Second Quarter, 2004

In our last quarterly letter, we commented upon the positive performance of the stock markets as the economy was gathering strength across a wide variety of industries. Investor optimism was then, and continues to be, extremely high. In the second quarter, the broad stock markets managed a small increase creating a positive 6-month return as of June 30. It seems that personal residences remain the most significant area of ongoing appreciation, but anecdotal evidence points to a declining rate of price appreciation.

So why, in our healthy economic environment, does the Federal Reserve continue to report that "the upside and downside risks to the attainment of sustainable growth are roughly equal"? We’ll keep this letter short by leaving the surmising to others, however from a stock performance standpoint, the market definitely continues to be choppy. We are only a few weeks into the third quarter and the domestic stock markets have taken a significant downturn subsequent to June 30, erasing earlier profits. The silver lining in this is that P/E levels continue to decline, as earnings have been advancing at a far more rapid rate than stock prices during the past 12 months. As a result, the stock market (with the exception of the tech stocks) continues to work its way down to just being high priced (as demonstrated in the chart below), as opposed to being ridiculously high priced. From today's P/E levels for the broad stock market indices, history suggests that stocks will not exceed the return of Treasury bills during the next 5-7 years!

If corporate earnings continue to move ahead at a robust level while the stock market continues to languish, we may begin to increase stock exposure in client portfolios. We are a long way from a cheap stock market with high dividend yields which begs for increased investor purchases, but things are moving in the right direction in terms of stock valuation.

In the meantime, compounding of dividends and interest is our strategy for real portfolio growth under present conditions.

Economic pundits are uniformly predicting further increases in short-term interest rates now that the Fed has taken the first step in this direction. From the recent 45-year low of 1%, expectations are that short-term interest rates will rise to as much as 4% or 5% by the end of 2006. We are immediately skeptical of any such common wisdom considering how frequently it proves to be wrong. However, should interest rates actually rise as predicted, investors in bond mutual funds will experience significant loses during the next few years.

We have prepared the bond portion of client portfolios for this possibility of rising rates by staying relatively short- to intermediate-term with individual bond holdings, while generally avoiding bond mutual funds. As a result, the individual bonds in our client portfolios will not experience a real economic (as opposed to a short-term paper) loss during the next few years unless we are forced by presently unforeseen circumstances to sell those bonds prior to their maturity dates.

A rising interest rate environment (should it occur) will drag down stock prices as well, with aggressive growth-type stocks and growth mutual funds suffering the most. We continue to avoid this sector of the stock market in client portfolios. As stocks become cheaper, we will eventually acquire holdings in this asset class, as noted above.

We have continued to diversify our clients' accounts further this year by adding additional international exposure through targeted international mutual funds along with higher dividend stocks. If interest rates continue to rise, future bond purchases will become more attractive from a current yield standpoint.