PacWest Financial Management Newsletter
2nd Quarter 2005

Volume IX, Issue 2

July 2005

Strong U.S. Factory Orders vs. Higher Energy Prices

We have noticed recent interest in reverse mortgages among our clients. While we do not recommend these products, we would like to give you some basic information about them. If you are considering one, we strongly urge you to visit AARP’s web site at http://www.aarp.org/money/revmort/revmort_basics/ for more information.

Basically, a reverse mortgage allows you to use your home’s equity to borrow money. However, it differs from home equity loans in that no repayment is required until the borrower dies, sells the home, or moves. In addition, the borrower on a reverse mortgage must be 62 or older and have little or no debt on their home.

Cash from a reverse mortgage can be paid all at once, as a regular monthly payment (over a lifetime or fixed period), or as a "credit line" account. The amount you can borrow is determined by a formula that considers the borrower's age. According to MSN Money, a very general guideline is that a 65-year-old homeowner can borrow up to 26% of his/her home's market value; a 75-year-old, 29% and an 85-year old, 56%. AARP’s website has a reverse mortgage loan calculator for the curious among you.

The main advantage of a reverse mortgage is that you can have a guaranteed source of income for as long as you need it, which will not have to be repaid by you. However, that guarantee comes at a price in the form of interest, high closing costs, servicing fees, insurance premiums and other costs. Although Social Security and Medicare benefits are not affected by reverse mortgages, Medicaid and Supplemental Social Security benefits can be. Another obvious disadvantage is that a reverse mortgage will reduce what you are able to leave to your heirs. The amounts that you can borrow are only a fraction of your home value, which is why you can never owe more than the house is worth. In addition, lenders CAN force repayment in full for a number of reasons, such as if the borrower fails to maintain the home or fails to pay property taxes or homeowner’s insurance. Finally, reverse mortgages are such complex products, applicants are required to receive counseling before applying. For these reasons, PacWest believes that reverse mortgages are not for the majority of our clients.

The U.S. stock market can probably best be summarized by this well known Yogi Berra quote. Through the second quarter of 2005, stocks have acted much like they did in the first half of 2004. Although the themes are different, the results are much the same. In 2004, the market was worried about the presidential election, among other things. As soon as the election picture cleared, stocks began to rally. Equities were flat in 2004 through September, only to rally roughly 10% during the fourth quarter.

The S&P 500 rose an insignificant 0.9% during the second quarter of 2005, but bested the 2.2% decline for the Dow. The small cap Russell 2000 index increased 4% for the quarter, while the NASDAQ advanced 2.9%.

At the risk of offending some of our readers/clients, the focus on real estate investing could also be a positive for stocks. Investing in real estate is now seen by many as easy money. We recall a time back in the 1990’s when investors reacted similarly to technology and telecom stocks. We all know how that worked out. Not all assets that move higher are in a bubble. However, bubbles eventually form when money begins to chase returns in specific asset classes.

We continue to believe that stocks should rally during the second half of the year. However, we see less upside potential than what was experienced last year. The strong move up in the price of crude oil is certainly a concern. If this trend continues, it could significantly dampen stock returns for the foreseeable future.

However, the positives certainly seem to outweigh the negatives at this point. Short-term interest rates are up, but not significantly. Also, valuations are under control and the economy is still on solid footing.

On June 30th, the Fed upped the Federal Funds rate for the 9th time by another quarter point to 3.25 percent. Are we near the 9th inning as Richard Fisher, President of the FRB Dallas, put it in baseball terms? Or, are we heading into extra innings?

As evidenced by the revised GDP, the economy is growing better than expected. GDP grew at a solid 3.8 percent for the first quarter, better than the 3.5 percent estimated a month earlier and the 3.7 percent most economists had forecasted. As the Fed sees the economy on reasonably firm footing, they will be less concerned with the negative impact that further rate increases might have.

The housing market continues to sizzle, which troubles the Fed, as Mr. Greenspan has repeatedly expressed his concern on housing bubbles. However, with mortgage rates remaining low and newer, riskier types of loans gaining in popularity, the market will stay hot. Unless we see signs of rising long-term rates, which mortgage rates are based on, the Fed will continue its current course of rate hikes.

Despite the possibility of further rate hikes due to continuous strength in the housing market, we believe the Fed’s restrictive monetary policy should be ending soon. The decline of both the Producer Price Index and the Consumer Price Index in recent months signaled that inflation remains well contained. With inflation in check, the Fed has fulfilled its primary function and we believe they will start to ease up on the monetary tightening policy.

We will keep the maturities short within this flat yield curve environment as the compensation is not high enough to justify investing in long-term bonds. We continue to stay away from corporate bonds for the same reason.

Rising U.S. interest rates, combined with some European countries’ struggling economies have sparked the dollar rally, driving good old George up more than 11 percent against the Euro and nearly 8 percent against the Yen this year. At quarter end, the Euro plunged to 10-month lows and Yen also traded at a 9-month low. So, what effects does a beefed up dollar have on the international investments?

To answer this question we need to re-examine the objectives for investing abroad. First; we believe it reduces long-term volatility. Second, we can capitalize on potential greater returns of companies listed outside the U.S. The diversification effect is still there as evidenced by the low correlation between the U.S. market and major markets abroad. As for the excessive return, many markets abroad still outperformed the U.S., even with a strong dollar. The EAFE Index and S&P 500 were neck-and-neck, down about 2 percent year-to-date. But the Emerging Markets Index returned a healthy 6.75% and most noticeably the South Korean KOSPI Composite Index returned a handsome 11.51%.

Even though the extra boost we have enjoyed from the falling dollar has diminished a bit, we are still achieving our objectives. We continue to believe international diversification is necessary and with carefully picked markets, value is likely to be found.