May 2005 Investment Letter

Periodic Investment Letter

May 11, 2005

Dear Investors,

For those portfolios which I’ve been managing, we were able to eek out a modest profit last month, in spite of what I see as the onset of a bear market. The only way we were able to do that is through the benefits of diversification, as just about every optimistic position I had taken went south.

The reason for this in my view is because the economic realities in the United States right now are appalling. The national debt is rising at an astronomical rate, while the U.S. Congress just voted another round of tax cuts ($70 billion) for their large, multi-national corporate sponsors last month. This was offset (but only by half), by cutting such government programs as Medicaid. Student aid programs, such as federally funded Perkins loans, are also in line to be cut.

This has taken money out of the hands of those who would spend it, thus creating a ripple effect, and put it into the hands of those who (if recent trends continue) will only use it to enhance their own cash flow positions. So far, in spite of record cash in-flows to the Fortune 500 companies, very little has been spent by them for investment in either capital improvements or labor. There is nothing on the horizon which leads me to believe that this trend will not continue in the foreseeable future and, even if it does, a good share of their investments will likely be overseas.

In case I haven’t been clear about this in the past, it’s the large, publicly traded, Fortune 500, multi-national companies that are being benefited by these policies, whereas local, closely held businesses in general are way off from profit pictures enjoyed a few years ago, which now seems like the distant past.

Whatever anyone’s politics (I view myself as a fiscal conservative), the realities are that the United States can’t sustain record level trade and budget deficits forever. Since its initial slide, the U.S. dollar has declined about 25% against other major world currencies. In my mind, this makes foreign investment out of the question, since you’d be buying into those markets with deflated dollars. Only if you knew for sure that the dollar slide would be permanent would it make any sense. Otherwise, you’d get killed on the exchange rate, when you cashed out of a given position.

The only thing that’s saving us from complete and utter disaster is the faith of foreign investors, mainly China, in the stability of investing in America. If/when foreign investors get their quota of dollars and shift to another reserve currency, we’re in BIG trouble! An alarming portion of our national debt is now held in foreign hands. That is the only reason that long term interest rates have remained relatively steady.

You may recall from my early 2005 investment letters that I felt the future, say two to five year health of the U.S. economy, depended on the fiscal policy that the U.S. government portrayed during the second Bush administration, most notably the debt to gross national product ratio. There are plenty of conservative Republicans who do not believe that spending this country into oblivion is in the long term best interests of the nation.

Last month, the message from the Congress was received in a loud and clear fashion, when they voted for an $83 billion appropriation for the wars in Iraq and Afghanistan, along with the special interest tax cut.

So, what does this mean to the everyday investing public? More than anything, it means that interest rates are rising (the Federal Reserve has increased the rates it charges member banks for overnight loans eight consecutive times.) This in turn means that consumer and business interest rates, including variable rate mortgages, are on the rise. There are also many more variable rate loans of other types, including credit card debt, which are also on the rise. This will choke off the purchasing power of the American consumer on whose back the current economic expansion was saddled. Consumer confidence and spending has and will continue to drop.

Real estate values, if the economic slowing is steady will first stabilize, then stagnate, then, most likely, even drop. If the slowing is not steady, the foregoing will occur much more rapidly and be considerably more abrupt. To make the picture clearer, when a plane takes off from the South Lake Tahoe airport, en route to San Francisco, it experiences downdrafts, while flying over the eastern edge of the Sierra. This causes the plane to buffet, descend and in some cases to crash. It has nothing to do with the prowess of the pilot, except insofar as his or her decision to fly above the phenomenon.

The real estate market, with its attendant impact on mortgage lending and consumer buying power, has already entered a downdraft, which will only intensify before it gets better. Only a change in government fiscal policy, or a rash of domestic corporate (as opposed to consumer) spending will stem the tide.

The lesson to take from this is that now is not the time to buy real estate and it may be getting close to the closing of the window for vast gains on its sale. Once market stagnation sets in, you may find it very difficult to unload black acre (what we commonly called fictitious parcels in law school) on any reasonable price and terms for some time to come.

In the stock and bond market arena, the repercussions are much more rapid and we’re experiencing them already. The only sector in which my clients are routinely invested that did well last month was health care. The Schwab fund which I’ve been using for that vehicle, SWHFX, Schwab Health Care Fund has a chart that looks like a rocket ship launching.

While this should not be occurring in the short run for the reasons previously stated, I am always eager to learn new explanations and theories. Nothing succeeds like success and, since I devise only balanced (i.e., diversified) portfolios [unless the client dictates otherwise], we were able to benefit from this good fortune. In the long term, it only makes sense that the U.S. health care industry will be prosperous (except for outsourcing) for years, probably decades, to come, as the baby boomers put increasing demand on these services.

So, I’m intending to increase your investment in SWHFX by *****, unless I hear from you to the contrary.

Otherwise, it seems to me that it is best not to modify current holdings. SNXFX (Schwab 1000 fund) inched up slightly (its gains were anemic), but there’s nothing to indicate that this is part of a positive trend.

The indices that I use to determine portfolio changes point toward adding to your bond portfolio. But, there’s a problem with that, namely that the funds I use to ensure a balanced bond portfolio are all trending downward, some more than others. I attribute this to a likely increase in the default rate as interest rates rise. This hypothesis is buttressed by the extraordinarily sharp decline in the value of so-called junk bonds, which are underperforming the market.

As my final point, I’d like to address the question, “Where are we headed?” A number of clichés occur to me in response to this. One is “to hell in a hand basket,” as my dad used to say, but I don’t like to be pessimistic. The U.S. economy is one of the strongest in the world. Four years ago, it was tremendously healthy and flourishing. Since then, war spending and tax cuts for a very narrow group have taken their toll. It’s like feeding arsenic to a healthy patient. Just how much arsenic can this patient take and still remain ambulatory?

The answer is “a lot.” The future is not so bright, however, as the question shifts to “How much more arsenic can it take?”

This is the subject of speculation. I will only say that if the patient becomes critically ill, cash and/or gold will become king. Stay tuned for further developments in this area. -Dan O’Connor- Note/PS: I’m working on a book, entitled The Truth About Investing, which I project for completion this fall, 2005. If you would like to ensure that you receive a copy, when it is finished (page count and retail price still uncertain), receive all published periodic investment letters for the next six months, and become an eligible test reader for this book (most likely seeing all or part of it prior to completion) you may enroll as a qualified test reader and book recipient for a one-time charge of $25 (plus a small shipping fee for when the book is completed) by pressing the button to follow:

PPS: Relevant mutual fund performance charts are available on request at no charge. Click on email to receive those. Simply put “charts” in the subject line.