3rd Quarter 2004 Review

From the Desk of Ron Rowland

As we wrap up the third quarter and head into the homestretch of 2004, we find that the mutual fund landscape continues to change. The proliferation of new short-term redemption fees imposed by various mutual fund companies continues unabated. To make matters even worse, brokerages are adding their own short-term redemption fees on top of those imposed by the fund companies. Many unsuspecting investors are now getting hit with combined redemption fees of 3% or more.

The arm of Fidelity Brokerage Services that serves many of our client accounts has now joined the fray, imposing their own redemption fees on many funds held less than 60 days. This new fee is 0.5% of assets with a $30 minimum and a $200 maximum. Fortunately, Fidelity has excluded their own funds from this new fee as well as fund families that are geared toward more active trading, such as Rydex, ProFunds, and Potomac. Since the bulk of our trading activity centers around these fund families, most of our operations will not be directly affected by this change.

In this new environment, Exchange Traded Funds (ETFs) make more sense than ever. ETFs are like mutual funds in that they represent a broad basket of stocks, but they have the added advantage of be highly tradable. In fact, they can be bought and sold at anytime during market hours instead of just once per day at closing time like most traditional mutual funds. ETFs also typically have expense ratios that are much lower than their traditional mutual fund counterparts.

ETFs are not new to us here at CCAM, as we have been actively trading a broad range of them for more than three years. Although each ETF transaction encounters a brokerage commission, we have found that the reduced expense ratio and the ability to execute our trades during the business day typically more than compensate for that commission.

New ETFs are coming to market at a rapid pace. Vanguard, Morningstar, and Fidelity have recently weighed in with new ETF products of their own. As a result, you can expect to see us increase the use of ETFs in your accounts in the months and years ahead.

The Quarter in Review

Major stock indexes were down in the third quarter. The amazing thing is that they didn't drop even more, given the steady flow of corporate bad news, economic uncertainty, and geopolitical turmoil. For the three months ended September 30, the Dow Jones Industrial Average was down -3.4%, the S&P 500 (with dividends) lost -1.9%, and the Nasdaq Composite lost -7.4%. At the same time, crude oil gained +34.0%, gold bullion rose +7.0%, and long-term Treasury bonds rose +5.5%.

Energy was the big story this quarter, along with its effects on other markets. Crude oil prices surged in July, fell back in August, then surged again in September to end the month near $50 a barrel. At first, the broad stock market reacted badly to the higher oil prices. By late September, however, stocks seemed to have adapted and oil became a lesser factor in the equity market. We suspect this is a mistake, but time will tell. Energy company stocks also rose but on a percentage basis not as much as oil itself.

Other commodities were also active. Gold has been very strong, as have base metals and building materials. Like crude oil, demand growth in these markets can be traced back to strong economic growth in China, which is voraciously consuming raw materials of all kinds. Stocks of U.S. companies that produce these materials have started to move upward as well.

We are beginning to see the outlines of what may be a multi-year megatrend that will deeply affect the markets we trade. After twenty years in the doldrums, natural resource commodities began to perk up about three years ago. This year that trend has accelerated to the point that natural resource stocks - energy, metals, and other raw materials - dominate the stock market leader board. It is possible that the equity bear market that began in March 2000 is far from over.

In our equity programs we will be paying special attention to funds that specialize in these sectors. At the same time, we won't ignore potential opportunities elsewhere. Even in a bear market there are plenty of periods where certain market sectors and styles are outperforming. We will continue seeking out such trends and pouncing on them where appropriate.

Bonds had a big gain in the third quarter. The reason for this, in our view, is that people have been parking their money in bonds because they are nervous about the stock market and doubtful about an economic recovery given the increase in oil prices. At the same time, the Federal Reserve remains on a slow but steady course of raising short-term interest rates. With long-term rates falling and short-term rates rising, the "yield curve" has flattened considerably. Historically this is not a good sign for the economy, but Mr. Greenspan is not to be underestimated.

Conventional wisdom is that the stock market tends to rally at year-end, and this may yet happen. Once third-quarter earnings reports and the election are behind us, stocks could find reason to end 2004 on a positive note. Value stocks, especially small-cap value, have been the strongest part of a generally weak market. We suspect this group will take the lead in any recovery phase.

To sum up, the third quarter brought a lot of noise, but not a lot of significant movement in most sectors. We know that markets spend most of their time going sideways, and the majority of change happens in short trends. Our goal is to capture part of those trends while avoiding big losses the rest of the time. In this we have been successful. As of this writing it appears the fourth quarter will bring more extended trends, and we look forward to new trading opportunities.