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Quarterly Letter to Clients

October, 2004

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

Dow Jones Industrials: 10,080.27 3Q'04 -3.40% YTD -3.58%

Standard & Poor's 500: 1,114.58 3Q'04 -2.30% YTD +0.25%

Did you happen to notice this anomaly during the quarter? Gasoline prices at the pump were going down while oil prices were hitting new highs, near $50 a barrel. Could this possibly have something to do with the election?

In my last letter I spoke of the malaise of the markets. It has continued. For three quarters now, the markets have produced percentage moves that are hardly worth noting.

The S&P 500, which is an index of America's 500 largest companies, has been dead in the water, opening the year at 1112 and finishing the period at 1115. But the true tone of the market has been more evident in the Dow Jones Industrials and the NASDAQ, which, after nine months, are down 3.58% and 5.31% respectively.

I confess to being worried about our Federal debt and budget deficit levels. Unless brought under control they will have a long-term negative effect on our currency. I do not particularly care that we do not manufacture anything; I do care if we owe more than we can repay. We are looking at a devaluation of our currency, either directly by edict, or, much more likely, indirectly by significant inflation.

On top of this, we still have a war going on, the election hanging over the markets, oil rising, and interest rates going up. It’s hard to get up in the mornings in times like these.

The Fed has now raised rates three times this year, albeit by only 25 basis points per. Greenspan and company have indicated that more rate boosts are in store. In a perverse and illogical digression from the Fed’s direction, the bond market has remained firm, with prices and yields essentially unchanged through the three Fed moves.

But to me the bond market looks like a slingshot, loaded and pulled to the max, waiting to be released. How many more times can the Fed tighten before we feel the effects?

Oil, too, looks like a stretched rubber band. A combination of war, demand from China, and the filling of the strategic petroleum reserves has led to significantly higher wholesale oil prices, while prices to the consumer have (likely) been artificially held down. After the election I expect that pricing pressure to show up at the pumps. I wouldn’t be surprised to see gasoline and heating oil 25% higher this winter.

This is notable, and worrisome, because stock prices have lately moved opposite to oil prices. It is also another harbinger of inflation.

How, one might ask, can anyone be bullish in the face of all of this? It is quite the small miracle that all of our markets have held up as well as they have.

For the last nine months market participants have been holding their collective breath. I suspect that after the election the markets will make up for lost time. I can only hope it will be in a positive direction.

In my opinion, it will pay to be very cautious for at least the balance of this year. All asset classes still look too high to me. Patience is very likely to be rewarded.

Jim Pappas