PacWest Financial Management Newsletter
3rd Quarter 2004

Volume VIII, Issue 3

October 2004

QUOTE:
Let us never forget that government is ourselves and not an alien power over us. The ultimate rulers of our democracy are not a President and senators and congressman and government officials, but the voters of this country. ~Franklin D. Roosevelt

•	Economic News
•	Financial Planning
•	U.S. Stock Market
•	Fixed Income Markets
•	International Equities

Featured Articles

•	Working Families Tax Relief Act of 2004
•	Key 2005 Medicare Figures Announced - October 7, 2004
•	Year-End Tax Planning

Economic News - Inflationary Concerns

Inflationary concerns remained in the forefront during this past quarter, especially with interest rates at the lowest level in decades. The potential growth of gross domestic product (GDP) also indicates an inflationary risk. The consumer price index (CPI) rose slightly by 0.1% in August after decreasing in July by 0.1%. With this increase, the index reached a level 2.7% higher than the previous year.

GDP grew by only 3.3% in the second quarter, compared to the growth of 4.5% in the first quarter. The softening of the economy, including the slight slowdown in the labor market, is the main culprit. However, economists from The Wall Street Journal’s “Economic Forecasting Survey” expect the growth to pick up again in the fourth quarter and estimate a 4.1% increase.

In an attempt to stave off an increase in inflation, the Federal Open Market Committee (FOMC) raised the federal funds rate twice since June. On August 10, the federal funds rate increased from 1.25% to 1.50%. Then again, on September 21, the FOMC raised the rate to 1.75%. Economists expect the FOMC to increase the rate again before the end of the year. In fact, the Fed would ultimately like to raise the rate to 2% or 2.5%, then after an evaluative period, lift the rate to a neutral level between 3% and 5%.

Economists from the “Economic Forecasting Survey” do not expect much of a change in CPI for the remainder of the year. However, they lowered their estimates for May 2005 to 2.3%, down from the previous estimate of 3.0%.

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Financial Planning

Year-end tax planning should begin in October. The goal is to minimize taxes by taking advantage of a few strategies that will reduce taxable income and increase deductions.

Investment planning: Offset as much realized gains as possible by realizing losses. The investor can always buy back the same security by waiting 31 days.

Gifting to charities: As an alternative to cash, give highly appreciated assets to the charity of your choice. The gains will be recognized by them and not you.

Gifting to minors: Since minors are usually at a lower bracket, gift appreciated assets to them and then sell the assets. This may save some taxes. The minors must be over 14. The gift is limited to $11,000 from one person to another. Otherwise, it may trigger a gift tax.

Maximize funding of retirement plans: There has been a significant change in the level of funding. This is most applicable to self employed individuals. Additional funding reduce taxes and build up nest eggs for retirement.

These are some of the more common strategies. Please check with your tax professionals for information on other opportunities. We can also assist with other strategies.

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U.S. Stock Market

U.S. stocks performed poorly during the third quarter, which is not surprising to many market participants. Historically, September is a lackluster month for equities. Although returns during election years for this period are normally stronger, that was not the case in 2004.

Causes for lagging stock prices include elevated light, sweet crude oil prices, and uncertainty regarding the presidential election, geopolitical environment and prospects for the economy.

The S&P 500 fell 2.3%, while the Dow Jones Industrial Average lost 3.4%. The NASDAQ had a rough quarter, declining 7.4% during the quarter. The small cap Russell 2000 was off 2.9%.

We continue to maintain our forecast of a positive return for the S&P 500 in 2004. This index is basically flat on the year, while the Dow and NASDAQ are down over 3% and 5%, respectively. Small cap stocks are up over 3% in 2004. We believe the Federal Reserve Board (Fed) will continue to raise short-term interest rates at a measured pace. However, we are concerned with the rising price of crude oil since our last newsletter edition.

Additionally, the tight presidential election could dampen returns through November. However, many investment professionals believe we could see a rally after November 2nd. Due to the contrarian view that we normally take, a market rally in October would not be surprising.

The anemic pace of economic growth continues to be a concern. Although leading economic indicators show a fairly strong economy, we feel that growth is overstated. We believe growth began slowing around April of this year, and did not stabilize until September. We will monitor this closely in the coming weeks and months.

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Fixed Income Markets

The Federal Reserve has raised rates three times now, taking the fed funds rate from 1% to 1.75%. As the Fed raised rates, actual long term market rates continued to fall. The dichotomy between the Fed and the market can partially be explained by the weaker economic data and corporate news that was released throughout the summer. Companies started to see orders slow at the end of the second quarter. Short-term rates are determined by the Fed and long term rates are a function of the market’s expectation for the economy and inflation. With longer rates falling, the market has been forecasting slower growth and subdued inflation.

The ten-year bond yield fell from 4.6% at the end of June to 4.1% at the end of the third quarter. Yields across all maturities except the three month T-bill fell from the end of the second quarter, which dramatically flattened the yield curve.

We expect rates to increase slightly from here as yields bounce back off their lows and investors prepare for the Federal Reserve’s meetings in November and December. The Fed could have one more rate hike left in them before year end.

We have continued to purchase short term callable government agency bonds and step-up government agency bonds to try to pick up extra yield and protect against higher rates in the future. With modest growth and low inflation, we could find a happy medium in rates soon.

As goldilocks might say, we should soon be at a rate that is not too high and not too low.

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International Equities

While it was not a spectacular quarter, the international markets were able to outperform the domestic U.S. market. The EAFE index dipped slightly with a –0.75% return in the quarter leaving it with a 2.3% return year-to-date. The dollar weakened slightly against the Euro, which helped U.S.-based returns. Hong Kong and Australia certainly helped, as they reversed their second quarter losses and moved up by over 8%.

China’s initiatives to slow their economy has lowered their growth rate slightly, but according to the International Monetary Fund they still appear to be on track to achieve 9% GDP growth this year. In contrast, they predict the U.K.’s GDP growth will come in at 2.5% this year. European countries are not growing nearly as fast as their Eastern counterparts, but valuations are in-line with their growth prospects.

Although there have not been outsized returns in the international markets lately versus the U.S., they still look attractive going forward. Valuations are relatively low versus the U.S. market. According to Standard and Poor’s, the S&P 500 is trading at a P/E multiple of just under 19 on this year’s earnings, while Morgan Stanley states the EAFE index is trading at a P/E of just over 17. We continue to keep a significant weighting in international funds and I-shares for most accounts.

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