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Capital Markets Perspective June 2003

 

Capital Market Future Performance

There is reasonably accurate information on all criteria effecting the investor except the future performance of capital markets, and the underlying economic factors which influence capital markets. Nevertheless, there are known factors about the economic environment, the capital markets and their sectors. When these are evaluated as a mosaic, guidance is provided on prudent investment decisions. Currently, we consider the following germane factors to consider in making investment decisions:
 

  • Stock Market Valuation
    Having declined markedly from their highs, and considering the extremely low return on taxable fixed income, stocks currently do not seem as extremely overvalued as in the late 1999. Particularly those stocks with yields above the rate of money market funds. This speaks only to relative valuation. Absolute stock price valuation based on yields and P/E rations is near historic highs.
    Index investing, which proved so successful for 25 years, and is firmly grounded in finance theory, needs to be reconsidered in the current environment. Large cap stocks are at high valuation levels relative to the market, and there is substantial market volatility. We believe current stock selection should be oriented, without sacrificing growth prospects, toward dividends, value, and a strong balance sheet.
     
  • Manufacturer Pricing & Capacity Utilization
    There is excess capacity. Producers are unlikely to be able to raise profits, nor report higher earnings per share. There seem to be few factors for an immanent increase in demand, which would provide the ability to raise prices.
     
  • Deficit Spending and Balance of Trade
    The federal government has embarked on the creation of a significant deficit. Deficit spending is a traditional and necessary response to economic malaise. One side of creating the deficit is tax cuts. The structure of the cuts is believed to benefit primarily those in upper income brackets. The tax cuts may not increase consumption. They will shift the tax burden for ordinary consumers to States and municipalities. This will increase the deficit while providing only moderate demand stimulation. If the deficit becomes overly large, it will cause inflation, and reduce foreign investment.
    The balance of trade deficits have reached an all time high, and continue to grow. While the timing of any affect on capital markets the trade deficit may have is unknown, it is a time-bomb with the potential to cause havoc. Currency risk is an aggravating and corollary factor. While a declining dollar may not directly affect investors, it will prove to be a disincentive for foreign investment in the U. S., and cause the trade deficit to increase.
     
  • Foreign Competition
    Industrial production has been lost to Asian producers. This trend will continue, and place continued earning pressure on selected sectors of the U. S. economy. One of our tests for any investment is the 'Asian factor' i.e. are the firms we buy susceptible to foreign competition.

 

Based on the factors above, we currently estimate the returns for these sectors:

SECTOR ESTIMATED RETURNS
Fixed Income
Money Market
Corporate Bond
Municipal Bond
High Yield Bond
Return-base 4% 7% 6% 9%
Year 1-5 2% 5% 6% 7%
Year 5-10 5% 8% 7% 10%
Year 10-15 4% 7% 6% 9%
Equities
S&P 500
High Dividend
Real Estate Trusts
Master Ltd Partnership
Return-base 10% 8% 7% 12%
Year 1-5 6% 8% 6% 10%
Year 5-10 11% 8% 7% 12%
Year 10-15 10% 8% 7% 12%

 

Background

As long-term investors, creating and managing diversified portfolios, Davidge & Co., first, and foremost addresses individual client requirements. Decisions are informed by these criteria:

  • Future cash and income needs such as college or retirement.
  • Tax considerations, including the evaluation of current and prospective tax laws.
  • Individual client risk preferences and assets.
  • Assessment of capital markets future performance.

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