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Quarterly Letter to Clients

October, 2005

Indices at quarter-end (September 30, 2005):

Dow Jones Industrials: 10,568.70 3Q'05 +2.86% YTD -1.99%

Standard & Poor's 500: 1,228.81 3Q'05 +3.15% YTD +1.39%

A friend recently told me that there was a time to sow, a time to reap, and a time to sit and watch the weather.

Which is where we are right now.

During the quarter the Fed raised rates twice, the tenth and eleventh consecutive upward moves that august body has made in its never-ending quest to contain inflation. There is an old axiom, “don’t fight the Fed”, but the bond market has been doing exactly that. To me, it seems to be folly to be a long-term bond buyer right now.

Oil continued it’s upward journey, rising above $70 a barrel for the first time, helped along by the destruction wreaked on New Orleans by hurricane Katrina. The markets managed to ignore the oil price, the Fed moves, and two hurricanes, but year-to-date no real headway has been made in stock or bond prices.

As Floyd Norris recently said, “Just because something is overpriced does not mean it will correct anytime soon” (think oil and/or gold). I would extend that thought to things that are low-priced as well (think bond yields).

A recent note from a broker quoted Keynes from his “General Theory” and, paraphrased, the selection said that it was rational for decision-makers to use gut instinct rather than financial forecasts since forecasts tend not to be very accurate.

I’m with Keynes on this one.

It is widely felt that profits are the long-term determinant of stock prices. And corporate profits in the U. S. have been in an uptrend essentially forever. It doesn’t matter how you measure it; pre-tax, after-tax, cash flow, EBITDA; the nation’s businesses have consistently expanded their income with only minor, short-term interruptions. The same is true of book value.

In part this has been because our country’s corporate tax rate has been steadily declining since the end of World War II. But you cannot deny that business has continually become more sophisticated and more efficient, and this contributes to the bottom line as well. This growth in profits is in spite of the fact that wages and salaries are in an up trend that has extended more than fifty years.

Thus, on a long-term chart of the nation’s Gross Domestic Product you can’t even see where the recessions were. One would be hard-pressed to forecast any change in these trends.

It would seem to follow, then, that the wisest course of action is to be fully invested in the stock market at all times. While there is a certain amount of truth in that thought, it is not quite that simple. Fear and Greed get in the way. It is the rare investor indeed who can sit through extended market declines comfortable in the knowledge that he will reap his profits at some unknown point in the future. Even more rare is one who can hold cash for extended periods to avoid erosion of capital.

Today’s threats are multiple: war; inflation; oil prices; natural disasters; foreign competition; trade and budget deficits; systemic problems in basic industries like autos and airlines. It is easy to find the fear. Opportunity is less evident.

You really want to be a buyer when values are low (times of fear), a holder while values are rising (stable periods), and a seller when values have peaked (bright outlook). And this is extraordinarily hard to do.

We utilize various metrics to assess at what point we should be buyers or sellers: P/E’s, interest rates, profit growth, inflation, debt levels, etc. All of these factors move markets, plus market psychology—the gut instinct mentioned by Keynes. It is this last that is so very hard to call. We are certainly at a difficult point in market history, but that can be said at almost any time. Recall my statement on corporate profits above: basically you want to be invested at all times. There are certain to be periods when stocks and bonds are better buys than at other times, but it is a near-impossible task to avoid the bad times and only be an investor during the good times. (That said, you don’t have to be fully invested all the time.) So ignore the static and focus on the long term.

For my part, while maintaining my current holdings, I am currently very cautious in making new commitments; but I stand ready to invest whenever I feel a good opportunity presents itself.

Jim Pappas