PacWest Financial Management Newsletter
1st Quarter 2007

Volume XI, Issue I

 April 2007

Market Overview

It seems that everyone is talking about volatility in the stock market of late, even as many broad stock market benchmark indices ended the quarter flat to slightly higher. Much of the buzz centers around the swift correction that occurred in February which was sparked by a correction in the Chinese stock market. While ups and downs occur quite regularly over the short-term in equity markets, a longer-term perceptive presents a different picture. As shown in the graphs below, a longer term investment program reduced overall volatility. The first chart shows 1 year annual returns for three different investment programs. The second chart shows 10 year average annualized returns ending each year. Thus, we would advise not to get shaken by short-term market volatility and remain focused on long term objectives.

Meanwhile, the economic climate in the USA remained relatively stable. The Federal Reserve neither cut nor hiked interest rates as mixed economic data failed to provide any conclusive evidence as to whether the US economy is too hot, too cold, or just right. The yield curve, while still inverted, steepened over the quarter as yields on 2 to 5 year maturities fell and 30 year bond yields rose, suggesting that investors are now demanding more of an inflation premium for longer term maturities even though the high cash yields engineered by tight Federal Reserve policies designed to cool off inflation by slowing growth points towards recession.

Oil prices declined in January and then recovered by quarter end. Basic material prices continued to rise as global demand remains strong.

Wall Street analysts have reduced their expectations for corporate earnings growth, even though we have yet to hear of companies reducing their guidance on future earnings (outside the housing sector).

In such a tenuous environment, utility and basic materials were the top performing sectors followed by telecommunications. Financial stocks were the weakest as higher default levels for sub-prime loans managed to weigh down the entire sector.

We remain optimistic about the future prospects of the quality companies we invest in and look forward to upcoming earnings announcement to come later this month.

Grace Y. Lau, CFA and Elliot C. Kauffman, CFA, CPA

  Tax Corner—Liberalized Payout Rules for Hardships and Emergencies
 

The IRS has begun to follow through on the PPA’s mandate to provide that an event that would be a hardship or unforeseeable emergency under the plan if it occurred with respect to the participant’s spouse or dependent, also will, to the extent permitted by the plan, be treated as a hardship or unforeseeable emergency if it occurs with respect to any beneficiary of the participant.

A 401(k) or 403(b) plan that permits hardship distributions of elective contributions to a participant may, beginning Aug 17, 2006, also permit such distributions for a primary beneficiary under the plan. Distributions are for expenses on account of an immediate and heavy financial need if made for:

1. Expenses for (or necessary to obtain) certain medical care

2. Costs directly related to the purchase of a principal residence (excluding mortgage payments)

3. Payment of tuition, related educational fees, and room and board expenses for up to 12 months of post-secondary education for the employee, spouse, children or dependents

4. Payments necessary to prevent the eviction of the employee from their principal residence or foreclosure on the mortgage of that residence

5. Payments for burial or funeral expenses for the employee’s deceased parent, spouse, children or dependents

6. Expenses for the repair of the damage to the employee's principal residence that would qualify for the casualty deduction.

For this purpose, a “primary beneficiary under the plan” is someone who:

1. Is named as a beneficiary under the plan

2. Has an unconditional right to all or part of the participant’s account balance under the plan upon the participant’s death.

Thus, beneficiaries could include relatives who are not dependents, or even individuals not related to the participant.

Mr. Market

In looking at the graphs on the first page, it is evident that the stock market becomes increasingly volatile as the time frame is shortened. One year returns are more volatile than ten- year returns and daily returns are more volatile, or random, still. This is why a long-term time horizon is necessary for prudent stock investing.

The reason the market is less volatile as the holding period lengthens is that longer periods reflect the true value of any investment- whether it be art, real estate or stocks- which is the present value of the future cashflows. So, in the short-term, price can vary widely around value. Conversely, the band around value long-term is fairly tight.

Therefore, all we need to do is buy when price is much lower than value, right? The problem is that not only is value difficult to calculate, but human tendencies get in our way. First, is the human aversion to loss. Second, the brain extrapolates short-term experiences- we tend to think if the price is going down it will continue down. Will the company continue to grow and at what rate? Will the price continue to fall? Do I have the courage of my convictions to buy when others are fearful? Should I be fearful when prices are high and investors uniformly giddy?

The answer lies in the parable of Mr. Market. This manic character was brought to life by Ben Graham in the best book ever written about investing, “The Intelligent Investor.” Mr. Market is continuously offers to either sell you his interest in your company or buy your interest. You must unemotionally decide on the reasonableness of his offer. Being a little unbalanced, Mr. Market some days offers you a ridiculously low price for an additional interest in the business and you would be wise to take him up on it. Other days, may be ridiculously high, prompting a sale. So it is with stock investing. Each share is a proportionate interest in the firm’s future cashflows. Price can fluctuate widely around the true value (the present value of those cashflows) day-to-day. By judging each stock on its own merits and courageously buying at the point of maximum pessimism, you can beat Mr. Market.