May ’06  Bonds - Rising interest rates and commodity prices are thought to be harbingers of inflation, but a weak dollar is the real thing, a guarantee of lower purchasing power.  Even higher interest rates have failed to prop up the currency.  The administration is quietly pleased, hoping the declining dollar will work to decrease the ballooning trade deficit.  The Fed is far from having reached an “equilibrium” interest rate, since gobs of liquidity are still sloshing around causing tsunami-like damage to orderly markets.   Further rate hikes are in the cards. The fiscal and monetary outlooks have been troublesome for some time, but they are now turning decidedly ugly.   The only bright spot is that fixed-income investors can look forward to higher returns.   Whether these will compensate for inflation, seldom the case in the past, is an open question.

 

 Equities - Two consecutive days of triple-digit declines in the DJIA occurring in the second week of the month signify, to us, a significant reversal of the equity market’s advance over the past 3 ½ years.  This is not a garden variety correction and implies coming further weakness in stock prices over an extended period.  What investments benefit from higher inflation and a declining dollar?  U.S. multinationals having a large component of sales denominated in foreign currencies and companies with pricing power.  The latter fall into two categories:  businesses with high volume, low-priced products and suppliers of absolute necessities.  Price increases by the first can be small absolutely and not likely to change buying patterns, but large on a percentage basis, leading to increased margins.  Some consumer discretionary companies qualify.  Products of second category companies must be purchased practically regardless of cost, e.g. gasoline, electricity and drugs come to mind, but emphasis should be placed on profitability.  While many, perhaps most, domestic equity groups will be pressured, the outlook for major commodities is still positive.  Expanding internal demand in foreign economies will more than make up for any shortfall here at home.  They have a lot of catching up to do.  In contrast to an expected decline in the U.S. equity indices, we see recent price declines in commodities and gold as prelude to higher prices, not least because of flight from a depreciating currency.  Going forward, investors should be intimately familiar with their holdings and have a strong conviction that they will be suitable in light of less than optimal economic conditions.

 

                On the subject of portfolio performance, there is much talk about the long term, but more attention is usually paid to short term results. The calculated (and promoted) returns from indexes and mutual funds assume a lump sum investment made once and held for the entire period being reported.  In the words of Dalbar, a think tank which studies investors’ behavior related to mutual funds,  “While mathematically useful, there are virtually no investors that exhibit this behavior, making the published returns applicable to no one.”  Investors are buying and selling, and they rarely have the discipline required to realize, much less exceed, the reported statistics.  Dalbar reports that in the 10 year period ended 12/31/05 the average mutual fund investor earned an annual return of 5.8%, far behind the S&P 500 return of 9.1%.  Another aspect of investing in mutual funds is the thorny question of capital gains taxes, where recent purchasers will be subject to tax on gains accumulated over many years and from which they received no benefit.  Capital gains distributions have been minimal over the last few years because plentiful offsetting losses were available.  Since these are now mostly exhausted, attention should be given to potential capital gains existing in any fund being considered for purchase.

 

William Wright