Quarterly Reports /1st Quarter, 2006

April 12, 2006

Dear Friends and Clients,

Too bad our October letter on regression couldn't have been followed by the one you are about to read. We tried to get current with you on asset allocation and portfolio management last quarter. Perhaps it would be best to regard this sequencing as an interrupted conversation. You know, like the ones you have with real people. 

Rotation...

Dan and I are not sure that the strategy "buy and hold" ever did work. Over the years we have developed a fondness for a number of highly successful companies: Berkshire Hathaway, General Electric, Intel, Wal-Mart, Merck and Microsoft to name a few. At the end of the last century these companies were considered one decision portfolio holdings, silver bullets, financial self-cleaning ovens... a breed of dog that doesn't shed. The millennium has disappointed shareholders.

One might want to be rather careful before picking on companies run by the likes of Warren Buffett, Jack Welch/Jeffery Immelt, Andy Grove/Craig Barrett, and of course, Bill Gates. Nonetheless, Buffett's stock was the only one out of the group to beat the S&P 500 for the last 5 years. None of the group showed up well against the likes of Nucor, FedEx, Apple, Progressive, or Goldman Sachs (we could have included the oil companies). This in-depth piece of research is not intended to provoke you into selling your grandfather’s GE holdings.  However, we all should have a pretty good reason to hold any of these stocks in an above average position size (an aversion to capital gains shouldn't count... currently the rate is an all-time low 15%).

So how does all this relate to sector rotation? Let's start with a couple definitions. A sector is a group of companies that all are in similar lines of business. The S&P 500 is divided into ten sectors and each sector is divided into smaller industry groups. Rotation is the term used to describe the ever-changing favor awarded by investors to each of these sectors/groups.  Technical guru John Mendelsen often quoted Matthew 23:1-12 to describe this phenomena, "And he who has been exalted shall be humbled, and he who has been humbled shall be exalted." What we would like to avoid is being the subject of sermonizing pundits reminding us that, "The righteous become self-righteous and the godly become holier than thou."

The end of the last century saw money rotate about as drastically as it ever has. Shareholders sold industrial and energy stocks in order to pour funds into technology. In 2001, those same dollars did an about face and rotated out of technology into real estate and fixed income. Like children chasing fireflies, momentum players chased this hot money from place to place. Many said they had lost their appetites for equities permanently. Apparently “permanently” lasts about 5 years. Although the NASDAQ has a ways to go, the Dow and the S&P are challenging their old highs.

To prove the existence of rotation a little more emphatically, we'll make a couple of not very farfetched assumptions and take a wider perspective.  Investors suffer the anxiety of fear and greed. Disruptive events in technology, politics, and economics create investment opportunities. Investment dollars need to be employed. They will find a home in stocks, bonds, real estate or commodities, but they won't stay idle very long. With these caveats in mind, let's take a look at the sweeping changes that have occurred in the weight of market sectors over a long period of time. The Investopedia.com website provides us with a couple of very interesting tables:

			US Sector		Weightings
Sectors	1900	2000	Change		Sectors	2000	1900	Change
Rails	62.80%	0.20%	-62.60%		Tech.	23.10%	0.00%	23.10%
Bks & Fin.	6.70%	12.90%	6.20%		Bks & Fin.	12.90%	6.70%	6.20%
Mining	0.00%	0.00%	0.00%		Mining	0.00%	0.00%	0.00%
Textiles	0.70%	0.20%	-0.50%		Pharma	11.20%	0.00%	11.20%
Iron & Coal	5.20%	0.30%	-4.90%		Telecom	5.60%	3.90%	1.70%
Brew. & Dist.	0.30%	0.40%	0.10%		Brew. & Dist.	0.40%	0.30%	0.10%
Utilities	4.80%	3.80%	-1.00%		Oil & Gas	5.20%	0.00%	5.20%
Tel. & Tel.	3.90%	5.60%	1.70%		Industrials	5.10%	0.00%	5.10%
Insurance	0.00%	4.90%	4.90%		Insurance	4.90%	0.00%	4.90%
Transport	3.70%	0.50%	-3.20%		Utilities	3.80%	4.80%	-1.00%
Chemicals	0.50%	1.20%	0.70%		Media & Photo	2.50%	0.00%	2.50%
Food Mfg.	2.50%	1.20%	-1.30%		Mining	0.00%	0.00%	0.00%
Retailers	0.10%	5.60%	5.50%		Retailers	5.60%	0.10%	5.50%
Tobacco	4.00%	0.80%	-3.20%		Small Sectors	19.70%	84.20%	-64.50%
Small Sectors	4.80%	62.40%	57.60%
	100.00%	100.00%				100.00%	100.00%

Succession is always a problem with long-term research like this. Telegraph became telecom, banks became brokers, and inventions like the automobile and computer spawned brand new sectors. To compound things, our frame of reference, the S&P 500, did not exist until 1928. Nonetheless, take a look at the Rails. They were the internet of their day back in 1900. Today they are far from extinct, but they are certainly enjoying a smaller market weight. The railroads were a disruptive technology in the 1800's and have continued to be a dominant factor in the economic development of our country. Towns sprung up along their right-of-way, communications followed their path, and new markets were opened to commerce. 

The same type of event is occurring today. In the late '90s the internet was heralded as the most pervasive technology to enter our lives in decades.  No doubt that is a true statement. However, we have since learned to regard this innovation as a utility, not unlike the electricity, telephones, or natural gas. During the last five years, the productivity that has been generated by combining the internet with personal computers, wireless communication, and next day delivery has created new businesses and been a key factor in stifling inflation. The benefit of an innovation often accrues best to those that can employ it most efficiently... not the inventor.

Sector rotation is like gravity, one of nature's undeniable forces. It will be with us forever. A typical investment portfolio generates 80% of its gains from 20% of its holdings. It is not unusual for investors to find themselves owning and coveting one or two stud positions. We have been fortunate enough to enjoy this experience ourselves. However, regression to the mean (October's letter) is like financial gravity and our long term interests have always been better served by trimming and diversifying those positions. We don't know which market sector will gain investor popularity next. We have opinions, but we don't know. As a result, our portfolio positions are equal-weighted, diversified, and best of breed. Minor changes in sector weightings can create the kind of improvement in relative performance that tends to be significant over time. We try to let the growth of favored sectors run, while reducing our exposure to out of favor industries. This process is kind of like choosing your birth parents... fairly difficult.

While we have reduced our ownership in the list of highly successful companies mentioned at the beginning of this letter, we would still be open to increasing our exposure to them in the future. It is important to remember that there is a difference between a great company and a good stock. Nothing is forever in the securities industry.

Deal or No Deal?

Last month we reviewed asset allocations with you. Any given allocation is a function of liquidity needs, income requirements, market expectations, age, and of course risk tolerance. This winter a new game show popped up on NBC. As it turns out, it is not new. The show originally aired in the Netherlands on December 22, 2002. Instead of pitting contestants against each other, the show allows its players to react to random chance, simple odds, and a banker.  It is an interesting observation of risk tolerance.

The program is a repeated exercise in Decision Theory, which owes its origin to at least two other mathematical explanations of risk. The first was advanced by Daniel Bernoulli in the late 1700's. He attempted to quantify the concept of financial Utility. Bernoulli wrote that the utility of a financial proposition is dependent upon the circumstances of the person confronting the risk. Different people ascribe different values to risk. In particular, the utility resulting from any small increase in wealth will be inversely proportionate to the quantity of the goods previously possessed.  Translation, people like Donald Trump don't go very far out of their way to pick up nickels.

The second is called Prospect Theory and has its roots in a paper written in 1979 by two ex-Israeli soldiers. Kahneman and Tversky observed that once people owned something or acquired net worth, they tended to be risk-averse when dealing with those assets. They also proved that people who were trying to avoid loss tended to be much less averse to risk. 

Bernoulli used a coin flipping game called the Petersburg Paradox to substantiate his theories. Kahneman and Tversky also employed a financial game to make their case. A group of contestants were given a choice between an 80% chance of winning $4,000 and a 20% chance of winning nothing ... Versus a 100% chance of receiving $3,000… the popular choice was to take the $3,000. The risky choice had a higher mathematical expectation, $3,200, but 80% took the $3,000.  In this scenario the players felt they "owned" $3,000 and the reward of an additional $200 did not justify taking the gamble. These people were risk-averse, just as Bernolli would have predicted. 

However, when offered the choice between accepting the risk of an 80% chance of losing $4,000 and a 20% chance of breaking even... versus a 100% chance of losing $3,000… 92% of the players chose the gamble. The mathematical expectation of a $3,200 loss was once again larger that the certain loss of $3,000. When the choice involves a loss, we tend to be risk-seekers, not risk averse.

Enter Howie Mandel, the MC of "Deal or No Deal". Contestants are asked to choose 1 of 26 brief cases with a cash prize in it between $.01 and $1 million. The contents of that case remains a mystery and is theirs to keep if they choose to do so. The remaining cases are then opened randomly, by the contestant, one or two at a time. Each opening eliminates one of the outstanding prizes. As the show proceeds, the contestant can begin to calculate the odds of having a large or small sum remaining in their case. From time to time the "Banker" offers the contestant a "Deal"... a specific amount of money for the case they own. If the contestant turns down the deal, they must continue to eliminate the remaining briefcases.

The show is an interesting look at how individuals deal with risk. The $1 million prize will only be won if a contestant eliminates all the small prizes first and has a reasonable net worth. I suspect the latter quality is screened out by the producers. All the participants I have seen disclose financial issues, not assets. The show is currently aired in a variety of versions in 11 countries. Since one production company owns all 11 shows and can diversify their financial risks globally, I suspect "Deal or No Deal" will be with us for some time. Next time you run into it while surfing the dial, frame your reference through the eyes of Bernolli, Kahneman and Tversky. The contestant decisions tend to run true to form.

The World According to Dan and Pitt...

In recent letters we have tried to make it clear that we believe that the market has begun the fourth leg of an extended bull market. We will be using this price appreciation to harvest capital gains and diversify your portfolios.  In addition to defensive common stocks, we will be adding fixed income to some of our portfolios. We have also found a regulated hedge fund that may work for some of our Clients. It employs quantitative disciplines, a modest expense ratio and regulated amounts of leverage. 

Our appetite for equities is changing from "really like" to "like". We find ourselves liking bonds more and more as interest rates rise. We are seeing 5-year agencies in the 5.75% range and comparable muni's with something close to a 4.00% handle. On a relative basis, taxable interest rates have increased much more than tax free rates. We will start to apply our equity rating system to fixed income; "Love", "Really Like" and "Like". Generally speaking, we think Clients are well served by balancing and diversifying their investment portfolios. Put us down on the equity side as "really liking" moving to "like" and on the fixed side as "liking" moving to "really like".

As Always,

James S. Pittenger Jr.
President, CFP

Dan Anderson
Executive Vice President, CFP

September 6, 2006

Federal security laws mandate that a Registered Investment Advisor will offer to deliver a current version of SEC Form ADV Part II to its clients annually. Form ADV Part II is updated and filed with the SEC whenever there is a material change in our business (address, phone number, fee schedule, investment practices, etc.). The form contains information about our background and business practices. We provide a copy of Form ADV Part II to all of our prospective clients as part of our brochure.

If you would like to receive a copy of Form ADV Part II or a current copy of our audited financial statement, please call us at 800-897-1588 or email lynda at pittand dot com. 

Pittenger & Anderson, Inc.

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