarterly Letters || Previous Letter || Next Letter

Quarterly Letter to Clients

July, 2003

Indices at quarter-end (June 30, 2003):

Dow Jones Industrials: 8,985.44 2Q'03 +12.43% YTD +7.72%

Standard & Poor's 500: 974.50 2Q'03 +14.89% YTD +10.75%

In an up market, performance is relative; we are concerned with our performance compared to that of our peers, or to certain indices. In a down market, performance is absolute; we don’t care what the indices or our peers are doing, we are only upset that we are losing money.

Similarly, in a bull market, dividends are ignored in favor of capital gains. When the bull goes on vacation and the bear comes to visit, dividends regain their importance.

In almost every type of market, we should be investing for total return: that is to say, we hope to have some (net) capital gains, and we look to garner some dividend or interest income. We then add these two sources together for our total return.

In some markets the bulk of the gain is from capital gains, and in others it comes from interest and dividends. It should not matter to us what the source is, but it is only prudent to constantly be prepared in both arenas.

Not long ago I wrote that I was remotely worried that stock yields could rise above bond yields, a la 1930-1960. That “remote” worry increases daily.

Today you can find many good-quality common stocks yielding 3% to 5%, and the 10-year treasury bond is paying only about 3.5%. While the overall market, measured by the Dow Jones or the S&P 500, is yielding thirty basis points to either side of 2%, you can still see that the relationship is starting to reverse.

Coming out of the Depression stocks were viewed as so much more risky than bonds that they had to pay significant dividends in order to attract buyers. Today, while we view stocks as inherently risky, we are not as frightened of owning them as our parents and grandparents. We believe that in the “long-term” stocks will out-perform bonds. That may be true, but it has not been the case over the last 15 years. Over that span the two security classes have run neck-and-neck in terms of total return. I guess it depends upon your definition of “long-term”.

Prices of corporate and government bonds have now risen to unprecedented levels, pushing yields to 45-year lows. In the last couple of quarters, corporate yields have narrowed their spread, which in translation means that their yields have come down (and prices gone up) to more closely parallel their government cousins.

The supply of attractively priced bonds has dried up. In order to buy good quality bonds you must pay prices that appear to me to be much too high.

The only justification that you can make for buying bonds at these levels is that we are going into a sharp recession (or depression) or that deflation is soon to be upon us.

The latter case is laughable, no matter how much press it may be getting lately. As for the former, I would suggest that we are nearer the end of the recession than the beginning. Time will tell, but the stock market is certainly giving us its opinion.

With interest rates at these lows, corporations are rushing to retire their outstanding (high-coupon) debt and refinance it at significantly lower rates. This is having a dramatic effect on income investors: where not too long ago we could generate 8% yields in corporate bonds, today that number is nearer 6% and seeming to drop steadily.

The effect on equity investors is somewhat more subtle, but still important. For as bonds are refunded at lower rates, the difference in the cost of capital flows unimpeded to the bottom line.

Lower interest rates on bonds mean higher price-earnings multiples on stocks, and when you combine that with a stronger bottom line due to refinancing, you end up with sharply higher stock prices.

The stock market is saying that the economic outlook is rosy, and the bond market is saying the opposite. Right now I view both markets as overvalued, bonds more so than stocks. I am investing cash very slowly and hopefully wisely, weighing dividend yields more heavily than in the past. Do not be surprised to see cash levels build up in your account.

Please have patience: recognize that holding cash is a legitimate investment option when prices are too high. We have come through the “dot-com” bubble relatively unscathed; we will weather this turn as well. My objective is only to protect your money and my own, while seeking reasonable growth of our assets.

Jim Pappas