Fourth Quarter, 2003

The stock market continues to move higher based upon extraordinary enthusiasm for the ongoing economic recovery in spite of unusually high market valuations. The bond market, however, has continued to experience declining interest rates since August, thereby signaling either a vote of "no confidence" in the economic recovery or a growing threat of deflation. Do these seem like totally contradictory market signals? Declining interest rates in spite of the most massive effort ever to bring the U.S. back to the good old days of inflation? You know, it just doesn’t get any more challenging than this in the life of an investor. 

We are in strong company with our opinions regarding the excessive levels of today’s broad stock market indices and the limited long-term return prospects that today’s valuation levels imply. Warren Buffett has delivered speeches on this topic for more than the past three years. Sir John Templeton, Jack Bogle (founder of the Vanguard funds), Bill Gross (manager of the country’s largest family of bond funds) and many other practicing investment manager luminaries continue to proclaim that we are at a precarious point given excessive stock market valuation trends. 

While the overall stock market is expensive, tech stocks are once again "through the roof". Even the chief market strategist of Merrill Lynch (remember the slogan, "we’re bullish on America") has noted his own surprise with today’s extraordinary level of tech stock pricing. We don’t understand what it is about tech stocks that has people willing to pay so much for them again. The average P/E ratio of the 100 largest Nasdaq stocks (mostly tech stocks) is 62 times earnings. Not only is this extraordinarily expensive, but the dividend yield on the top 100 is only four-tenths of 1%. The desire to take risk is back with a vengeance as is also evidenced by the dramatic rise in margin debt (borrowing money to buy stocks). Alan Greenspan’s now famous "irrational exuberance" is back for an encore. While it may be irrational, it just may continue for an indefinite period into the future as no one wants to miss this bull while it’s running. 

The budding U.S. economic recovery has spilled over into emerging markets around the world. Less-developed nations, particularly in Asia, look like potential big winners once again in 2004 assuming our economy holds up. Emerging markets remain attractive due to their low labor rates and huge markets for consumer goods as their own populations move up from poverty to higher standards of living. China and India are but two of the most obvious examples.

The challenge, the dilemma actually, all investors face today is how to participate in the continuing stock market advance while recognizing that the broad stock market averages are overpriced. Of course, there are many others who would dispute our position of market overvaluation, just as there were back in 1999 and early 2000.

It appears to us that the biggest news of the fourth quarter and of the entire year, in fact, has been the decline of the dollar (relative to other currencies). The most immediate and obvious consequence of the dollar’s decline has been to cause a growing list of foreign goods (including oil) to become more expensive for us to purchase. Americans will eventually scale back on purchases of foreign goods, in turn, slowing the growth of imports and possibly helping our trade balance of payments. 

A second consequence of the declining dollar should be an eventual increase in domestic interest rates as foreigners decide they need greater financial inducements to continue acquiring investments denominated in our depreciating dollars. Rising interest rates, when they finally occur, will hurt the consumer and the economy. For the present, as mentioned above, the bond market is not responding to these negative trends. We repeat what the noted economist, John Maynard Keynes, said many years ago: "Markets can stay irrational longer than you can stay solvent."

Given these various economic observations, we are continuing along the same path with our investment strategies for client portfolios in the new year. We are diversifying client portfolios to a greater extent than ever before. We hope for the best, but we have planned for the worst—especially in light of domestic stock market overvaluation. 

Specifically, we continue to minimize investment in the most overpriced sectors of the stock market. Treasury bonds today offer higher yields than the earnings yields of tech stocks, for example. Tech stock investors receive no investment return premium for ownership in one of the most volatile and risky sectors of the stock market compared to safe government securities.

Second, we have continued to acquire non-dollar denominated assets. The decline of the dollar throughout 2003 has enabled you to profit from non-dollar denominated investments in your account. These investments include foreign stocks and bond funds specializing in foreign bonds. Gold mining stocks have also benefited from growing global dissatisfaction with the dollar.

Third, the threat of rising inflation caused by rapidly growing trade deficits and budget deficits causes us to maintain a defensive posture with the domestic bond portion of client portfolios. By "defensive", we mean that client portfolios own relatively short-term, high-quality bonds maturing within a one- to seven- or eight-year time frame. In addition, clients own inflation protection bonds which increase in principal amount as the CPI moves higher. So far, inflation has not re-emerged as a significant problem. There is near unanimous consensus that the economy will continue to strengthen in 2004 which should eventually result in rising inflation and interest rates.

In our last quarterly letter, we observed that our increasingly diverse portfolio of stocks has caused the S&P 500 Index to lose its relevance as a benchmark for clients’ equity portfolios. As an alternative, we believe a broader stock market index which de-emphasizes large cap growth stocks will be a better gauge of overall stock market performance. Hence, we now include the Russell 3000 stock market index for client consideration. We have added the EAFE index which monitors stock markets located in Europe, Asia, and the Far East—as illustrative of general stock market trends outside the United States. Also, we have included other fixed income indices as additional reference points and information. 

Recently a wonderful book came to our attention which puts the stock market bubble of the late 90’s into very clear perspective. Published in early 2000, at the top of the bull market, it is entitled Irrational Exuberance and was written by Robert Shiller. The book is written in easy-to-understand prose, and I heartily recommend it to you if you desire a better understanding of the general investment mentality which has pervaded our country not only at the bull market peak in 2000, but also right up until the date of this quarterly letter.  The author draws on a variety of diverse and unrelated fields of information to reach thought-provoking conclusions regarding why investment markets experience speculative bubbles. In the process, he shatters a number of misconceptions and illusions. Two of the biggest misconceptions are:

·         The stock market as a whole has always been the best investment and always will be, even when the markets are overpriced by historical standards; and

·         Market analysts and other lay people can explain why the stock market behaved as it did on a particular day and why it is at its current level.

 Irrational Exuberance is, in our opinion, an investment classic that will help you expand your knowledge of how the stock market really works.