Second Quarter 2003

From the Desk of Ron Rowland

Fear reigned supreme in March of this year as the equity markets cascaded lower, threatening to establish even deeper lows on the third anniversary of the bear market. The turnaround attempt that began in October 2002 had been declared a failure, just like the previous four attempts had failed. We were in the midst of a massive bear market, and that governed my management of your money. Part of my investment philosophy is that risk-management is a key ingredient to long-term success. My approach is to manage risk over a full market cycle by prudently increasing a portfolio's risk level over that of its benchmark during sustained bull markets, and decreasing a portfolio's risk level to below that of its benchmark during sustained bear markets. The bear market conditions in equities of the past three years has dictated a more conservative approach, and I have responded to that by significantly reducing the risk levels of all the portfolios, primarily by reducing exposure to the stock market.

As a result of this approach, CCAM's portfolios have exhibited much lower risk levels than their respective benchmarks during the last three-year period, using whatever your favorite definition of risk is (standard deviation, maximum draw-down, ulcer index, or other). Nothing in this world is free, and part of the cost associated with this approach to risk management is the fact that portfolio returns lag during bear market rallies. That of course is the situation we had this past quarter. The markets were moving lower on fears of war in early March, and our equity portfolios had essentially no exposure to the equity markets. The market started a relief rally in mid-March, even before the war started. At that time, we started moving back into the market, buying technology and large cap growth funds. We bought additional positions as the market demonstrated that it had the ability to move higher by breaking through various resistance levels. By mid-June, our most aggressive portfolios were once again 100% invested, while our other portfolios typically had about 75% allocated to equities. Since the bulk of the market gains for the second quarter took place in April and early May, our equity portfolios lagged the market due to the fact that they were still in reduced-risk mode. Our bond-oriented portfolios surpassed their benchmark by avoiding treasury securities, and focusing on high yield, international, and convertible bond funds.

It is still not clear to me whether this current move is the start of a new secular bull market, a small cyclical bull market, or just another bear market rally. It depends mainly on what the future holds, but quite a bit also depends on definitions. While a 20% drop from a high is now almost universally accepted as the definition of a bear market, attempts at defining a bull market are wide and varied. Some market watchers, including the esteemed Wall Street Journal, believe that the definition of a bull market is the opposite of a bear market, or that once a market rises 20% from its low point it is a new bull market. I for one, find that definition ludicrous, as it fails to account for the subtleties of bear market math. By this definition, those internet and telecommunications stocks that were once selling for $100 and then plunged to $5, were in a new bull market once their price reached $6. If you were to look at the chart of such a stock, its 20% rise from $5 to $6 would be dwarfed by the fact that the stock was still down 94% and would need another 1,566% gain to get back to its $100 level. By the same token, requiring that a new high be established before declaring it a new bull market would also be misleading.

Perhaps it is a futile effort to try to precisely define a bull market. To me, it is more a state of mind than anything else. A bear market is when investors are motivated by fear. They are afraid of losing money. A bull market is when investors are motivated by greed. They are afraid of not making money. 

From a technical viewpoint, the market is looking more bullish every week. The breadth of the advance and the mildness of each pullback have impressed me. New uptrends are now being established as additional money enters the market to buy the dips. Monetarily, the Fed has cut interest rates to 1.0%, about as low as they can go, and Congress has passed a tax reduction bill. There appears to be plenty of stimulus in the pipeline, but it is just not showing up in the economic measurements yet. Politically, much of the uncertainty surrounding the war in Iraq has been eliminated, but the new reality of continued uncertainty of further terrorist attacks is still a factor. Fundamentally, current valuations are higher than many investors want to see at the beginning of a new bull cycle, but valuations are always tricky at turning points. Companies are taking additional steps to reduce their expenses even further. Unfortunately, that means that many individuals have to face the unemployment line. Much of the groundwork is now in place for an economic recovery, but until corporate capital spending starts to grow again, I believe there is reason to be cautious.

The Quarter in Review

The second quarter saw the stock market advance smartly - though some might say "stupidly" - in spite of an economic environment that still has not exactly sounded the "all clear." The equity markets posted some of their best returns in years, but the three-year and five-year returns are still negative numbers. In other words, most of the investors who received all that the market had to offer last quarter were those who also received the full brunt of the bear market, namely the "buy & hold" investors. The market has changed so much the past three years, that some of the leading proponents of passive asset allocation are starting to change their tune (see article below). The market favored small cap stocks over large cap stocks during the first two months of the quarter. As the calendar rolled over to June, large cap stocks took the upper hand in the relative strength battle for about three weeks, before abdicating to the small cap stocks again. 

Surprisingly, the strength in the stock market was not at the expense of the bond market. The bond market raced forward to new all-time highs, and prompted many analysts to issue warnings about a possible "bond bubble." In 1994, a 5-year Treasury yielded about 7.8%, providing a cumulative return of 45% if held to maturity. In early 2000, the yield was 6.6%, producing a 38% cumulative return. In mid-June 2003, the yield briefly dropped to 2.0%. Anyone who bought 5-year Treasuries at that price can expect a cumulative return of 10%, if held until 2008. Taxes and inflation will likely reduce the spending power of that investment to less than the original amount. As a result, some of the stock market gains we saw toward the end of the quarter were probably the result of the start of an asset allocation shift out of bonds and into equities.

Passive Asset Allocation Falls Short

In 1997, many financial planners thought that they had discovered the holy grail of investing in the most comprehensive, objective study ever done of historical returns in the U.S. capital market - Stocks, Bonds, Bills and Inflation: Historical Returns (1925-1996). The authors, Roger Ibbotson and Rex Sinquefeld, analyzed the indicated asset classes, their total returns, and their volatility over extended time periods. 

Their conclusion was that small stocks can be expected to return an average 12.5% annually, while large cap stocks, represented by the Dow Jones Industrial Average, would average 10.0%. Bonds were pegged at an average annual return of 5.2% while treasury bills could be expected to average 3.7% annually.

The Securities and Exchange Commission has long required money managers and investment advisors to warn clients that past performance is no guarantee of future returns. But that didn't stop the planning industry from trotting out historical returns as a basis for designing passive allocation investment portfolios. Some planners implied that all investors needed to do was to establish their required rate of return and risk tolerance based on existing savings and intended future savings, have a passive asset allocation prescribed, and then build a portfolio of mutual funds to meet that allocation. 

The idea that large cap stocks gain 10% per year on the average also formed the basis of arguments against trying to "time" the market, or actively manage portfolios.

But times have changed. Roger Ibbotson, head of Ibbotson Associates and co-author of the Ibbotson-Sinquefeld study that ingrained the 10% concept, now says the next quarter century will not live up to the past 75 years. Why? Conditions are different, says Ibbotson. 

Fidelity Investments recently lowered to seven percent its annual return target for its in-house pension plan. The Vanguard Group's Plain Talk About Realistic Expectations For Stock Market Returns has been removed from the fund family's web site. Likewise data on historical returns (up to 50 years) from T. Rowe Price are gone from that firm's web site.

We don't know what returns will be for the next year, or the next twenty years. Nor do we know which market sectors will prove the most profitable. In fact, the most accurate prediction of market behavior may well be simply that stocks will go up and go down. What we do know is that fluctuations create opportunities for profit if investors are willing to take an active approach. 

Financial markets tend to establish trends, some short, some longer. The active manager strives to be positioned on the right side of the trend. To quote Will Rogers, "...if it don't go up, don't buy it." Because we are not limiting ourselves to a fixed allocation, investment positions can be flexible to take advantage of different sectors. As a result, returns are not limited to those achieved by the major market indices. 

Active management doesn't need to be 100% accurate because many short-term moves are continually taking place in the financial markets, providing opportunities to recapture losses from trades that don't work out as hoped. To achieve Ibbotson's once forecast average annual return of 10% annually, an active management strategy would need to realize 0.8% a month and let it compound. 

CCAM News

Disclosure Document and Privacy Policy - As one of our valuable clients, it is important that you stay current on our services and operations here at CCAM. Therefore, we are including a copy of our disclosure document with this mailing. In addition, our privacy policy is also included so that you can stay informed of how your personal data is used and protected.

Fidelity's Check Writing Policy - As a reminder, Fidelity's check writing policy is that a check will be returned if there is not enough cash in the account on the day the check is presented. Therefore, it is imperative that you contact CCAM before writing a check. We must ensure that there is enough cash is in the account in order for your check to be honored. This applies even though you may have stock, mutual fund, or money market positions in your account. 

New Employee, John Schloegel - You may have had the opportunity lately to speak with John, who recently arrived from California. He had spent the past 5+ years with Fisher Investments in the San Francisco Bay Area. His wife is a Texas native, and he was born and raised in Milwaukee, WI. (Please do not hold that cheese head stuff against him). John's background includes an undergraduate degree in Finance from the University of Notre Dame and a MBA from Georgia State University in Atlanta. Previous to Fisher, he had stints at Morgan Stanley Dean Witter and Charles Schwab. Overall, one counts more than 13 years experience in the financial markets. John and his wife have a wonderful 2-year-old daughter. John tells us he has taken the whole Lance Armstrong connection here in Austin to heart and is back on the saddle riding regularly along the Capital of Texas Highway - one of Armstrong's training venues. We are delighted to have added John to our staff. 

If you have any questions about the latest news at CCAM, please call your account executive at (800) 767-2595.

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