Fourth Quarter, 2005

This quarter our letter addresses three topics which have been prominent in the news because of their significant impact on 1) investment thinking and, as always, 2) the structure of your portfolio.

The first issue we explore is the federal government treasury yield curve. Recently a great deal of press has been given to the current structure of the yield curve and its predictive ability regarding future economic activity. What follows is a brief discourse designed to clear the air for our clients on this extremely important economic indicator. Bear with us;  the discussion, while not complicated, is extremely insightful.

First, exactly what is a yield curve? Quite simply it is the relationship between the cost of borrowing money and the length of time it is to be borrowed. The most widely followed yield curve is that of our federal government and the cost it incurs to finance its borrowing needs. Most of the time the interest rate it must pay on short-term securities such as a three-month treasury bill is much lower than the rate it must pay to borrow money for 10 years or longer. This axiom is true for all borrowers—most of the time. The difference between the short-term and long-term rate is called the spread.

It stands to reason that investors will demand a higher rate from a borrower to tie up money for a longer period of time because the future is uncertain. The longer into the future that a borrower wishes to obtain funds, the greater the uncertainty and, thus the greater the borrowing cost to compensate for that uncertainty, which results in a positive yield spread. That’s the textbook description.

Infrequently this spread goes to zero or becomes "inverted." This means that the government’s borrowing cost for issuing ten-years or longer maturity bonds is the same as (zero spread) or even less than (negative or inverted spread) the yield or cost it must pay when issuing three-month treasury bills.

Now here is the key element which concerns us. During the infrequent times when the yield curve flattens, i.e., the spread approaches zero, the odds of an ensuing recession in the following 6-12 months increase dramatically. The odds in favor of a recession increase even further during a yield curve inversion. Furthermore, history has shown us that the longer an inversion lasts, the greater the severity of the subsequent recession. A study by the Federal Reserve Bank of New York reveals a significant level of predictability between yield curve spreads and recessions going all the way back to 1858.

Since 1960 there have been seven "officially designated" recessions in the U.S. Every one of them was preceded by a flat or inverted yield curve.

This brief historical sketch brings us to the discussions taking place today in the financial press. As this letter is being written, three-month treasury bills are yielding 4.43% and 10-year treasuries offer a yield of 4.48% resulting in a yield curve spread of 5 basis points. That’s pretty close to zero and not far away from an inversion. All that can be accurately said at the present time based upon this indicator is that the odds of a recession in the next six to twelve months are increasing and that the likelihood will increase further if the yield curve inverts and then stays inverted for a while.

Should additional evidence begin to mount that the odds of a recession are increasing, we will consider a variety of actions to reduce potential declines in value to client portfolios.

A second topic gaining increasing frequency in the financial press has been the relentless rise in the price of gold since early 2001. Gold, as a commodity, and the companies that mine it have now completed their fifth strong year. A five-year bull market in ANYTHING should make folks stand up and take notice, however, gold has only recently begun commanding some widespread respect in the financial press. But the question puzzling many people is, why should gold be rising so powerfully? Our economy, and furthermore, the global economy, continues to experience solid growth, inflation and longer- term interest rates have been relatively calm, and the dollar actually strengthened against the Euro and other currencies as 2005 progressed. Following are two theories on gold’s rise.

During the period from 1980 through 1999, gold experienced a persistent decline in its dollar price as a global decline in interest rates resulted in massive gains for equity and fixed income markets. Interest rates in the U.S. and in other developed overseas markets, however, bottomed out early in the new millennium thus bringing an end to the past extraordinary rates of return for these markets. Investors are more and more searching beyond the U.S. stock and bond markets for additional returns, and this has benefited gold as well as other precious metals.

A second theory posits that the powerful wave of economic development occurring primarily in resource-rich developing nations (and a few other resource-rich countries such as Canada and Australia) has contributed to gold’s rise. Billions of developing nations’ peoples want a piece of the good life, and commodity prices which include gold, have exploded upward in response to global economic growth. We believe we are still in the early stages of this commodities boom. We expect an occasional recession to interrupt this shifting global growth pattern, but our secular view is for long-term commodity price increases vis-a-vis depreciating currencies. Developing nations now have what the people of the developed nations need and want: 1) cheap labor (Asia, Eastern Europe) and 2) energy and mineral resources (parts of Africa, Asia, South America, and the Middle East). We may just be in the early stages of the most massive shift in wealth that the world has ever seen to developing nations from the developed nations. Many of these countries have relaxed their former restrictions to gold purchases by their citizens. China and India stand out in this regard. Whenever billions or even millions of people are granted access to gold as an alternative to currencies, which are subject to manipulation, it’s reasonable to assume demand will increase.

It was just prior to the beginning of the new millennium that the first exchange-traded funds (ETFs) were created.(1) After studying their features as far back as the year 2000, we concluded that it would just be a matter of time before these investment vehicles would forever change the face of the mutual fund industry—for the better. In their early years, ETFs were created to track the best known stock indices such as the S&P 500 index and the NASDAQ. Within a relatively short period of time, niche funds were created in narrow investment areas such as industry sectors (health care, energy, semiconductors, etc.), foreign country funds, and segments of our domestic bond markets to name but a few. Securities markets in Europe and Asia also created their own ETFs to meet investor demand in these other areas of the world.

As 2006 began, there were approximately 220 different ETFs traded in the U.S. and perhaps an equal or greater number traded elsewhere around the world. The most recent development in the ETF world has been the creation of funds that own commodities rather than shares of various stocks or bonds. During November, 2004, for example, the first gold bullion ETF was opened to U.S. investors (symbol GLD) with each share representing ownership of one-tenth ounce of gold bullion, stored in vaults. This single ETF now holds ten million ounces of gold (312 tonnes) on behalf of its investors!

We have been active investors on our clients' behalf in a variety of ETFs, and we expect that additional investment of client money will occur in the future as the ETF universe continues to expand into new investment areas. This year, for example, many new "non-traditional" ETF products are expected to begin trading. Included among these will be a silver bullion ETF, two commodity index ETFs, a crude oil ETF and various currency ETFs. In fact, the first Euro-currency fund began trading in the U.S. approximately one month ago. Many of these funds will provide the opportunity for additional portfolio diversification which, we never tire of saying, will help to further reduce portfolio volatility.

Energy, gold and foreign diversification all combined to generate strong gains in client portfolios last year. Our year-end asset allocation review has led us to envision the same strategic portfolio structure for clients in 2006.

Asset mixes are a journey and not a destination. During the past five years, we have reduced client domestic equity exposure and increased investment in foreign stocks. "Other" assets, primarily REITS and commodities, have increased in many portfolios. Presently, the biggest drag on portfolio returns is coming from the domestic fixed income asset class due to the low current interest rate environment.

(1) These mutual funds can be bought and sold throughout the day just like other stocks. Originally conceived to mimic the price action of a variety of stock indices, they operate at a much lower expense level than traditionally managed open-end mutual funds, realize less capital gains, and experience relatively low portfolio turnover.



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