PacWest Financial Management Newsletter
1st Quarter 2005

Volume IX, Issue 1

April 2005

Impact of Baby Boomers on the Economy

Unhappy with the performance of his lagging mutual fund over the past 3 years, Mr. Ima Investor walks through the store and spots the latest issue of Money. He peeks inside this issue and reads an article about Incredifund and how it earned an annualized return of 30% over the last three years. He gets up the next day, sells out of Crummifund, puts all his money into Incredifund and starts having champagne wishes and caviar dreams. Other investors also notice Incredifund and reward it with large sums of money to invest. Over the next three years, Ima is dismayed to discover that “Incredifund” has posted sub par returns, whereas “Crummifund” has had quite a rebound from its lows. Ima is depressed—that is, until he reads an article about Amazafund…

This sad fable has more than a grain of truth to it. By December 2002, bond funds had a better three-year track record than stock mutual funds. Consequently, by the end of 2002, bond funds received the largest inflows of cash on record of $133.5 billion (Source: AMG Data). In 2003, the S&P 500 returned over 28%, whereas bonds returned under 5%.

The moral of this fable is people tend to chase returns, rather than creating a sound, well-diversified investment portfolio. The equal and opposite emotions of fear and greed are constantly pulling at investors. Investors are afraid to lose money, yet they do not want to miss out on the latest investment fad, whether it be rare, collectible tulips in the 1600s, or Florida real estate in the 1920s, or electronics in the 1960s, or even internet stocks in the 1990s. Thus, they end up buying high and selling low.

Déjà vu all over again! Same as last year, the equity market slumped in the first quarter despite the fact that the market was filled with news of initial public offerings and mergers and acquisitions. In addition, the skyrocketing oil prices overshadowed a fervent merger environment. U.S. oil prices have surged more than 30% this year and undoubtedly, Wall Street is concerned about the impact higher energy costs have on corporate profits.

The S&P 500 dropped 2.6 percent and the Dow struggled as well, losing 2.6% for the quarter. The small cap Russell 2000 slipped 5.6 percent and the NASDAQ, slid 8.1 percent to its steepest quarterly drop since the third quarter of 2002. Energy stocks, by far, came out as winners while auto-related shares, among many others losers, saw their share prices plunge.

One positive note to take from this lackluster market is that inflation has pretty much stayed in check. Data ranging from consumer spending to employment reports all suggest that inflation is under-control. We believe the Fed’s easing concern on inflation eased will allow them to keep interest rates rising at a controlled pace, and hence bring only minimal impact to the equity market.

Unexpected interest rate jumps and oil price surges are still two of our major concerns. We see 2005 as a year of stronger performance for larger stocks, and the first quarter results validated our view. The Dow and S&P 500 outperformed the NASDAQ and the small cap Russell 2000. We will continue to purchase large, fundamentally sound companies at reasonable valuations.

It certainly does not seem that way anymore. For the past year the Federal Reserve and Mr. Greenspan have been raising the short-term federal funds rate to where it stands now at 2.75%. To their chagrin, this has not had much of an impact on longer-term rates. The ten-year bond, which is looked at as a benchmark for long-term rates and mortgages, has remained stubbornly low. At the end of the quarter, the yield was at 4.48%. This is lower than its previous 4.59% level when the Federal Reserve began raising rates on June 30 last year.

This makes it difficult for the Fed to slow down one of the areas they are targeting: the housing market. Just as the Fed targeted the Internet stocks of old, they would like to reign in some of the speculation and run-away pricing they see in some housing markets. Although, this might be better done through other methods, such as requiring more money down or trying to curtail the use of interest only loans, they have thus far left the market to act on its own.

The Fed is also targeting inflation. As oil prices and other commodity prices have risen, these costs have been passed through to the consumer causing higher prices for everything from frozen pizza to coffee. Do not feel bad for Starbucks though, as they will continue to raise their prices to offset their higher costs. Five-dollar coffee might not be far behind. Healthcare costs are also part of the problem increasing at a 5.2% annual compounded rate.

We continue to invest in short-term bonds so we can hopefully re-invest them at higher rates in the future. We also use inflation-protected bonds as these will protect us against higher prices that seemingly appear down the road.

George Washington, of course, is the face of the U.S. dollar. His value has dropped significantly over the past three years. The big question is, how does this impact your investments? As an example from last year, an investment in Europe returned 9.4% for local investors holding Euros. However, when converted back into George Washington’s the return escalated to 17.8%. The same holds true of the Yen. An investor in Japan had a return of 9.7% versus a U.S. dollar holder’s return of 14.7%.

In the past few years, the fall in the dollar has been due to the worries over the trade deficit, which is at record levels. This certainly hasn’t eased and will most likely continue to grow as the U.S. is more of a consumer of goods than a supplier.

But, how will the dollar’s value impact my international investments this year, you ask? So far, the dollar has risen about 4.5% versus the Yen and Euro, yet international investments have continued to outperform U.S. markets. The EAFE Index has been flat since the beginning of the year and emerging markets managed to eke out a small gain. Even without the extra boost from the falling dollar, we still feel the international markets have good value and we will continue to look for opportunities in this area. One of the biggest areas to keep an eye on is China. Their growth has slowed somewhat from the frenetic pace of last year and their ongoing friction with Taiwan will certainly be something to monitor for its implications on global trade.