Second Quarter Update
Beware:
Inflection points ahead
On March 1st 2004, Sullivan Wood Capital Managementcelebrated its
One year Anniversary. We are grateful to all of our clients
and associates who have supported us and continue to work
with us and look forward to many profitable years ahead.
As we recover from the first market correction of the recent
bull market phase, we can now focus on market outlooks for
the remainder of the year. During 2003 the economy gained
strength here as well as abroad. Even the long struggling
Japanese economy gained strength, leading to what appears
to be a long awaited global economic expansion. Yet, we seem
to be approaching many inflection points within the investment
markets. For one, the periods following major speculative
bubbles have usually included significant deflationary pressures.
However, the Federal Reserve Board has been very accommodative
in pursuing an anti-deflationary policy. But with the recent
strength within the global economy and the recent low interest
rates, if the Fed remains too accommodative the risk will
turn more toward an inflationary surprise. So when will the
Fed shift gears and raise rates and how will this change affect
investment markets? In addition, Corporate America has seen
strength in economic productivity mostly from cost cutting
and less from growing revenues. But to progress from here
companies need to invest in goods and services and begin to
hire again. Will this investment increase and will return
on this investment be sufficient to maintain economic growth?
And last but not least this is an election year. Historically
the 4th year in an election cycle is the second best for investing,
followed by the 3rd year, the year we just left. Where are
the opportunities and what are are the risks for the remainder
of the year?
The
Fed
So when will the Fed begin to raise interest rates? Just last
month, the Federal Reserve Board issued a revised policy statement,
suggesting that the risks of deflation and inflation are currently
in relative balance. But at the same time, they reaffirmed
their commitment to maintaining an accommodative policy for
a "considerable period" of time. Future Fed policy
statements may back off slightly from that commitment, but
we anticipate that the first actual step to lift the Fed Funds
Target Rate will not be taken until sometime this spring.
And then, we think, the Fed will raise rates only moderately
- possibly to 1.75% from the current forty five-year low rate
of 1%. We consider it highly unlikely that the Fed will undertake
any significant tightening moves until after November's presidential
election, and perhaps not until early 2005.
The
Bond Market
Our government is on a spending spree. It appears there are
few fiscal conservatives left in Congress, and we have been
surprised that President Bush has yet to use his veto power
to block even one spending bill. Despite two years of economic
growth, the deficit shows no sign of peaking. We hope that,
following the election, there will be a serious effort made
to restore fiscal discipline.
Our outlook has the ten-year U.S. Treasury note yield rising
from the current rate of 4.25% to the 5.25 - 5.75% level,
over the next year or so. And when interest rates rise, bond
prices fall. At this time, corporate and municipal bonds seem
somewhat more attractively valued than U.S. Treasury bonds
and notes, however their attraction is purely relative. With
this outlook, we recommend that fixed-income investors strive
to protect asset value either by keeping their effective maturities
very short, purchasing higher quality Treasury Inflation Protected
Securities and/or their Corporate and Government alternatives
or, as was suggested in the 2004 Investment Outlook, by substituting
quality higher-dividend equity alternatives.
The
Stock Market
Our bottom line for this year is that the vigorous fiscal
and monetary stimulus, combined with the previously mentioned
positive cyclical factors and tendencies, will likely continue
pushing the stock market higher. But we also expect increased
volatility and shift in market leadership. But we also believe
that investors will not really begin to worry about the prospect
of rising interest rates until the Fed actually raises the
Fed Funds Target Rate. At that time, we would expect to see
a more meaningful stock market correction. That would also
seem the logical time for a leadership shift to higher-quality,
more-defensive issues.
The more serious stock market risk will come sometime after
the election, when the Fed removes the punch bowl and begins
its efforts to contain the next signs of inflation. Then,
we think, the stock market could enter a period similar to
that of the second half of the 1970s - a time during which
there was a series of cyclical bull and bear markets, with
little overall net progress. Prudent use of volatility during
those years allowed many investment managers to provide attractive
returns. Obviously, we must continue to monitor the status
of our longer-term concerns. But for now, the wind is at our
back and our intention is to judiciously enjoy the ride ahead.
SWCM Composite Portfolio (Equity and Fixed Income)
As discussed
in the last portion of this update, we remain very comfortable
with the current equity market conditions and consequently
the current holdings in the SWCM composite. With better than
anticipated earnings and revenue expectations, we are confident
we will see strong returns from our holdings in both the long
and short-term. Recent additions to the SWCM Composite include
Walt Disney Co. (DIS) and Chevy Chase Preferred C (CCX_c)
with a current dividend rate of 8.5%. On the fixed-income
front, we have begun to purchase high quality, various maturities,
floating rate bonds and have increased our asset allocation
on bonds to near 10%. These are bonds where the interest rate
will fluctuate due to changes in inflationary pressures and
interest rate changes. Bottom line, floaters will increase
in value with increases in inflation and with higher interest
rates. Contrary to last quarters outlook we believe we will
see higher interest rates by the end of the election or into
the first quarter of 2005, putting increased pressure on bonds
and increasing signs of commodity led inflation.
Our
approach for the quarter
Market
conditions will remain similar to the past year during the
second quarter as low interest rates, stronger than anticipated
earnings, and election year economics will continue to see
volatile market conditions. As stated earlier, we believe
there is a strong possibility for a continued increase in
stock prices throughout this quarter and most of 2004, though
a change in interest rates and market macro dynamics may begin
to take hold and set up a different set of market conditions
for the end of 2004 and into 2005.
Closing
Statement:
We remain
optimistic about the long-term opportunities in the equity
markets and continue to feel comfortable regarding the current
stock market environment where stocks remain the most attractive
broad investment category currently available to the average
investor. Bottom line, we remain constructive on stocks, continuing
in our belief that the current risk/reward environment is
positive for equity investors.
While
our strategy remains solid we continue to focus on companies
with strong earnings and growing revenues as we select new
names for the SWCM composite. Our strategic outlook has us
positioned for a longer, more powerful bull market.
As always,
SWCM values each client and continues to focus on your investment
objectives. If you have any questions or concerns please do
not hesitate to call.
* All performance measures are based on a
model composite portfolio managed with a growth perspective.
All numbers are not audited and are not in compliance with
AIMR. Ask for more detail regarding the model growth portfolio.
Disclosure: Examples of specific securities and/or sectors
are given for illustrative purposes only and should not be
used or construed as recommendation for any security and or
sector. Past performance does not guarantee future results.
Total returns are historical and include security values and
reinvestment of dividends. Cumulative total returns are reported
as of the period indicated. The results provided have not
been audited and are based on a composite of client's accounts.
. For information pertaining to the registration status of
SWCM, please contact SWCM or refer to the Investment Adviser
Disclosure we site (www.advsierinfo.sec.gov).
