Letter - May 2004





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What is that rhyme I hear....?

Inflation and interest rates are rising; the country is fighting a controversial war; politicians are pursuing an unprecedented new round of social welfare initiatives; the dollar is weak; there is a presidential election; the Dow has rallied in the last year. Sound familiar? In 1968, we had the Vietnam War, Lyndon Johnson's Great Society welfare program, the Dow at 1000. Today, we have Iraq, prescription drugs, medical insurance, social security insecurity and the Dow at 10,000. While history does not repeat itself exactly, it sure does rhyme .... so said Mark Twain.

The guns and butter economy of the late sixties gave rise to an inflationary spiral that lasted into the early 1980s. Are we are treading down the same path again today? Maybe, but it is much too early to predict whether the current cycle will turn out as badly as the last one. The inflationary palsy that infected the US economy during the 1970s was in part self-inflicted. Poor policy choices (remember wage and price controls?) together with an OPEC orchestrated spike in oil prices contributed to a weak dollar, a recession and then stagflation which followed. But policy makers may have learned something from past mistakes.

Inflation initially gathered momentum slowly during the 1960s; today's inflation seems to be following the same pattern. Perhaps Mr. Greenspan can continue to keep the economy on the straight and narrow and fight inflation by raising interest rates. Skeptics point to rising gold, oil and commodity prices but these are more likely a result of a recovering world economy and exceptional demand from an emerging China. And while it is painful to fill up the old buggy with gas these days, high oil prices should not cripple economic growth as they did in the early 1980s. The price of oil in 1980 was the equivalent of roughly $80 per barrel in today's dollars. And today the economy uses substantially less oil per unit of production than it did in the past. So while the skeptics and alarmists may eventually be vindicated, it is probably too early to batten down the hatches.

The stock market did not fare badly during the initial period of the last inflationary cycle. We think the situation today is similar. For seven years from 1966 to 1973 the Dow traded widely up and down each time topping out at around 1000. It was not until early 1973 that the economic situation deteriorated to such an extent that the market finally broke, falling by over 40% through year-end 1974. However, there was good money to be made over those seven years by those willing to trade the market cycles up and down. We believe that a similar strategy will likely be effective over the next few of years. The bull and the bear are evenly matched for the time being. Until the formidable challenges of the twin deficits (federal and trade), medicare and social security inadequacies, and a long war on terrorism are dealt with, extended growth is likely to be restrained. And stocks still sport relatively high historical multiples in the aftermath of the "Bubble" which means that it will take a number of years of earnings growth to make them cheap again. A buy and hold strategy that was so successful in the 1990 s seems unlikely to produce exceptional results in the next few years.

Admittedly, the past two months in the stock market have been dismal. Politically, the war in Iraq has gone poorly. Oil prices have skyrocketed. And while it has been a foregone conclusion for quite some time that interest rates would rise this year, signs of economic strength that push rates higher seem to have caught the market unprepared. The much vaunted ability of the market to discount events seems to have short circuited this time. Any security suspected of interest rate sensitivity has dropped sharply. We believe this will prove temporary as yields seem to be discounting unrealistically high inflationary expectations. These securities will probably rebound in the months ahead. Meanwhile, clients with a relatively high percentage of assets invested in fixed income securities (REITs, preferreds, and bonds) should take comfort in the fact that while the mark-down in quotations has been immediate, a large part of the total return of these securities is represented by dividends and interest that are paid over the course of the year to come.

So what lies ahead? The war in Iraq continues to have a huge psychological hold on the country and the market. How it plays out will surely influence the presidential election. The course of events will color the degree of uncertainty in the months to come. And, as always, the market hates uncertainty. Perhaps if we caught Osama bin Laden? On the other hand, the economy and corporate profits are robust. While high oil prices and higher interest rates will increase business costs, restrain consumer spending and economic growth, such a slowdown could relieve nascent inflationary pressures. So for the time being, we see the economy continuing to advance. This is not a bad environment for the stock market and, subject to the usual caveats, the market should move higher this year. In light of this, we see the current market weakness as a continued consolidation after last year's exceptional gains.

While we usually comment on stocks that we have recently bought for clients, this time we will beg a pass. We are enthusiastic about current holdings but find that in general the market appears well valued with few obvious bargains to be had. We have been taking some profits in energy stocks, particularly for clients whose positions exceed 10% of assets. We fear that the strength in oil may be unsustainable. If we are wrong, clients still have a substantial energy position.

Finally, a word about my father, Philip Herzig, who passed away on February 20th. As I have written before, his loss to us was a great one. He was a terrific communicator beginning with "Gold Dustings" in the late sixties. His writing was always witty, informative and lacking in hubris. He told it as he saw it. If he didn't know something, he was not afraid to say so. We may not be able to replicate his style, but we will adhere to his standards.

Tom Herzig

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