Another year is laid to rest and with it the bear market of 2000
to 2002, the third worst in history. The S&P 500 Index closed
up 26.38% for the year. The five year total return for the index is
still -9.54%. The market has a lot in its favor going forward. Since
1900, presidential election years have yielded positive returns 70%
of the time. Since 1960 they are positive 82% of the time. We should
be in the second year of a bull market although the second year rarely
outperforms the first. The best performing index this year should
be the S&P 500 as we see a rotation out of techs and into large
cap growth stocks. I’m targeting 1195 for the year-end S&P 500
price, a mere 5% away from where we are now.
The dollar lost some 20% of its value in 2003. It is oversold but
I would rather it stabilized here than return to its level of 18 months
ago. The cheaper dollar helps U.S. exports and is a shot in the arm
to a global economy that buys its oil in U.S. dollars. Oil is recalcitrant
at $35 a barrel and is a real drag on the economy. We would be booming
with $20 oil but that does not seem imminent. Everything in America,
particularly our equities and our real estate, is cheaper for foreigners,
and they are buying. It’s estimated that as much as 30% of our real
estate markets may be immigrant driven. America's for sale. The weaker
dollar will drive our longer term bond rates up, though when I hesitate
to predict. Better to be positioned for them rather than moving in
anticipation. Roll with the changes.
We've come to the housing party late but it is a trend strong enough
to warrant participation still. We do so with builders Pulte Homes
and Dominion Homes and with Fidelity National Financial, a title insurer
and provider of real estate systems support. REITs are suspect as
commercial real estate vacancy rates are high, markets are overdeveloped,
and rents are slipping.
Did we miss the trend in gold which was up 20% in '03? Deliberately
so. One did better in the S&P 500 as above and the gold miners
are way overpriced. When we participate it will be in exchange-traded
gold bullion funds which are soon to be introduced to the U.S. It's
been said gold is God's control of the money supply. I like the sentiment
but it seems antedeluvian in a world awash in freely floating currencies.
If the supply of gold is finite it is also permanent. The first ounce
of gold ever mined in human history still exists, refined, somewhere.
It's scarce but not scarce. Then consider oil and its price potential.
I'm looking for corporate profits to increase 17% in '04, a bit higher
than most estimates. I'd expect the S&P 500 P/E to stay around
27. The dividend yield, presently 1.6%, I'd expect to see closer to
1.8%. These are all healthy numbers even if we factor in another 1%
additional annual inflation over the next several years. The Fed has
been fighting deflation and a small dose of inflation, properly controlled,
is stimulative.
Arthur Andersen, Martha Stewart, Imclone, Enron, Healthsouth, Worldcom,
Tyco, Mutual Funds, and many more…Accountants, Corporations &
Mutual Funds
Left unresolved in 2003 are the scandals. Stealing is nothing new.
If a starving man steals a loaf of bread he's committed a crime but
not a sin. (Now there's a passé concept. What's new is the
discarding of the concept of sin.) If the man backs up a trailer truck
and cleans out the bakery he's committed a crime and a sin. There
are measures of proportionality. When I hear federal regulators state
that "new regulations will be forthcoming" to address these
scandals I can't help thinking of Judge Roy Moore in Alabama. He already
had the appropriate regulation carved in stone outside his courtroom,
to wit: Thou Shalt Not Steal. He was thrown off the Alabama
Supreme Court bench by a Federal Court last August.
These scandals aren't garden variety thefts. They are symptomatic
of deeper pathologies.
If the concept of "security" is removed from the securities
industry there will be much less of the industry in the future. Investments
are based on confidence in fair trade practices supported by laws
uniformly enforced. Consider three parts of the problem: corporations,
accountants, and mutual funds.
The corporations
This current crop of corporate suspects would have done what they
may have done for one reason: they felt they could. It's a simple
exercise of power. I would want to congratulate Healthsouth for fraudulently
constructing its financial statements for as much as ten years,
if true as alleged. It's amazing that they could get away with it
for so long, if in fact they did. They had high-priced, independent
analysts studying their every quarter. They had high-priced accountants,
some of the best in the country, advising them. They had audits! They
had investors throwing money at them. I suppose all this combined
toadying would be enough to camouflage ten long years of "fudging."
Hubris could seduce management into thinking they could get away with
it. Winston Churchill said it so well: "The truth is incontrovertible.
Malice may attack it, ignorance may deride it, but in the end, there
it is."
The accountants
One of the worst trends of the last ten years is the death of accounting
as we used to know it. The "count" in accounting is misleading
because they do little or none of it. In fact bookkeeping is, in the
words of my own accountant, a dying art. The accounting industry is
necessarily a political beast as evidenced by the composition of the
Financial Accounting Foundation (FAF) and the Financial Accounting
Standards Board (FASB). Look at the sheer number and complexity of
FASB statements. Accountants are legal interpreters of the tax laws
and of the principles and reporting practices generated by its own
industry and peddled in Washington by willing donors to the politicians
who ordain them in return. Everybody gets paid. In a further reach
for revenue the industry has insinuated itself into the investment
business. This is a Pandora's Box of conflicts of interest and larcenous
temptations. In its metamorphosis to "full service" the
accounting industry is sacrificing accountability. Accountants should
be outlawed from the investment business. Doing both, they do both
poorly, to the detriment of the public welfare.
Mutual Funds
They are less "mutual" than ever if the name is to connote
some "mutual benefit." Some say the government can't legislate
morality. It certainly legislates immorality. Thus the present loophole
allowing insiders of mutual investment companies to profit from inside
dealings. The market timing issue best falls under Judge Moore's preferred
regulations. It is stealing, plain and simple. More and more sophisticated
investors are eschewing mutual funds for private, independent money
managers like yours truly.
Case study
Perhaps the following true story best illustrates the deficiencies of the current investment securities/accounting/mutual fund business.
A client referred a woman to me for a portfolio review and some advice.
The woman had inherited a legacy of about $600,000. On the advice
of her CPA, who had recently become a registered investment adviser,
she put the money with another adviser who manages portfolios of mutual
funds for a fee. The CPA, acting as an investment adviser representative,
got paid a fee from the portfolio manager. The portfolio manager was
paid an annualized fee of .4% of the client's assets under management.
The mutual funds in which the client became invested also charged
fees and expenses, ranging from .22% to 1.08%. So, the CPA was paid,
the portfolio manager was paid and the mutual fund companies were
paid. So what did the client buy for her payments?
When she came to my office in February 2001, her portfolio had declined
over 40% in value, to around $350,000. Mind you the S&P 500 had
declined over 10% in 2000, but the real blow-off was about to begin
in earnest in April, 2001. The woman was scared, skeptical and suspicious.
I explained my system. To her I sounded a lot like "the other
guy." She didn't understand much of it. She was seeing me at
the urging of a mutual friend, but then that's what had got her into
the mess she was in—seeing a portfolio manager on the advice
of another trusted friend, her CPA.
Faced with her stasis, I agreed to review her portfolio of mutual
funds and render an opinion on them, no charge. And herein lies the
real story. They were all no-load funds. Almost all of these funds
were big household names. Five of the eight funds had Cisco Systems
and GE in their top five holdings. I calculated that the woman's total
portfolio was approximately 8% in GE and 11% in Cisco, big over-concentrations
in both. Cisco Systems had never doubled its revenues or earnings
year over year in the prior ten years and was priced at roughly 30
times expected earnings five years away. GE had clearly stopped growing
from manufacturing and was morphing into a financial services giant
which would not have the earnings to support its valuation. And Jack
Welch was retiring. He knew when to leave. Both Cisco and GE, among
many others, had significant and growing contributions to earnings
in '99 and 2000 from market investments. This clearly could not last.
Those earnings were going away and when they did the market would
implode.
One huge fund had Enron as its second largest holding. Another fund
had as its objective "to buy and hold stocks of quality companies
for the long term." The average annual portfolio turnover: 45%.
How long term is that? Or did 45% of the fund's companies go from
"quality" to "low-quality" in one year?
But the real lulu was a utilities fund, a fund meant to pay regular dividends,
presumably suitable for widows and orphans, run by one of the biggest,
most common names in the mutual fund industry. Herewith were its top
five holdings in year 2000: Voicestream Wireless, Nextel Communications,
Qwest Communications Intl, Sprint PCS Group, and AES. They totaled
31.5% of the total fund assets. According to the Morningstar report
on the fund, the fund manager was adding to positions in these stocks
as of 7/31/2000, right as the tech bubble was peaking. None of
these companies paid dividends. This group of stocks lost 80%
of its value from July 2000 to December 2002. This is a utilities
fund? Talk about style creep!
Not knowing who to trust and thoroughly spooked by the markets this
woman decided to do nothing and "wait it out," convinced—probably
by her CPA—that "it'll come back."
One year later her portfolio value was $214,000. It didn't and it
hasn't "come back." This is only one case of dozens, all
with the same fact pattern.
The accountant gave his client bad, unqualified, investment advice.
The accountant spends most of his time interpreting tax laws and their
applications. The accountant didn't read the financial statements
of the companies in the mutual funds. Neither did the mutual fund
managers nor the portfolio manager. They all should have if they're
holding themselves out as investment professionals. They were being
paid.
To all who choose to participate in the securities markets, where,
truly, animal instincts prevail, caveat emptor. Beware! Regulatory
authorities were created to give investors some protections but who
can you trust? It's enough to make you want to shout, "There
oughta' be a law!" But there already is a law. Judge Roy Moore
could tell you.
Best regards,
