Third Quarter, 2005
With nine months of history under our belts for 2005, investment trends which have had a significant
impact on our clients’ equity results have come into clear focus. Chief among these are the following:
Commodity-type investments continue to experience sharp price increases. Oil is, of course, the
most obvious example as growing demand from emerging markets—most notably China and India—continue
to absorb what in the past had been categorized as excess supply. Add to this the impact of supply
disruptions from hurricanes and terrorists attacks on sources of production and the stage is set,
in our opinion, for oil prices to remain relatively high for the foreseeable future.
Other commodities are also experiencing surging prices as evidenced by broad-based commodity
indices. Industrial commodities and materials such as copper, lead, cement, diamonds and nickel are
all experiencing rapid price increases attributable to strong global demand, particularly from
emerging nations. We believe this trend is secular.
Perhaps we are at the early stages of a growing global desire to convert worthless paper currencies
(which continue to be printed in quantities that defy our comprehension) into "hard assets". One of
the most sensitive barometers to the debasement of currencies is gold, and during the past quarter
gold rose to a 17-year high in dollars, Euros and Yen. This is unprecedented. The markets are
telling us that global discontent with fiat currencies is on the rise! Gold’s rise to a new high
has caused gold and precious metals mining stocks to increase by 30-40% this year.
Overseas stock markets in general, and emerging markets in particular, have dramatically
outperformed our domestic stock markets this year. The third quarter witnessed an acceleration
of this trend.
Inflationary trends appear to be re-emerging—both at home and abroad as evidenced by various
indices of inflation. In the U.S., the rate of increase in the federal debt is stunning. In the
past twelve months (through September) an additional $563 billion has been added to the national
debt, equal to an increase of $1.54 billion of debt each and every day. So far, the rest of the
world continues to acquire our treasury securities issued to fund this rapid growth of government
debt. Global demand for our treasury securities has kept pace with increasing supply preventing,
thus far, longer-term interest rates from rising in sympathy with increases in short-term rates.
Eventually, interest rates rise during periods of increasing inflation concern. For the first nine
months of this year, however, this growing expectation still hasn’t affected the price of
long-term treasury bonds. Long-term interest rates are virtually unchanged as of September 30
compared to interest rate levels on December 31, 2020. Bond returns for the year to date remain
low. Should longer-term interest rates begin to rise in the fourth quarter, bond total returns
will likely become negative for the year.
Finally, the broad domestic stock market continues to sputter as it has done all year despite
strong corporate earnings growth. The U.S. stock market may also generate a loss for the year
if incipient inflation fears result in rising long-term interest rates during the fourth quarter.
Client portfolios have enjoyed strong price appreciation for the nine-month period as investments
in energy, precious metals, and foreign stocks substantially outperformed our domestic markets.
During the fourth quarter we will review client taxable account for tax loss possibilities and
give clients a preliminary report on losses (if any) that we have realized. Please recall that it is
our policy to take losses when available in taxable accounts near year end to offset other taxable
gains, or to "stockpile" the capital losses for use in subsequent years against future capital gains.
Realized losses have an economic value by virtue of our tax laws.
Our diversification efforts in the "other" category have been quite successful this year to date.
Client portfolios have investments in real estate, gold, a commodities fund, and a hedge fund. The
price action of each of these assets is relatively uncorrelated to the price action of our domestic
stock market. In other words, these other assets follow their own pricing patterns independent of the
price movements of the stock market. This is a good thing as client portfolios’ overall volatility
will be lower by virtue of their inclusion. In plain English, our continuing diversification of client
portfolios helps reduce the overall level of portfolio risk. This statement is illustrated by the
enclosed charts presenting a sequence of hypothetical portfolios that are increasingly diversified.
The objective of diversification, being reduced risk without a commensurate reduction of portfolio
return, is clearly demonstrated.
One further observation regarding hedge fund investments is appropriate here. Hedge funds typically
earn larger returns when the volatility of investment markets increase. We have now come through a
period of very low stock and bond market volatility matched by low hedge fund returns in 2004 and
2005 to date. This may be coincidental but we think not. Markets are becoming more volatile now and,
if old relationships hold true, hedge fund of funds returns should begin to improve.
Investment Management, Inc.
Circle 75 Parkway, Suite 750
fax (770) 953-3586
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