Current Outlook & Investment Strategies

Major investment markets* have not treated us to a "boo" all year long, with essentially flat performance on a year-to-date basis. The persistent trading range behavior of these markets leads to the conclusion that investors must be spooked.

However, it is important to keep in mind that, given the onslaught of uncertainties found in today's news as well as others described here in some detail, it is remarkable these markets have managed to hold their own. After two years of strong profit growth, the economy's recent cooling off appears to be dampening across-the-board inflation, and actually increasing the likely longevity of the economic cycle. Retailers are also expecting the upcoming shopping season to be strong. Now that the third quarter has ended, earnings reports are slated to begin in the next few weeks. Even if the emerging earnings season portends a slowdown in profit growth, there are numerous reasons to stay invested for the long-term and even expect new buying opportunities for patient investors.

Key Markets and Asset Classes: Continuing with Real Estate Investment Trusts (REITs)

REITs sold off sharply this past spring amid fears that stronger than expected growth in the economy, and in the jobs market in particular, could spark inflation and force the Federal Reserve to move interest rates higher to keep prices in check. The monthly jobs report released in early March 2004, which indicated that the economy had produced three times the number of jobs forecast by most economists, sparked a selloff in interest rate-sensitive vehicles, including REITs. The sharp decline in prices left REITs down by more than 17 percent in a matter of weeks, just 3 percentage points shy of the percentage point decline that often defines a bear market.

In the ensuing months, REITs have rebounded, and evidence continues to emerge that the pace of the economic expansion has slowed; GDP has declined from a 4.5-percent annualized clip to 3.2 percent. Moreover, Fed Chairman Alan Greenspan has held true to his promise to raise rates at a “measured” pace, implementing just three quarter-point increases in the closely watched Fed Funds rate since the end of June. Accordingly, we continue to consider the REIT asset class, both as a strong diversifier to the more traditional asset classes of stocks and bonds, and as a potential source of increased yield for more income-oriented accounts.

REITs have been a strong diversifier (low correlation) to more traditional asset classes such as stocks and bonds, and, as a result, they can enhance longer-term risk-adjusted returns for investors. The extended decline in interest rates in recent years, combined with heightened volatility in the equity arena, has increased the relative attractiveness of REITs. REITs remain a viable source of yield for income-oriented investors.

Finally, although past performance is not indicative of future results, REITs have delivered solid long-term results on both an absolute and a relative basis:

Source: NAREIT. Price return data through 8/31/04.

*All Indices are unmanaged and are not available for direct investment by the public.Past performance is not indicative of future results.

As an asset class, REITs are most highly correlated with small-cap value stocks. Small-cap value (as measured by the Russell 2000 Value Index) has risen sharply in recent months to the point where it appears prudent to reduce, albeit slightly, the allocation to this asset class.

Overseas: Reducing exposure to emerging market stocks in favor of more developed markets overseas

Emerging market stocks, as represented by the MSCI Emerging Markets Index, have risen 24.13 percent in the 12-month period ended September 24, 2004, or about 50 percent more than the more developed economies represented in the MSCI EAFE Index. And while emerging markets will likely continue to benefit from increased growth in the world economies, and in China in particular, the sharp advance this past year has reduced the relative attractiveness of emerging markets vis-à-vis more developed economies in Europe and Asia.

Fixed Income:Continuing with shortened fixed income durations.True to its word, the Federal Reserve implemented its well telegraphed intent to lift interest rates at a “measured” pace by raising the rate on the closely-watched Federal Funds rate by a quarter-point at the end of June. Since then the Fed has since raised rates twice more with the Fed Funds rate at 1.75 percent today vs. 1.25 percent at the end of the second quarter.

Contrary to conventional wisdom longer term rates have fallen in the face of the Fed's tightening with the yield on the benchmark 10-year Treasury bond declining from 4.61 percent at the end of June to a more recent 4.03 percent rate. The three quarter point increase in short term rates combined with a 58 basis point decline in the 10-year Treasury has led to a slight “flattening” in the yield curve which implies slower economic growth in the months ahead. And slower economic growth in the face of benign inflation implies that longer term rates can continue to fall as short term rates rise. Core inflation, as measured by the Consumer Price Index or CPI is up a mere 2.2 percent this year and only 1.7 percent in the last 12-months.

And while longer term rates are note expected to fall far from current levels, intermediate term (four to seven year maturity) bonds offer the strongest risk/return potential vis-à-vis' their short or longer term counterparts. Accordingly, increase (albeit slightly) a commitment to intermediate term bonds. With regard to credit spreads, high quality continue to be favored over high yield bonds, particularly in light of the narrowing in yield spreads this past year.

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