Second Quarter, 2005

We begin the third quarter of 2005 with the economy performing quite well. For example, employment continues to rise, albeit on a gradual basis; office occupancy across the country is increasing as are office rents; inflation (as officially reported) is benign; the budget deficit is beginning to decline due to rapidly growing tax receipts; construction spending is strong; corporate profit margins are very strong; and long-term interest rates continue their bumpy yet gradual decline, giving continuing support to the feverish pace of home sales. To the amazement of many, these positive economic trends continue in the face of a massive spike in the price of oil. Previous oil price spikes have inevitably led to recession, but not this time so far.

Of course, all the above is yesterday’s news, fully discounted in the market price of the stock and bond markets. It’s reasonable to ask, therefore, if the economy is doing so well, why isn’t the stock market booming? From its peak in early 2000, the Dow is still down 11%, the S & P 500 Index is down 23%, and the hapless NASDAQ Index is down a whopping 59%, all as of June 30, 2020. A study of the history of the stock market and the economy reveal a fairly simple answer: The economy and the stock market have never had a history of strong correlation.

One of the biggest economic events this year has been the decline in long-term interest rates which has perplexed the economic community for some time. Lately, various theories have been floated to explain why short-term interest rates are rising while long-term rates are falling. If the causes of this phenomenon can be identified, then it may be possible to derive benefit from investing in areas contributing to the trend. Recently, an increasing number of influential portfolio managers and economists have switched from being bond "bears" (believing long-term interest rates will be rising) to bond "bulls" (believing long-term rates will continue to decline for the foreseeable future.)

Here is a summary of the current thinking. The U.S. faces massive outflows of money from the combination of the trade and budget deficits. When we purchase goods from less developed countries such as China or India, our dollars wind up in the hands of those foreign merchants. These merchants then exchange their dollars for local currency through their banks. The foreign banks in turn take a significant portion of these dollars and invest them in U.S. Treasury securities.

Given the magnitude of our appetite for foreign purchases, these local governments continue to accumulate hundreds of billions of our dollars each year which, in turn, they seek to invest. The U.S. government, which has been running an enormous fiscal deficit, borrows money in international markets from these countries to cover our own budget deficit. It’s a convenient relationship between borrower and lender – so much so, in fact, that demand for Treasury securities now appears to be continuously exceeding newly created supply. Recently, the budget deficit has begun to shrink at a surprisingly rapid rate, due to unexpectedly large increases in tax receipts. As a result, U.S. government borrowing needs are actually beginning to diminish. Therefore, the present thinking goes, bond prices have been rising causing yields to decline. If the U.S. remains fortunate enough to avoid a recession, it is reasonable to assume that our trade deficit will continue to be a prime contributor to a continuation of the trend of declining interest rates.

Here are some consequences of this point of view:

1. The real estate market for homes may continue its speculative frenzy for an extended period of time. An entirely new wave of refinancing may result if the 10-year Treasury drops another 1%, (perhaps less) from today’s level. Consumers will wind up with more cash to spend, either from refinance proceeds or lower mortgage payments. The high cost of oil will continue to not harm overall economic growth.

2. The scramble by investors for investment yield, or cash flow, will intensify. REITs and utility stocks are perfect examples of the effect of the scramble for yield. Those two sectors of the market have generated returns in excess of two times that of the overall stock market during the last two years. Equity yields in these industries have been cut in half or more during the past few years as prices continue to escalate.

3. Solid economic growth at home fueled by strong consumer spending will continue to promote rapid rates of development in the less developed nations of Asia and Africa, which in turn will lead to incrementally greater oil consumption each year. Oil prices should remain high or move higher until the U.S. economy slows down.

Your portfolio has been the beneficiary of the trends identified above. In past quarterly letters, we have discussed your portfolio’s meaningful weighting in energy stocks and our continuing efforts to boost portfolio yield. Both of these factors contributed to your strong equity returns year-to-date. Thus we do not anticipate any major shifts in portfolio construction as the third quarter gets under way.