Second Quarter 2004 Review

With apologies to Garrison Keillor's A Prairie Home Companion radio show, it's been a quiet quarter on Wall Street. Stocks have been acting quite woebegone. The first six months of this year have been flat. The market's gone up a few points up one day then down a few points the next, week after week. The Dow Jones Industrial Average ended in June about where it began in April. Last year we enjoyed a good recovery from the 2000-2002 Bear Market. So far this year, we have been stalled in a narrow trading range. Investors are now looking ahead to the next two quarters, hoping that the healthy earnings reports we're getting from many of the major firms will propel the market upward. With good earnings reports coming in daily, the Price/Earnings ratio of the 1700 stock universe followed by The Value Line Survey is down from around 19 a few months ago to 17.7 recently. This means that the stocks in this grouping are cheaper now than they were earlier in the year. If this trend continues, the market is likely to act like a coiled spring depressed by uncertainty. The average stock market Price/Earnings ratio for the last sixty to seventy years has been about 14. Roughly half the time the market trades above 14 times earnings, half the time below 14. The stock market seems to be waiting for some kind of optimistic trigger that will release the continuing hesitation, allowing the market to spring up out of the doldrums. Each week, as the prices of stocks stay about the same and the earnings picture improves, the market becomes more attractively priced.

"The market hates uncertainty" is an old maxim, always quoted when the direction of the market is neither up nor down. The winds of uncertainty have been blowing harder. Our concerns are terrorists, the Mid East in general and Iraq in particular, the U.S. elections in November, the general shape of the economy and worries about our jobs. That's enough to keep anyone up all night. Here's the stew of worries. I'll add a pinch of optimism to each batch.

1. Terrorism is not a new phenomenon. What makes this current brand of sneak attack so virulent is the amount of time and planning that has gone into an international effort to upend Western economies. Some think there is a cause and effect issue here. "If only the West would do this or that then terrorism would cease. Others think that the terror masters believe that they are doing the will of God. The reality is simply this: terrorists might get to a few of us, but they can't get to most of us. Those who believe in terrorism hold a totalitarian view of the world. Even a casual glance at world history illustrates that totalitarian systems eventually fail, regardless of their fanatical beliefs. Freedom will not be denied.
2. The Middle East is the source of much of the oil that the world uses. There are not yet enough alternatives to oil and gas in the world. We will continue to depend on hydrocarbons for some time, until other methods of supplying adequate power are employed. Oil wealth concentrated in the hands of a few countries makes for interesting politics. The price of oil has gone up quite a lot, but not enough to stall our economic recovery. Relative to the oil shocks of the 1970s and 1980s, oil is still reasonably priced. Gasoline prices roughly doubled during the last year. For a family that drives their car 10,000 miles a year getting 27 miles per gallon, the increase in cost from $1.45 a gallon to $1.95 a gallon is about $184 a year. Hopefully this is not a budget buster. But for a major airline, any increase in fuel costs is a big deal. Although higher energy expenses have hurt the transportation industry, the average American consumer has been able to adjust to the increase in gas prices.
3. The Iraq issue is on the front burner in America. The opinions about going to war, staying to help establish some form of stable government and the cost in lives and money will continue to be hotly debated right up to and, no doubt, beyond the November elections. If a positive transformation of Iraq occurs within a few years, as proponents of the overthrow of Saddam contend, then it will be seen as a great victory for freedom. If freedom wins, neighboring countries, specifically Iran, might be drawn to a moderate form of government. There are millions of young Iranians who might welcome the end of mullah rule in their country. One significant result of the Iraq action has been the move by Lybia to end certain weapons research programs. We all hope for freedom for those oppressed by tyrants. History will be the arbiter of our actions.
4. Every four years, we Americans have the opportunity to exercise our right to vote. Only half of us who were eligible voted in the 2000 elections. Every vote does count. Spread the word. A casual review of U.S. Presidential elections over my adult lifetime suggests to me that most of those who served in the Oval Office tended to move to the political middle once inaugurated. The current resident has recommended spending programs that many of his own party members do not support. His predecessor moved in directions that his party did not fully support. Democracy is messy and noisy. Once the votes are counted and counted and counted again, if need be, the country gets back down to the business of arguing over whose vision for the nation is best, preparing for the next election. There's always a little uncertainty in the political arena.
5. Jobs and financial security concern most of us. Ours is a country of more opportunities than guarantees. Many Americans whose savings are modest or meager are only a few paychecks away from homelessness. Financial security is always in the back of our minds. What would happen to any of us if we lost our ability to earn a living or if our Social Security checks bounced or if our pension payments stopped? These thoughts cross our minds from time to time. Job uncertainty will be one of the primary election topics going into the fall. Along with health care, financial security is near the top of the list of our nagging worries. How the politicians will slug this one out remains to be seen. The unemployment numbers aren't bad, but the doubt about "my job security" is always there. Again, if unemployment is at 5.5% that means that 94.5% of us have jobs. In Europe, several countries are struggling with 8% to 9% unemployed. We're really in pretty good shape, in my opinion, but expect the political debates to question our well-being with a wide divergence of proposals for improving our common wealth. The government can't hire all of us. What government can do is set conditions that encourage or discourage certain economic activities. I believe that if you tax something you end up with less of it and if you subsidize something you end up with more of it. If we overtax savings and investment we end up with less savings and investment. If we oversubsidize any of the government support systems we will end up with more of whatever was supported. The complexity of a multitrillion dollar economy and national budget is immense. The common sense of "tax and subsidize" is very simple. Let your elected representatives know your opinions.

There are a number of positives to offset the list of worries I've just listed. They are:

1. Improving earnings reports with increased hiring by many publicly traded companies. About 1.4 million new jobs have been added to payrolls over the last year.
2. Continued low inflation and interest rates.
3. Healthy economic vital signs with ample liquidity in the financial markets.
4. Convictions and jail for a number of high-profile corporate lawbreakers with more to follow.
5. Better enforcement of securities rules and regulations that have produced cleaner, more transparent corporate reporting and remarkably,
6. An economy that has continued to grow despite the problems of the recent past.
7. Every day, progress is made in defeating terrorists. We have not suffered another horrific attack since September 11, 2001, in no small part due to the vigilance of our citizens, public servants, and allies around the globe. Perhaps this six-month rest in the stock market presages a renewed spurt of positive energy in the near future. When traders return from summer vacations I'm hoping for some back-to-school bargain hunting.

Stocks have been cool, but housing has been hot. Over the last three years, money has flowed into the residential housing market, prompted by extremely low interest rates. Refinancing to lower monthly mortgage payments frees up millions of dollars every month. Post 9-11, many Americans have been investing in their own homes, eschewing the stock market and embracing stay-at-home activities like gardening and home improvements. Many people with whom I've spoken over the last several quarters have expressed a desire to invest in what they see as a sure thing: real estate, specifically their own real estate. That begs the question: Is this the top of the real estate market, now that so many feel this way? Perhaps it's the top in terms of rapid appreciation, but some indicators suggest a continuation of growth in residential real estate, though at a slower pace. Interest rates, which determine how much house you can buy if you finance with a mortgage, are still historically low, making it easier for first-time home buyers to qualify for a loan.

In the second quarter, the U.S. economy grew at a pace of 3.0 %, down from 4.5% in the first quarter. Inflation continues to increase at about 3.5% per year. Unemployment registered a steady 5.6%, which is considered reasonable at this stage of an economic recovery. According to the Bureau of Economic Research, consumer confidence is slowly improving. The Federal Reserve edged short-term interest rates up by 1/4%. This sent certain high-dividend stocks and many bonds lower for a few weeks mid-quarter. Rates have since settled back and many of the dividend-payers have recovered. A slower growing economy takes pressure off the Fed to increase short term interest rates rapidly. All of these factors are positive for stocks. It's not that there's a lot of selling; there just doesn't seem to be much buying. To counter a stagnant market, some investors have focused on higher dividend-paying securities. Also, stop-loss orders can limit downside exposure, but can also result in a stock being sold simply because of short term trading pressures unrelated to the fundamentals of the company.

Today's investors are facing a very low interest rate environment which offers few attractive investment opportunities. I believe we should be looking at dividends and higher-interest options, at least until something wakes up the bulls. Diversification is the key discipline. Total return, the combination of gains and income, is our focus.

Financial Planning Reminders

Beneficiaries named on life insurance policies, retirement plans (IRAs, Profit Sharing Plans etc.) and annuities determine who will receive distributions. Be sure to periodically check your various beneficiary designations. Situations change. Without formal notice, your plan custodian or insurance company can't know if you changed your mind about certain distributions. It's also a good idea to keep a check list of the plans where you save your important papers.

Minimum Required Distributions (MRDs) are easily forgotten. Once a retiree with a qualified retirement plan or IRA reaches age 70 ½ a predetermined periodic amount must be withdrawn to satisfy government tax rules. Most mutual fund families and custodians offer a monthly or quarterly distribution option and will recalculate the MRD annually.

Next quarter I'll be enclosing the year-end planning check list. You can visit our web site any time for the check list, archived quarterly letters and general financial planning information. Tell your friends and families to look us up on the web at www.brimmerfinancial.com.

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