BakerEllisLLC_Commentary

INVESTOR UPDATE
JULY 2004

Stocks were lackluster in the second quarter, as optimism over stronger corporate earnings was tempered by concern over rising energy prices and interest rates. The Standard & Poor’s 500-stock index ended the quarter up 1.3%, while the Dow Jones Industrial Average gained 0.75% and the Russell 2000 index of small stocks finished nearly flat. Other asset classes generally lost ground, with the Lehman Aggregate Bond Index declining 2.44% and the Morgan Stanley Real Estate Investment Trust Index dropping 6%.

Baker Ellis accounts eased on average 1.5%, giving back some of our strong first-quarter gains. Year-to-date, our main composite is up 4.6% compared to 2.60% for the S&P 500.* We are satisfied to be ahead of the market again for the year while maintaining exposure to various asset classes.

The Federal Reserve’s decision to raise the benchmark interest rate for the first time in four years was the widely anticipated event of the quarter. This move prompted an unwinding of the so-called “carry trade,” in which investors borrow at short-term rates to lend at higher long-term rates or to invest in theoretically higher-returning assets. During the quarter, the dollar had a counter-trend rally as investors who had borrowed money to invest in higher-yielding currencies converted their investments back into dollars to close their positions.

While artificially low interest rates, tax cuts and massive deficit spending have roused the economy from its post-bubble malaise, we remain skeptical of the strength of the recovery. The Federal Reserve has backed itself into a corner. Clearly, the Fed must raise interest rates from current negative real rates to counter inflation. Revised official estimates now show inflation running at 2.9% in the first quarter, above the original estimate of 2.6%. Even a modest increase in rates, however, runs the risk of choking off the recovery. Indeed, we are beginning to see signs that growth is slowing. U.S. motor vehicle sales dropped 13% in June from May, while retail sales fell 1.1%.

We are not surprised by this data because both the government and consumers have been on a spending binge and now are carrying an extraordinary amount of debt. Sooner or later, both will have to rein in their free-spending ways. At the end of the first quarter, Americans owed nearly $9 trillion in home mortgages, car loans, credit-card debt and other types of borrowing. As illustrated by the chart on the next page, the economy has not seen this level of total debt in many decades. We have little trouble imagining how higher adjustable-rate debt payments, a decline in asset values and/or continued high prices for commodities such as oil could create major problems for the economy.

From an investment standpoint, we believe the prudent strategy in the current environment is one of balance and caution. In our equity selection, we continue to emphasize defensive investments, including an overweight position in energy stocks. We remain staunchly underweight the technology sector, where the leading-indicator semiconductor-stock index, or SOX, is now down 11.2% this year and inventories are ballooning at perennial favorites such as Intel, Cisco and Dell. We continue to be surprised that so many investors are attracted to companies where average selling prices fall every day and technological obsolescence strikes almost at random.

Many of our widely held smaller stocks have had big run-ups over the last year – oil shipper OMI (OMM), Investors Title (ITIC) and real-estate investment company LNR are three examples – and we are finding fewer opportunities to replace them. While small stocks offered relatively attractive valuations when we founded Baker Ellis two years ago, the median price-to-earnings ratio in Value Line’s small-to-mid-cap universe is now higher at 20.1 than its large-cap universe at 18.1. Consistent with our flex-value strategy, we find ourselves putting more new money to work in larger companies and holding a relatively high level of cash.

Sincerely,

Brian C. Baker, CFA
Barnes C. Ellis, RIA

*Composite represents discretionary accounts over $100,000 with Fidelity Investments as custodian. Performance is size-weighted monthly. Individual results vary based on risk tolerance, timing of investment and other factors. Size-weighted dispersion for the quarter was 1.4%. Index data does not include dividends. Performance is unaudited and net of fees. Additional details available upon request.