We are off to a good start in the still New Year of 2004.

Last year finished out nicely as 2003 was the first year that equity investors made money in the markets since 1999.

The U S economy has been improving in recent months after several very difficult years, and it appears to us that the recovery will be sustainable although there will be the inevitable setbacks.

In our Commentary “THE FED’S 2003 DISINFLATION CONCERN AND A LOOK BACK TO MARCH 1933” dated May 17, 2003, we wrote:

Since September 11, 2001 Americans have again been presented with enormous challenges, as this country has not been able to fully recover from those attacks. This fact is reflected in our economy and in stock and bond markets.

For the stock markets to have a sustainable recovery there are two primary requisites:

Confidence in the stock markets and the players – the investment bankers,
the corporate CEOs, the Exchanges, the accountants, the analysts, et cetera.
Will the $1.4 billion settlement be enough to make Wall Street change its
ways without holding CEOs personally accountable?
Corporate profits must show a real promise of improving – despite the Fed’s Disinflation Concern.

The operative words of the last requisite are “real promise.” Signs of economic recovery continue to be paltry as May’s unemployment rate was 6.1%. The June 6th Labor Department release showed unemployment to be at its highest level since July 1994.

On January 9th the Labor Department announced that the U.S. jobless rate is now 5.7%. Lackluster job creation, however, continues be a serious problem, and many major U. S. companies continue to hire cheap labor abroad.

Positive factors continue for stocks:

– An improving economy.
– Higher corporate profits and productivity.
– An improving, albeit ragged, employment outlook.
– Higher levels of consumer and investor confidence.
– Interest rates that are still near 45-year lows.
– A continuing lack of attractive alternative investments.

2004 is an election year that should prove to be very interesting. The financial community will also continue to provide us with non-stop entertainment as Richard Grasso, Martha Stewart, Andrew Fastow, formerly Enron’s chief financial officer, and a constant parade of others march into the headlines and over the airwaves.

Recently the New York Stock Exchange has called on NY Attorney-General Eliot Spitzer and the Securities and Exchange Commission to investigate its former Chairman Richard Grasso’s $187.5 million pay package given by the not-for-profit organization.

We wonder if they were surprised when Mr. Spitzer raised the prospect on January 13th that NYSE board members who approved Grasso’s compensation might be liable for part of it when he said “Board members who acted improperly could provide a piece of the recovery.”

Jurors are being picked for Martha Stewart’s federal trial. Not many realize that Martha was a governor of the New York Stock Exchange at the time of her alleged misdeeds.

Mr. Fastow and his wife will do time in jail – 10 years for Mr. Fastow. The government is hoping that his cooperation will assist in convictions of other Enron big fish.

We note a major scandal that is only several weeks old: Parmalat, the gigantic Italian dairy company, collapsed in December. With drama comparable to a fine opera, Parmalat’s founder, accountants and lawyers have managed to make almost $13 Billion vanish. It’s the largest scandal in European history, and the tale is just beginning to unfold.

In keeping with our objective of Preservation of Capital, it is always time to be cautious when universal euphoria takes over. The reality at this writing is that stock prices are high vis-à-vis traditional valuations.



Asset allocation is always an extremely important part of portfolio management, and bonds have worked very well for us.

Bonds, for example, have outperformed stocks in recent years as “The five-year average annual return for the S&P 500 through 2002 was a negative 0.6%, versus an 8.55% gain for 10-year Treasuries.” (BARRON’S, January 6, 2003) This occurred as interest rates fell to 45-year lows and bond prices rose.

We now anticipate a rise in interest rates. The question is when, not if.

The Federal Reserve has kept short-term rates at 45-year lows. We do not think that Chairman Greenspan and his colleagues will increase them anytime soon as that could be damaging to the recovering economy.

We believe interest rates will rise despite the Fed’s position. The market will cause interest rates to rise if the economy continues its climb and deficit conditions worsen. A sharp fall in the dollar could lead to higher interest rates that would dampen the economy.

Rising interest rates will result in lower bond prices, perhaps sharply lower bond prices as the interest rates and bond prices move in opposite directions.

We were astounded when we saw the following poll results:

“Bethesda, Md. – June 26, 2003 – A survey conducted by Harris Interactive on behalf of ProFund Advisors LLC finds that, although most U. S. investors (57%) believe interest rates will rise in the next two years, nearly two-thirds (65%) are unaware that rising rates generally have a negative impact on the value of bond investments.”



Last year at this time General Motors, the world’s largest automaker, had the world’s largest unfunded pension liability – $19.3 billion.

Then on June 26, 2003 GM sold $17 billion of bonds – the largest amount of bonds ever sold in the corporate debt markets.

The purpose, in large part, was to offset about $20 billion of GM’s unfunded pension liabilities. While the hole was plugged for the time being, GM’s stockholders are left with the obligation to repay the borrowing and pay the interest on it for up to the next 30 years.

GM bonds tap into ‘wall of money’” according to the June 23, 2003 Financial Times which then reported “Car giant benefits from buying frenzy as cash-rich investors ignore shares and scramble to buy bonds in search of higher returns.

Later from the same article:

Disillusionment with slumping stock markets has caused investors to migrate in droves toward the bond market, with the result that fund managers have mounting piles of cash waiting to be invested but not enough new bond issues to absorb it. And the dramatic decline in interest rates is making investors increasingly desperate for yield.

Total orders for the GM and GMAC, its financing arm, amounted to $30 billion with European demand strongest in the 30-year bonds. The bonds apparently appeared to be extraordinarily attractive investments because of their yield. GM bonds were sold to buyers who were in a frenzy to buy bonds 1) having a long life and 2) having a much lower than “investment grade” rating at a time when the bond markets were at or close to all time highs.

Aside from professional traders, many of the GM/GMAC bond buyers have chosen to disregard the bonds’ inherent risk or did not care about taking large risk in their passion for higher yields. It is possible that some simply did not understand the risk they were taking when bond yields were at almost half-century lows — just as stocks never looked better than when they were at their all time highs in March 2000.

After the power-ball financing, it appears that a return of 9% will be necessary to keep the $83 billion fund from slipping into negative territory.

Now for a financial decision equivalent to a Hail Mary Pass: On December 15, 2003 General Motors and its external consultants announced a target return of 9% from its pension fund. In 2002 the fund fell 7%.

The pension fund will now be investing in hedge funds, junk bonds, emerging markets, real estate and other vehicles offering high returns and high risk. Perhaps GM bonds?

GM “has decided the best way to maintain the annual 9 per cent return it needs is to invest in riskier assets. A side benefit is that, thanks to portfolio theory, it believes the risks will cancel out.” (FT 12/15/03)


We, of course, wish the General Motors pensioners the very best of luck.

John W. Hamilton
January 20, 2004