T HIRD QUARTER 2004

O CTOBER 2004

Sea Change

interest would INSIDE put this other- GRAPHS:

wise undistin- u u u u u u guished career officer in a posi- tion to change · Graph 1: Capital Market the course of Returns—page 2 history? But that is exactly what · Graph 2: Fading Stim- Commander uli—page 2 Rochefort did. The five months · Graph 3: Net Saving as a following the Percentage of Gross Na- attack on Pearl tional Income —page 3 Harbor were an especially de- · Graph 4: Current Account pressing time Deficit—Page 3 for the free world. Nazi · Graph 5: 200+ Years of Germany con- United States Interest Rates trolled virtually —page 5 oseph Rochefort had a per- all of Europe and North Africa, and J fectly uninspiring career. He Japan controlled all of the western Pa- enlisted in the navy in 1918, cific and East Asia. Malaysia, Singapore, · Graph 6: Dow Jones In- earned an ensign’s commission, and was the Dutch East Indies, Papua New dustrial Average (1896- known principally as a lover of cross- Guinea, and the Philippines fell quickly Present) —page 6 word puzzles. Stationed on the USS Ari- to the Japanese onslaught (see map). zona in 1925, he shared this love of Neutralizing Australia and India were crosswords with his CO, Commander the next official Imperial war objectives, Chester Jersey. Later that year, when the to be followed by attacks on Alaska and navy decided to double its the west coast of the United States. In department (to two), Jersey remembered conquering this immense area, Japanese and recommended Rochefort on the forces lost not a single battle, and their grounds that skill in crossword puzzles sureness of divine invincibility appeared qualified one for cryptanalysis. Along the justified. way, Rochefort picked up Japanese, and Before Imperial Japan could be in 1941 was the obvious choice to head defeated, it had to be stopped. Perhaps Station Hypo, the navy’s communica- that sounds obvious, but before a trend tions center at Pearl Harbor. Who could can reverse, it needs to be stopped in the have imagined that a crossword puzzle first place. It is only in hindsight that we

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PAGE 2 THIRD QUARTER 2004

Graph 1 Israel, down 17% in these Capital Market Returns three months. We draw no political conclusions from REITS, 18.3% these data. Convertibles, 5.1% ontributing to the 5-Years US Bonds, 7.5% modest rebound in Int'l. Equities, -0.9% bonds last quarter is US Equities, -0.1% C evidence of a slowing econ-

REITS, 25.6% omy. Nothing dramatic here, Convertibles, 11.5% as the economy is still chug- 1-Year US Bonds, 3.7% ging along, but most of the Int'l. Equities, 22.1% recent indicators have taken US Equities,14.3% a dip, from retail sales to employment growth. Oil REITS, 8.2% Convertibles, -0.8% over $50/barrel may be US Bonds, 3.2% partly to blame for this slow- 3Q04 Int'l. Equities, -0.3% down, but two other factors US Equities, -1.9% are probably much more -5.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% important. Tax cuts provided a big stimulus to the econ- omy in 2003, but the effects are now fading. The biggest confidently identify a turning point, as much as in battles retardant to growth is probably the large decline in mort- or wars as in financial markets and economies. But turn- gage equity withdrawals (see Graph 2). These stimuli ing point is a poor description for how events unfold; kept spending (and economic growth) higher than would rarely do trends just turn and go the other way. This was have otherwise been. In the four years prior to 2001, real true in the in 1942, and has been so in finan- spending kept pace with real pre-tax income, both grew cial markets throughout time. And we think this is where at 5% p.a. In the subsequent four years, real income we are today: a transitional period between very different growth fell to just 1.5% p.a., but spending only fell to investment regimes. 3% p.a. So spending was boosted by 1.5% p.a. relative to t’s been a seesaw year in most of the capital income, or about $150 billion. But these economic tail- markets. In the first three quarters of 2004, winds are fading, and near-term drivers of growth are I stocks were up/up/down while bonds not clearly visible. The concern is that slower economic were up/down/up, with little overall progress made. growth with modest hiring will lower productivity Following a gangbuster 2003, stocks now trail bonds year-to-date, which would make four out of the past five Graph 2 years that bonds trumped stocks, if Percent of disposable income Percent of disposable income 3 3 the trend continues a few more Year-to-year Effect of: months. Of course, a lot can happen Personal Tax Changes Energy Prices in a few months. 2 2 Real estate securities had a Mortgage Equity Withdrawal bear market (down 20%) the first few weeks of April, and have been on a 1 1 tear ever since, posting the best re- turn of all major asset classes, not just 0 0 last quarter, but now over each of the past 1-, 3-, 5-, 7- and 10-years. The -1 -1 most curious result for the quarter just past was that the best stock mar- ket in the world was Egypt, up nearly -2 -2 50%, while the worst performer was 1998 1999 2000 2001 2002 2003 2004 Chart courtesy Goldman Sachs

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M ARKET COMMENTARY PAGE 3

growth and push up labor costs, result- Graph 3 ing in lower profits and/or higher 16 Net saving as a percentage of gross national income prices. Growth drivers for the econ- 14

omy are obscured because of a large 12 structural imbalance in savings. This applies worldwide, but we’ll address the 10

US side first. The savings rate has been 8 in a structural decline (see Graph 3), but it can’t get much lower. It’s possible that 6

savings out of income declined over the 4 past twenty years as outsized capital gains were available for spending, but 2

this era has ended. The private savings- 0 | | | | | | | | | | | | | | | | | | | | to-investment balance plus the public ------

sector’s balance combine to form the 1947 1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 current account balance, the difference Source Bureau of Economic Analysis between domestic savings and invest- ment that must be financed with foreign capital. This is of each Treasury auction. So, for the moment, it’s good not a choice; it is an accounting truth. The US current politics, but questionable economics, to buy our debt at account deficit is now over 5% of GDP (see Graph 4), current prices. That may continue for some time, but so we need foreigners to send us about $2 billion more then again, maybe it won’t. each day than the previous day. Of course, they do Our point is not that we are at that turning (because they have to—remember, this is just account- point; we won’t know that till after the fact. Incomes are ing), but the question is, at what price? Currently, the growing, productivity is still high, and it is certainly pos- price (Treasury yields) is pretty low, but private foreign sible that we resolve our savings deficit through a com- capital flows (presumably somewhat rational investors) bination of rising exports relative to imports and main- have slowed to a trickle, and the slack has been picked taining our high productivity. But the risks are clearly by foreign central banks, who are generally guided more shifting: the tax stimulus and mortgage equity withdraw- by politics than by economics, and are now buying half als are ending and debt levels are high. It seems more

Graph 4 6% 30% Current Account Balance % GDP US Real Trade Weighted Dollar 20% 4% Capital flows drive up dollar

10% Chart 4 2% 0%

0% -10% Financing hurdle -20% -2% -30% Dollar drives down trade balance -4% -40%

-6% -50% 70 74 78 82 86 90 94 98 02

Graphs Courtesy Bridgewater Associates

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PAGE 4 THIRD QUARTER 2004

likely that savings rates will rise, tax rates will rise and cycle can turn vicious, affecting (infecting?) everyone on foreign capital flows will slow, all implying that the econ- both sides of the Pacific. omy will face some strong headwinds. Of course, there’s a more palatable resolution ur savings imbalance is mirrored with to these imbalances. Asians can develop domestic de- the opposite problem in the rest of mand by adopting consumer- and investor-friendly poli- O the world, especially in Asia. If Ameri- cies, Americans can save more, the dollar can adjust cans don’t save enough, Asians save too much. Histori- downward gradually and the path between stagflation cally, there have been good reasons for excess savings. and deflation can be navigated. Economic boom-and-bust is a frequent pattern in Asia, nd this is exactly where we are, trying and over time, returns on capital have been paltry. Lack to rebalance these imbalances. If it all of attractive investment opportunities, central planning A feels uncertain, it should. These past that distorts the economies, the threat of government few years have witnessed the confluence of a number of confiscation, all have promoted high savings. But in the momentous changes. The integration of the world’s past few years, the savings imbalances on both sides of most populous country into the global economy, and the the Pacific have grown substantially with linkages that spread of technological innovation worldwide have have been mutually reinforcing. caused global productivity to rise, but also serious dislo- Without sufficient domestic demand, Asian cations as people, industries and countries adjust. The economies are dependent on exports for economic investment regime of the past twenty-odd years has dis- growth, especially to the biggest consumer market by far, integrated, asset class by asset class, and the new direc- America. In order to maintain price competitiveness, tions are unclear. undervalued currencies are defended by recycling export In 1981-82, in the depths of economic ruin, earnings back to their currencies of origin (i.e., US dol- financial assets began major, new long-term projections. lars). This has the added benefit, in addition to lowering Stocks and bonds ascended, while gold, oil and com- the value of their own currencies, of keeping interest modities declined, all reversing the environment of the rates lower in the US, thus helping to stimulate further prior decade. Those long-term, structural trends have all demand for Asian exports. This virtuous cycle grows now reversed, with the possible exception of bonds. ever bigger and bigger: Americans buy goods from Asia Stocks broke an 18-year uptrend in 2000, gold reversed a in exchange for dollars, those dollars are spent buying 20-year bear market, commodities reversed a 22-year US Treasuries, lowering interest rates, which stimulate downtrend, and oil has broken through a 24-year pla- consumer demand, and so on. teau. The 24-year bull market in bonds is the last remain- Of course, all virtuous cycles end eventually. ing structural trend to reverse decisively. Asian central banks now hold $2.2 trillion of foreign Historically, the transition from falling to rising reserves, 80% of the world’s total, 70% of which is in rates has been a gradual one (see Graph 5, pg 5 for a dollars. China’s exports represent one-third of that coun- 200+ year perspective). This is probably because a low try’s GDP. Record low interest rates is spurring a hous- interest rate environment is likely deflationary or near- ing boom in Shanghai that makes Los Angeles look de- deflationary, and the risk of falling into deflation takes pressed. time to diminish. Thus, a period of yields moving in a Herbert Stein, a leading economist a generation low range is required before deflation worries abate, and ago, observed that “things that cannot go on forever, yields move higher. We think this describes today’s envi- don’t” (who said economists weren’t clever?). But the ronment: the bull market in bonds has probably ended, real message here is not that these trends cannot go on but we are range-bound for a time, till the next rise in forever, but that all of these observations are interre- rates begins. lated. The savings deficit in the US is directly linked to History can also offer some guidance for equi- the savings surplus in Asia. If Americans shudder at the ties, although the pattern has differed from bonds. With idea of slower growth in the years ahead, Asians (should) bonds, we see bull markets fade into a period of consoli- tremble at that prospect too. Not only would the princi- dation, or transition, from one structural environment to pal driver of export, and therefore their economic, the other. With stocks, we see bull markets end abruptly growth diminish, the value of all prior earnings now in- (1906, 1929, 1966, 2000), followed by a bear market, vested in Treasuries at negative real yields will fall with where prices decline to a trough, and then a period of the value of the dollar, which in turn will diminish de- years climbing back before the next bull market begins. mand for Asian exports, which in turn will reduce the Graph 6 on page 6 is the DJIA from 1896 to today, with demand for recycled dollars, ad infinitum. The virtuous bull market peaks clearly visible, followed by troughs,

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M ARKET COMMENTARY PAGE 5

and then a period of transition before the next bull mar- Japanese navies. Carrier-based aircraft sank a carrier on ket. The Dow peaked at about 100 in 1906, and took 16 each side, and the Battle of Coral Sea was the first naval years to recover before breaking out to a great bull mar- battle in history in which ships did not actually fire a ket. That ended in 1929, the dramatic fall through 1932, shot. The Japanese inflicted more damage than they re- and then ten more years before the next bull market, ceived, so it was a tactical victory, but it turned out to be which ended in 1966. The Dow peaked at about 1,000 a strategic disaster, as proven a month later when their that year, made a low in 1974, then broke above 1,000 in damaged ships would be much-needed. The Japanese 1982, beginning the next bull market, that finally peaked advance was stopped for the first time at the Battle of in 2000. We acknowledge that many would say that Graph 5 these observations about history are bunk: there are SMITH BARNEY 1981 - ? too few data points and we TECHNICAL RESEARCH ? YEARS are fitting a story to the 10 1798 – 1825 facts. We agree; these ob- 9 27 YEARS 1861 – 1898 8 servations are statistically 37 YEARS spurious. But we always 7 1920 – 1946 6 have imperfect data, and 26 YEARS even less perfect vision. But 5 that shouldn’t stop us from trying to make sense of the 4 events around us, and past patterns of market behavior 3 1825 – 1861 1898 – 1920 seem to have some descrip- 36 YEARS 22 YEARS 1946 – 1981 tive applicability to the cur- 35 YEARS rent environment. Bonds 2 have probably (though not certainly) seen their lowest yields (last year) for this 200+ YEARS OF UNITED STATES INTEREST RATES long-term bull market, and 1 rates will likely trade in a 1790 1800 1810 1820 1830 1840 1850 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020

range before moving deci- Data Used in Chart: sively higher. Stocks may Foreign loan made to U.S. government: 1790, 1792, 1794 New England municipals: 1821-5, 1827, 1829-30, 1832-40, 1849-59, 1865-1884 Average foreign loans made to U.S. government: 1791. Highest grade corporates (RR): 1862-4, 1885-98. have seen their bear market Federal government bonds: 1798-1820, 1860-1. 30- year prime corporates: 1899-1976. Federal government average new issue: 1841. 30- year treasury bond yield: 1977- present. lows in 2002, but it could Federal government average market yield: 1842-8. Interpolated: 1793, 1795- 7, 1822, 1826, 1828, 1831. be a number of years be- Note: 1821 – U.S. debt insignificant. 1833 – No federal debt all all. fore a new bull market be- gins. Choppy seas, then, for Graph Courtesy Smith Barney bonds and stocks. etween Papua New Guinea and the Coral Sea, and much of the credit belongs to Com- Solomon Islands lies a body of water mander Rochefort’s cryptanalyst team for providing cru- B called the Coral Sea, adjacent to the cial intelligence. northeast shore of Australia. Two Japanese carrier Rochefort noticed a very high level of urgent groups were assigned to clear the way for the invasion of traffic following the battle, and sensed that something Australia, a preliminary step to Admiral Yamamoto’s big was being planned. He could read only about 10% of grand plan of taking Midway and the Aleutians. The dar- the intercepts, but was able to identify a place code- ing raid on Tokyo on 18 April 1942 led by Jimmy named “AF” as the target of a huge Japanese operation. Doolittle and 18 B-25 Mitchell bombers caused little Suspecting it might be Midway Island, he called the US physical damage, but shook Japanese confidence, and base there via an underwater telephone cable, and asked their invasion plans were accelerated. that they send him an uncoded message that their desali- On 7-8 May 1942, the first carrier battle of the nation plant had broken. Sure enough, a few days later, war was fought in the Coral Sea between the US and Rochefort intercepted a Japanese message that the de-

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PAGE 6 THIRD QUARTER 2004

Graph 6 DOW JONES INDUSTRIAL AVERAGE (1896 – Present) 100,000

1/14/2000 11,722.98

10,000

10/9/2002 7,286.27 2/9/1966 995.15 9/31/1929 1,000 381.17

8/12/1982 776.92 12/6/1974 577.60 1/19/1906 103.00

100

4/28/1942 8/24/1921 92.92 63.90 12/24/1914 53.17 7/8/1932 41.22 10 1895 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Graph Courtesy Smith Barney salination plant on “AF” was broken. He was able to way. It’s a mystery (to me, anyway) why Midway is not identify positively Midway as the target of attack by the celebrated as a national holiday, and Joseph Rochefort, entire Imperial Fleet, and with this information, Admiral the unassuming lover of crossword puzzles, isn’t lauded Chester Nimitz was able to move every available ship as a national hero. out of Pearl and onto Midway. In hindsight, we can identify Midway as the At the , the Americans lost a turning point in the Pacific war, although it took another carrier and a destroyer. But Admiral Yamamoto’s Grand three difficult years to end. But before the tide turned, it Fleet was destroyed: four carriers, 3,400 sailors and 100 was stopped, at the Battle of Coral Sea. For most of the experienced pilots were lost, along with the secrets of past two decades, investors have seen markets move in the Zero fighter, which crashed in the Aleutians and was one direction. That directional movement has stopped; recovered by the Americans. Control of the seas and of investors have been through their own Battle of Coral the skies shifted thereafter to the Americans. Midway Sea. In hindsight, we’ll be able to identify clearly the was the most important naval battle in over 2,400 years, markets’ turning point, their own Battle of Midway. when the Athenians routed the Persians in the straits of What is clear is that the new environment will be unlike Salamis, preserving Greek (and European) civilization. the old, and investors will, as Shakespeare penned in The We remember June 6th as D-Day, but the Normandy Tempest, “suffer a sea-change into something rich and invasion would not have occurred on that date if, two strange.” years before, the Battle of Midway had gone the other

MICHAEL A. ROSEN PRINCIPAL & CHIEF INVESTMENT OFFICER OCTOBER 2004 This report is not an offer to sell or a solicitation to buy any security. This is intended for the general information of the clients of Angeles Investment Advisors. It does not consider the investment objectives, financial situation or needs of individual investors. Before acting on any advice or recommendation in this material, a client must consider its suitability and seek professional advice, if necessary. The material contained herein is based on information we believe to be reliable, but we do not represent that it is complete or accurate, and it should not be relied on as such. Opinions expressed are our current opinions as of the date written only, and may change without notification. We, along with any affiliates, officers, directors or employees, may, from time to time, have positions, long or short, in, and buy and sell, any securities or derivatives mentioned herein. No part of this material may be copied or duplicated in any form by any means and may not be redistributed without the consent of Angeles Investment Advisors, LLC. © 2004 Angeles Investment Advisors, LLC All Rights Reserved.

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