BakerEllisLLC_Commentary

INVESTOR UPDATE
JULY 2005

Stocks stalled in the second quarter as the Federal Reserve raised short-term interest rates for the ninth consecutive time and oil prices climbed higher, threatening to crimp economic growth. The S&P 500 rose 1.37% for the quarter, including dividends, while the Dow Jones Industrial Average fell 2.18%. Baker Ellis accounts performed relatively well, with our main composite notching a gain of 2.98% for the quarter. For the year, our composite is now up 4.68% while the S&P, Dow, Russell 2000 and NASDAQ are all in negative territory.*

While the Fed has boosted the federal funds rate to 3.25% from a low of 1% a year ago, long-term rates have been declining. Fed Chairman Alan Greenspan has called the divergence a “conundrum,” while other policy makers have cited a “global savings glut.” If financial markets are a forecasting mechanism, they could be telling us that the risk of inflation is negligible or that a recession is looming. However, in the former case, we would not expect commodity prices to be going through the roof; and in the latter, we would expect stocks to be declining and spreads between corporate bonds and Treasuries to be wider.

Our view is that an extraordinary amount of liquidity was injected into the global economy in the first part of this decade, and it needs a place to go. The result is persistently cheap money for borrowers and inflation in prices for stocks, bonds and real estate (all of which are excluded from the consumer price index, which is one reason official inflation remains low). Much of this liquidity has been created through the sale of Treasury bills, bonds and notes to Asian central banks. The consequences are apparent in China’s $18.5 billion bid for Unocal through China National Offshore Oil Corporation. Protectionists are predictably up in arms about the deal. However, we fail to see how Americans can expect the Chinese to buy our debt but cry foul when they want to use their dollars to invest in American companies. In contrast to our massive borrowing from foreigners to sustain current consumption, China has saved an estimated $750 billion in foreign reserves (it will add at least $250 billion more this year) and is prudently looking to diversify its dollar holdings. We would do the same thing. We only regret that most American politicians (and Fed governors) seem content with this buy-now, pay-later mentality.

Meanwhile, General Motors serves as a microcosm of the tensions we have noted in the domestic economy. During the quarter, GM launched a campaign offering “employee discounts” to the already highly leveraged American public. The prices are so good you cannot afford not to buy. June sales were up 41%, giving the company its best sales month in almost 19 years. Yet GM lost $1.1 billion in the first quarter, and the ratings agencies finally acknowledged the obvious by downgrading its debt to junk. GM, once the nation’s largest industrial company, is drowning in a sea of health-care and retirement obligations to a population that could fill the city of Portland.

GM carries too much risk for out taste, but savvy investor Kirk Kerkorian has acquired a large stake in the company. We expect him to prod GM to pay out cash to shareholders and spin off its profitable finance arm, leaving a heavily indebted GM to sink or swim. Such financial engineering could reward common stockholders at the expense of employees, bondholders and taxpayers, who could get stuck with billions in future pensions and health care obligations. The market has responded enthusiastically in the near term, but what will happen when India’s Tata Motors rolls out its planned $2,000 car in 2008?

India remains one of our primary country plays, and recorded growth in the first quarter of a healthy 7 percent. American companies continue to outsource to its highly skilled workforce. IBM announced recently that it would increase payroll in India by more than 14,000 workers this year while laying off 13,000 in the U.S. and Europe. We recently undertook a review of individual Indian companies that stand to benefit from a growing middle class. Although we found a number of potentially attractive opportunities, caps on foreign ownership and premiums on American and Global Depository Receipts present challenges to efficient participation. For now, we are content with our stakes in the broad-based India Fund and conglomerate Reliance Industries, the country’s largest private-sector company.

During the quarter, we sold the rest of our position in Deb Shops (DEBS), the women’s apparel chain. This turnaround play worked out well, with the company tripling first-quarter profits and paying a $6-per-share special dividend out of its excessive cash hoard. We increased our positions in Deutsche Post (DPSTF.PK) and SABMiller (SBMRY.PK), two attractively priced core holdings. In addition, we began accumulating a position in Oregon Steel (OS). Steel stocks have been hit hard recently by fears of softening demand and rapidly increasing production in China. Although prices for hot-rolled band products are softening, we expect OS to benefit from major pipeline projects to transport Canadian tar sands oil to the Midwest and West Coast. If these projects can help drive earnings of $3 a share over each of the next few years, as we expect, the stock is trading at only six times projected earnings.

Stocks aside, the greatest impact of the economy’s excess liquidity is found in soaring prices for real estate. In California, prices have increased 103% since 2000. We find the psychology of the market somewhat irrational. While most Americans are distressed if the prices of basic necessities such as food and electricity rise, they celebrate when the cost of shelter skyrockets. As long as home prices are going up, housing is perceived not as a cost but as an income source through capital gains and refinancing.

Although capitalization rates in many areas make housing unattractive on a fundamental basis, speculators are swarming. In the Ashland-Medford area of Oregon, for example, 22.3% of the purchases this year through April 30 were made by investors. Conventional financing is fast disappearing as buyers choose riskier loans to acquire houses they otherwise could not afford. Despite 30-year fixed mortgage rates of less than 5.5%, more than half of all new mortgages are either interest-only or adjustable-rate loans. One in four home buyers did not even make a down payment in 2004, according to the National Association of Realtors. We doubt the market would provide such financing without the giant socialization of credit risk facilitated by government agencies such as Fannie Mae.

As with tech stocks in the late ‘90s, calling the top is next to impossible and the market is not monolithic. Some areas may appreciate while others decline. What we do know is that investors tend to put a larger amount of capital into an asset class near the top of a cycle. Once prices begin to ease, people who have been stretching to buy more and bigger houses only because prices are rising will suddenly feel saddled with debt and become sellers. The Fed would presumably attempt another rescue with another round of interest-rate cuts, but if everyone already owns too much real estate, who will step up to buy? We are mindful of the Japanese example: even with interest rates of 1%, prices can decline.

Given the implications of a decline in home prices for stocks and the economy, we continue to shy away from consumer cyclicals and financial stocks with potentially vulnerable collateral. We remain over-weight international stocks, including Europe, based on relative valuation and our preference for holding some non-dollar-denominated assets. In the fixed-income department, while we would have been better off so far this year with longer-dated bonds, we are comfortable holding a fair amount of cash and equivalents. If investor psychology changes, we may be presented with attractive opportunities.

From the back office: Many of you have received multiple amended 1099 tax-reporting forms on your accounts. We have received them also, both before and after the tax-filing deadline. The reasons are complex, and generally involve companies changing the tax treatment of dividends. Recently, we learned that many mutual fund companies plan to amend the tax reporting of their international funds due to an error in the handling of a tax treaty between the U.S. and the U.K. that became effective last year. In turn, your custodian may mail another amended tax-reporting form. Although you may want to consult your tax professional, the amounts involved are so small that they should not be consequential.

Sincerely,

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

*Composite represents discretionary accounts over $100,000 held at Fidelity Investments. Performance is size-weighted. Performance of individual accounts will vary based on risk tolerance, timing of investment and other factors. Size-weighted dispersion for the quarter was 1.0%. Performance is presented net of fees. S&P index data includes gross dividends. Other indices reflect price change only. Investors cannot own an index, which is always fully invested and does not include management fees or other expenses. Data is believed to be accurate but is not audited or guaranteed. Past performance is no guarantee of future results.