Tower Private Advisors

Investment Management

Investment Strategy – What we see

March 31, 2006

As a rock on the seashore he standeth firm, and the dashing of the waves disturbeth him not. He raiseth his head like a tower on a hill, and the arrows of fortune drop at his feet. In the instant of danger, the courage of his heart sustaineth him; and the steadiness of his mind beareth him out.

Aristotle

Someone with more credentials and experience than us said something like the following: it’s not the story on page one of the newspaper that really costs an investor; rather it’s the story on page sixteen that one should be concerned with. Similarly, we should be more concerned with what the average investor is not concerned with rather than with what he or she is concerned with, since the latter is, by definition, priced into the markets. Accordingly, we present to you a few things that we are keeping an eye on.

N Terrorism and the Globe’s Baddest Neighborhoods

In 2006, Hamas won a majority of parliamentary seats in the Palestinian elections, becoming the majority party of the Palestinian Authority. The Council on Foreign Relations describes Hamas as operating “a terrorist wing carrying out suicide bombings.” In contrast to the Axis of Evil, this is not a government that supports terrorists; rather, it is comprised of terrorists. We don’t think enough attention is being paid to this, nor to terrorism, in general, although developments in Iran may be changing this.

Some time ago we created a basket of stocks that we thought would benefit from the effects of a major terrorist attack, especially in the U.S. For most of 2005 it tracked the broad stock market closely. Then, at year-end 2005, it began to rise quite sharply while the rest of the market went sideways. As the stock market is forward looking, this development troubles us, and we think it makes sense for portfolios to have some terrorism-resistant holdings, whether they be select defense stocks, treasury securities, or high-grade municipal bonds.

N Foreign stocks and mutual fund flows

While we have liked foreign stocks as an asset class for some time now, the class has become very popular with the average investor, as evidenced by recent mutual fund flows. In January 2006, investors put $31.8 billion in equity mutual funds. Of that figure, 74%, or $23.5 billion, went into foreign stock funds; only 26%, or $8.3 billion, went into funds focused on the U.S. Historically, when investors flock to the hottest asset class, that class subsequently underperforms. This reflects the additional capital seeking out undervalued investments, as well as the tendency for the average investor to seek out ideas after their appeal has been nearly exhausted.

N Chindia

This clever word we did not come up with smushes (yes, spell-check caught that one) together China + India, two global growth darlings. We have concerns with respect to both countries.

L China will enter the U.S. automobile market in 2008 with two vehicles selling for $10,000. This will continue to pressure domestic automakers and the ancillary industries they support. (Remember the first Honda Civic. Think of the present Honda Civic.) We do not think, however, that the China story is yet over-hyped, in part because of the lousy performance of domestic Chinese equity markets. Furthermore, while many have focused on the 2008 Olympics to be held in China, few have mentioned the World’s Fair, which is to be held two years later; lasts more than ten times as long as the Olympics; and attracts more than just the athlete crowd. Finally, we gauge the optimism over China to be relatively low based on the discount to net asset value (NAV) in Chinese closed-end funds, which is in contrast to . . . .

L India. Closed-end funds invested in Indian shares are trading at premiums to NAV approaching 20%. In other words, investors are paying $1.20 to get $1.00 in assets.

N Protectionism

Historically, policy efforts to correct trade imbalances—whether in the name of protecting industries, workers, or national security—have produced disastrous consequences; witness The Great Depression or 1987’s Black Monday. The cries for action on this front are getting louder, and the results could prove to have massive and unpleasant consequences.

N Complacency

To us, many markets—especially domestic stock and bond markets—are acting as if nothing could go wrong. The Dow Jones Industrial Average is approaching its high of 2001, which is only 700 points below its all-time high reached in early 2000. Measures of implied volatility for both stocks and bonds are quite low, if not at all-time lows. Implied volatility is calculated from option prices, and it reflects volatility expected over the following 30 days. Corporate bonds are pricing in very little default risk.

While we by no means expect things to go wrong—indeed, markets appear poised to continue their climbs—there is little room for error. For one, the Federal Reserve has a nasty history of going too far by either raising or lowering rates too far. For another, markets priced to perfection do not weather external shocks well.

It is quite possible that we are entering an era of muted economic and interest-rate volatility, which would also translate to lower equity volatility and higher equity valuations. In fact, one research source we use, Bank Credit Analyst, has posited this very thing. Also, investor sentiment is by no means extreme, which is positive for stocks. Most measures of sentiment are decidedly neutral, painting a complete picture of the average investor being neither decidedly bullish nor bearish. Finally, the price-to-earnings ratio for the Standard & Poor’s 500, at 18 times trailing earnings, is just about at the average for the last fifty years, 17.8. A caveat must be added, however, in that profit margins are at their all-time highest, begging the question, where can they go from here?

At the outset, this paper focused on what could go wrong in the world and affect the capital markets. Much could, of course, go right—and likely will. If so, portfolios will perform handsomely, and we will all be happy. The quote from Aristotle that heads the previous page, however, does not describe a man who only considers the outcomes that pleased him. Rather, only by considering numerous—some unpleasant—outcomes can it be said about him: “the dashing of the waves disturbeth him not . . . and the steadiness of his mind beareth him out.”

We would appreciate your feedback to this piece. What concerns do you have that are not widely recognized? Where have we gone wrong in our list of concerns? Give us a call or e-mail us. In the meantime, we appreciate the confidence that you have placed in Tower Private Advisors.