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Quarterly Letter to Clients

July, 2004

Indices at quarter-end (June 30, 2004):

Dow Jones Industrials: 10,435.48 2Q'04 +0.75% YTD -0.18%

Standard & Poor's 500: 1,140.84 2Q'04 +1.30% YTD +2.61%

It seems that the summer doldrums have lasted all year. While the business of long-term investing is very often akin to watching paint dry, it has been even more so this year. We have marked time for this entire year, waiting for the Fed, which, it happens, finally moved to raise rates on the last day of the quarter.

In my opinion, the Fed needs to move its targeted short-term rates from the 1% level of the last four years to a range of 3% to 4% in order to give it some stimulative flexibility in the future.

This widely-anticipated move by the Fed may be the catalyst that brings the markets to life. Time will tell. But in the interim, the markets have been very quiet, very uneventful for two quarters now. And I have been unusually inactive, initiating very few transactions. I am not alone, as volume on the exchanges has been relatively low. I don’t know about others, but for me, the reason falls basically to price: I feel that all securities classes are overpriced, or at best, fully priced.

With interest rates expected to continue to rise for the near future, it does not appear to be a particularly propitious time to buy bonds. Bonds are down sharply from the lofty levels they saw early in the year, and I am encouraged in that I am beginning to see attractive offerings. But I feel that it is the wiser course to move slowly, as prices are likely to drift lower.

On any given day the market has followed the price of oil, or the change in interest rates, or, occasionally, the news from Iraq. None of this static noise provides any compelling reason to make long-term investments. We have rising interest rates, high oil prices, a war and an election on our plates.

All of that being said, overall, I must still admit to a bullish, positive sentiment, regardless of who wins the White House later this year.

The economy is bubbling along, stronger than the stock market would seem to indicate. And is it any wonder that the economy is looking stronger? The government has pumped out cash at an unprecedented rate, and a hundred thousand young Americans have found employ in Uncle Sam’s armed services.

Friends in the manufacturing sector have been telling me that they are able to pass along price increases without resistance. This anecdotal evidence buttresses reports in the press, and represents the first time in a long time that companies have any pricing flexibility. As long as we can hold inflation to a dull roar, everything will be rosy.

If rates do in fact continue to move up, eventually the PE ratios of stocks will experience downward pressure; thus my feeling that most stocks remain a bit too high, and my reluctance to initiate positions. Conversely, price increases by businesses should lead ultimately to higher profits, with higher stock prices the logical next step. But, as I mentioned above, so far it has been as quiet as the proverbial mouse.

After 37 years in this business, the market still surprises me; in this instance, by its very lack of movement. Given all of the factors weighing on investors today, can anyone not be surprised at the lack of volatility? I do anticipate that the markets will soon break out of their confines, hopefully to the upside. But it is not clear when that might happen, and I am in no rush to put additional capital at risk until there are clearer signs.

Jim Pappas