Markets Remain In An Unpredictable Trading Range

The stock markets have gone nowhere in seven years. We now have values that are less than the 11,722 high posted on the Dow seven years ago. During that period of time, stockholders have lost money two ways: (1) the value of their shares are generally down; and (2) their capital has been eroded over those seven years by inflation. The purchasing power of the dollar has lost 16% (Bureau of Labor Statistics, US Department of Labor). For us to be “even” in the stock market from the high of 11,722 seven years ago, the Dow would have to have reached 14,000 points.

Moreover, there is absolutely no way to predict what will happen to the market in the next several years. Many economists feel the markets will do extremely well over the next five years, and just as many feel that the market will continue to be frustrated until the economic dislocations correct themselves. Highly regarded Goldman Sachs analyst, Abby Cohen, feels the market is undervalued by at least 15%. Here is a list of our obligations, any one of which could result in severe economic consequences, and which is huge when taken all together:

1. Outsized and unsustainable, trade deficits;
2. Outsized and unsustainable,consumer borrowing;
3. Outsized and unsustainable, government borrowing to cover deficit expenditures;
4. Outsized and unsustainable, future Medicaid and Social Security obligations;
5. The continuing loss of our manufacturing base coupled with the accelerating loss of jobs to nations with lower labor rates.

If this market follows historical trends, it can be expected to continue to go nowhere for the next several years.

The erosion of values in the stock market has provided an opportunity for investors to accumulate some reasonably good values in stocks. In October of 2005, Dr. and Mrs. Millhalf began to build a portfolio of well established securities while the cost of those securities were historically low. So far, the Millhalfs have earmarked four securities of about $50,000. Each $50,000 investment represents 10% of the Millhalf’s portfolio. Followers of Market Watch will recall that Dr. and Mrs. Millhalf have $500,000 to invest with the goal of turning that into a million dollars to be left to their grandchildren. All returns from their portfolio are being compounded and used to purchase additional securities—this is known as dividend reinvestment.

THE MILLHALF'S PORTFOLIO as of September 1, 2006
Security (*)	Current Value
Bank of America (BAC)	$60,100
Gold ETF (GLD)	$66,570
U.S. Tobacco (UST)	$69,855
Pfizer (PFE)	$59,790
Tax Free Bonds	$307,425
Total	$563,740

(*) Initial investments were all $50,000.
(**) Represents a return of 15.3% annualized.

Dr. Millhalf: All of these securities have done really well in only 10 months. It appears that the tax free bonds are holding down an increased return in the portfolio. Wouldn’t we be wiser to add more stocks?
Market Watch: We are looking for companies that dominate their industry and are priced well below their historical averages. The only stocks that qualify for this portfolio right now are Citigroup, Bristol Meyers Squibb and Merck.

Mrs. Millhalf: Why don’t we buy them?
Market Watch: As far as drug stocks are concerned, you already have Pfizer which you purchased a little over a month ago. Pfizer is a monster drug company and has fewer problems than Merck and Bristol Meyers.

Mrs. Millhalf: What about Citigroup? It’s all over the world. We are familiar with Citigroup and the fact it is well managed.
Market Watch: Citigroup is yielding 4.1% and selling at a price earnings ratio of 10. It is cheap and would qualify for this portfolio; however, the stock has already moved up 5 points from $43 to $48. Should Citigroup back off a price of $48, you might consider adding it to the portfolio.

Dr. Millhalf: At that point we would have 10% of the assets of the portfolio invested in Bank of America and 10% invested in Citigroup. Is 20% of the portfolio in financial stocks too risky?
Market Watch: It’s not too risky. Financial stocks make up a much greater percentage of the stock market in America than they used to represent. They also have provided better returns over the last several years because of their increasing cash flows. Most investors are not aware of the fact that the spread between what the banks paid for money from inter-bank overnight loans (federal funds rate), and the prime lending rate, was 1.5% until 1991. Thereafter the spread increased to 2-1/2%. That represented an increase in cash flow to the commercial banks of 40%. The subsequent fall out for stockholders has been increased earnings from increased cash flow. The increased earnings to stockholders has led to increasing dividends.

Mrs. Millhalf: Why don’t we just buy more of the securities we have already purchased in this portfolio? These securities have done so well.
Market Watch: You currently have 60% of the portfolio in cash, and 10% of the portfolio is in each of four different investments. You have invested 40% of your funds in four different situations when those security prices dictated they were a good buying opportunity. Those buying opportunities have passed. It is also less risky to limit the amount invested in each security to only 10% of your portfolio.

Dr. Millhalf: If our portfolio is averaging better than a 15% annualized return, how can that be sustained with so much of our portfolio in tax free bonds?
Market Watch: Returns of 15% are really good, and there is no guarantee that those returns can be sustained. We just need to be patient and see what stocks become available at the right price down the road. Buying the best managed companies in their businesses, at their historically low prices, is likely to continue to provide good percentage gains over the years.

Conclusion:

The market continues to bear a great deal of risk. In addition to the economic problems enumerated above, there is great uncertainty as to how the continued situation in the Middle East will affect U. S. stock markets. World War I represented a re-alignment of power by replacing the monarchal system of government in favor of more democratic institutions. World War II represented a re-alignment of power away from evil dictatorships that tried to undermine those new democratic governments. The current unpleasant situation in the Middle East also represents an effort to re-align power. As in World War II, in the Middle East we are also dealing with a great deal of just pure evil. With all that in mind, the Millhalf’s portfolio is positioned to enjoy a favorable performance over the years.

America will continue to prosper and build wealth. We will carry on as a democratic society because we have no choice but to do so. American’s will not give up their freedom. Most of the rest of the world is mired in their own problems. They are unwilling to pay for and support our efforts in the Middle East, just as they were unwilling to nip in the bud those problems that existed prior to WWI and WWII.

The Government and the Federal Reserve will literally do anything to avoid a recession. They will continue to flood the economy with money and create more inflation; they will tinker with interest rates to try to control both inflation and the economy’s growth; and they will involve us in war, which, as most of us know, is a very profitable business for the winners.

It is important for investors to stick with a program of buying only the best businesses, at the right price, while we struggle to remain patient during the process of building a portfolio. Sorting out the world’s problems and determining how they will affect our stock markets will have a bearing upon what investments one should choose in the future.

Caveat Emptor.
George Rauch
September 1, 2006

....