PacWest Financial Management Newsletter
3rd Quarter 2005

Volume IX, Issue 3

October 2005

Next to knowing when to seize an opportunity, the most important thing in life is to know when to forgo an advantage. ~Benjamin Disraeli (1804-1881)
 

Investment Secrets of the Rich (and Not So Famous)

The third quarter helped to erase or minimize losses accumulated through June for many of the U.S. large capitalization indices. The last few weeks of September were especially helpful, as stocks rallied to put the indices in decidedly positive territory.

The S&P 500 rose 3.1% during the third quarter, while the Dow advanced 2.9%. The small cap Russell 2000 index increased 4.4%, while the NASDAQ rose 4.6%. Small and mid capitalization growth stocks outperformed value stocks of all sizes. However, even with the solid third quarter returns, stocks are down-to-flattish on the year. The Dow is off 2%, while the S&P 500 is up just over 1%. The more volatile NASDAQ is off 1.1%.

Although returns have been lackluster in 2005, we continue to believe that stocks will move higher into year-end. We do not foresee the 7% returns for the S&P 500 that we projected at the beginning of the year. However, we think stocks will show a gain in 2005.

The main risks to our thesis include oil prices that do not abate and continued increases in interest rates by the Fed. Although we think crude oil prices will remain much higher than their historical average, we do not believe $65 per barrel oil is sustainable. Longer-term, we see oil falling back to the mid-40’s. Also, the Fed has a knack for overdoing interest rate changes. In an attempt to keep inflation in check, the Fed could significantly dampen equity returns.

As discussed in our newsletter last quarter, we still feel that money will move out of real estate and back into the stock market in the near future. One only needs to look at the strong demand for 600 square foot condominiums to see the excess in the real estate market. The significant price increase in single family homes is pushing large numbers of homebuyers into the undersized condominium market.

Hurricanes Katrina and Rita devastated the Gulf coast, with New Orleans particularly hard hit. Fearing this gruesome disaster would have a significant impact on the economy, Wall Street called on the Fed to pause on its course of rate hikes. However, contrary to their wish, the Fed increased the Fed Funds rate on September 20th for the 11th time. Why?

The hurricanes not only disrupted crude oil production, but more seriously, they shut down a large percentage of the nation’s refining capacity and sent gasoline prices higher. Elevated energy costs added to the worry of inflation. One-year inflation expectation spiked from 3.1% to 4.6%, the biggest reading since 1990, according to the chief economist at RBS Greenwich.

Worry about inflation and the optimism of economic growth explained the Fed’s recent action, but will the interest rate increases continue? We believe they will. The real estate market is still overdone and the yield curve remains extremely flat. Orders for durable goods rose greater than expected in August and the National Association of Purchasing Manager’s (NAPM’s) Business Barometer rose to 60.5 in September. These readings suggest that after a pause, businesses are likely to resume spending.

Given our belief that the Fed will continue to increase rates for the foreseeable future and the yield curve will remain flat, we will continue to invest mainly in short-term government bonds. The spread is not wide enough to justify taking additional risk.

Following the trend from last quarter, the U.S. dollar continued to rise. At quarter end, it traded at 0.8393 against the Euro and 114.20 against the Yen, both up compared to the end of last quarter. Despite the rising dollar, international investments still turned in an astonishing quarter. MSCI’s EAFE Index returned a handsome 10.90% and the Emerging Market Index gained 18.55%.

Election results played a role. In Europe, the German ZEW survey, which measures investor confidence, dropped and underscored the belief that the election standoff between Merkel and Schroeder could hamper economic recovery. Contrast that to Asia, with Prime Minister Koizumi’s landslide re-election victory. Japan revised its Q2 GDP from 1.1% to 3.3% and pushed the Nikkei to trade at its four-year high.

On July 21st, China announced it would abandon its decade-old peg between the Yuan and the Dollar in favor of a link to a basket of world currencies. Since then, the Renminbi (RMB) has appreciated from 8.28 RMB to a Dollar to 8.09 RMB to a Dollar, a 2.35% increase. With further RMB appreciation anticipated, investing in China is likely to bring an added exchange rate benefit for U.S. investors.

Data released by the Investment Company Institute shows U.S. investors are increasing investments overseas, as world equity funds posted an inflow of $8.22 billion in August. We believe this trend will continue as international investing continues to outperform. We will continue to place emphasis on international investing.