Overall Market Outlook

We are entering a traditionally slow second quarter for the market, but will the market follow its tradition this time? Is the market done with its correction, and will the bulls be allowed to run free again?

While we do not know of anybody with a statistically significant verifiable track record of predicting the market, we do have quite a strong opinion this time around. And this time, we believe, the market will be a renegade. Surely, to be a traditionalist one should at least have an environment where tradition is fostered. But take a look at the current situation for stocks. We argue that it is in fact quite contrary to a typical spring setting. Indeed, what does a typical spring look like? It usually follows a "good time" market that includes January effect, a boost from new money coming to retirement accounts, and an expectation for a seasonally weaker quarterly earnings reports from bellwether companies—such as retail and high-tech.

This spring, however, is quite unusual. Indeed, the January effect is long gone and forgotten (and, in fact, started much earlier than January 1st this year), the money additions to the retirement accounts were offset by the smart tax management (taking losses for all the bad times), the market already went through some correction, and the earnings reports are expected to be compared to a miserable 1st quarter of 2003. At the same time there were virtually no economic surprises to speak of lately. The US economy is making a comeback, with unemployment stabilizing, inflation in check and stagnation a remote possibility, while at the same time the growth rates are quite robust. Furthermore, now that the heating season in the US and Europe is over, the energy prices will be more of a function of macroeconomic developments than that of weather patterns—and these are much more predictable (even the OPEC's decisions, which are never followed through anyway). The biggest macroeconomic question we see as somewhat uncertain is the direction of interest rates. But given the fact that the Fed's main priority is a long-term goal of maintaining sustainable low inflation, we argue that any short-term indications should be taken into account with a grain of salt—meaning that the Fed is not likely to change target interest rates any time soon.

So, in light of the above we see two possible scenarios (other than a chance of major geopolitical or global macroeconomic event) for economic development in the remaining part of 2004:

• Scenario 1 (less likely, approximately 25% probability). The US economy heats up more than expected and the unemployment rate drops by 0.5% to 1%. While the higher level of economic activity means higher earnings for the companies, the Fed is also likely to react to higher employment numbers by at least shifting its "economy risk profile" towards inflation (and we indeed have seen a pick-up in inflation in the recent months), if not outright raising target Fed funds rate. This will definitely increase long-term discount rates for stock valuation. On balance, the resulting valuation of equities are uncertain—under this scenario, we would expect volatility in the market to raise dramatically, with primary measures of the market volatility, such as S&P 100 volatility index (VIX) increasing 25% to 50%. While making our equity strategy more complicated, the higher volatility brings additional options to our options strategy (pun intended). That is, we would certainly expand writing of covered calls to increase profits in a stationary market.
• Scenario 2 (more likely, approximately 70% probability). The economy continues to run its course as expected. The confluence of economic conditions is such that if current pace is kept, and bearing in mind low discount rates for valuation of equities, the overall market is, in our opinion, approximately 15% underpriced (based on forward earnings). Together with a reasonable inflation expectation such estimate warrants a 20% increase in equity prices in 2004. While not as spectacular as 2003, this is still above average annual equity returns, and being, in our opinion, the most likely scenario demands a more aggressive stance for an equity investor.

Force Major circumstances or economic shocks (approximately 5% probability). If any global geopolitical changes occur (such as new developments in the war on terrorism), all the above predictions are obviously off. Note that this is not to say that we do not take chances of such events into account in construction of our equity portfolios. Yet the probability of these events adds overall constrains on portfolio construction rather than establishes an ultimate goal. Such constrains, for example, include limiting of our exposure to global transportation system, and increasing exposure to energy sector.

First Quarter Performance Review

We began our first quarter with mixed economic and stock market indicators. Even though the momentum was strong, we believed that there were several major economic uncertainties in the market. Most notably, the employment data was not too encouraging, and the desire of Fed to hold its economic policy was vague, especially in view of somewhat ambiguous comments from several Fed presidents. Thus, we expected higher than average market volatility.

Consequently, we started the year on a very conservative note, with the target exposure of approximately 70%. As some of the economic uncertainties were getting out of the way, we gradually increased our exposure. At the same time the market went through a roller coaster ride—with actual annualized volatility of S&P 500 reaching 12% mark (almost twice the long-term average) and Nasdaq volatility hitting 18%. Ultimately, the market ended the quarter with mixed results, S&P slightly up, and Nasdaq and Dow slightly down (+1%, -0.5% and -1% correspondingly). Vega Equity+™ portfolios returned on average +0.2% and Vega Equity *™ portfolios were up +0.6%¹ —this, however, with a much lower underlying volatility of 8% (which, coincidentally, is equal to our long term volatility target).

Strategic Direction for the Remaining part of 2004

Striking a good balance between accepting appropriate risks and planning for high returns in our equity portfolios has always been our main objective. The three step process is typical, and involves first, setting overall portfolio metrics goals based on our understanding of macroeconomic developments, second, choosing overweighed/underweighed sectors and/or styles and, finally, selecting individual positions. In choosing the individual positions we try to find stocks that satisfy more than one goal—for example, one of our recent purchases, BASF AG (NYSE ADR: BF) belongs both to a low debt/high dividend and European recovery group.

In view of our positive economic outlook, out equity exposure is increasing (compared to the first quarter of 2004, where our average beta was 0.7); we are now 100% invested with target weighted average beta of our portfolio being 1.0. To achieve this target while keeping our exposure to known risks in check we now emphasize the following components of our portfolio (the exact composition of individually managed accounts will vary depending on the risk profile of investors and their allowed trading patterns—we just love how technology nowadays allows custom tailoring of a single strategy to various needs and constrains!):

The defensive part: low debt, high dividend. Hope for the better, but plan for the worst. Many money managers will tell you the same thing, but what does it mean exactly for their portfolio? For ours it means that part of our portfolio will be dedicated to stocks that behave well in volatile market conditions. These are the stocks that have low debt burden (less than 40% debt-to-equity), and pay relatively high (though high these days may mean anything over 1%) dividends. Several examples of our recent picks in this group are Merck (NYSE: MRK) , already mentioned BASF AG (NYSE ADR: BF) and Novartis AG (NYSE ADR: NVS). Note that the last two are in fact, European ADRs, which leads us to the second overweighed group of stocks.

The global part: playing European recovery. We believe that the exchange rate environment is stabilizing. Many of the European companies are still trading at lower multiples than their US and Japanese competitors, possibly due to unfavorable exchange rate environment. We do not believe that such concerns are warranted, and therefore, the risk-return profiles of some of the major European companies, such as Daimler-Chrysler AG (NYSE ADR: DCX) and Infineon Technologies AG (NYSE ADR: IFX) have recently become very attractive. Daimler is consumer cyclical stock of a company that is bound to benefit from imminent European economic recovery, and Infineon is a global semiconductor manufacturer that is trading at a forward P/E of 18—compared to, for example, Texas Instrument's (NYSE: TXN) forward P/E of 23. In fact, Infineon is a great example of a tech company that is, in our opinion, still undervalued despite the huge run-up in tech share prices that we've seen in 2003. Yet the technology the company makes is very much in demand that is not anywhere near its peak, and the momentum is strong and grounded in fundamentals, which brings us to the next important part of our portfolio.

The momentum part: technology in demand. Yes, that word, momentum, has become an anathema in the years past March 2000. But the fashion for words on Wall Street comes and goes, and has little to do with market realities. And the reality is such that there is a strong fundamental momentum that is driving technological advances, and ultimately, the profits of most technologically advanced companies. This momentum is broad based and is rooted in continuously increasing demand for productivity-enhancing technology. And the rate of change in the productivity is almost inevitably the highest during the early stages of economic recovery—which is exactly the environment we see now. Unfortunately, the market knows this very well and tends to play out this momentum far in advance of the actual increase in profits of the tech companies. But today, we believe that there are quite a few names that will keep surprising the market (those will, we hope, be positive surprises!)—such as already mentioned here Infineon and recently added to our portfolio Adobe Systems (Nasdaq: ADBE). Yes, we do believe in momentum—as long as we can understand where this momentum comes from.

The macro part: increasing global energy needs. Finally, let's look at the energy sector. The global economy is like a furnace that needs fuel. Despite much advances in research on sustainable energy sources, much of this fuel remains fossil. What we are seeing so far is the need for more and more of the fossil fuels—with no end in sight. With the winter over, the typical winter volatility of oil prices based on weather patterns (always uncertain) is going to subside, warranting higher valuations for the oil companies (lower risk means higher premiums). Thus the single major factor influencing the equity prices for the energy companies will be the global demand for energy—and we strongly believe that the only direction for this demand is up (think China).

While the above statement is rather trivial and reflects the investment premise utilized by virtually any diversified money manager these days, the style of their energy investing strategies differs substantially. In our strategy we attempt to pick the stocks of the companies that have significant technological or marketing advantages (read—higher margins) than their peers. The good example of such stock that we recently added to our portfolios is Precision Drilling Corporation (NYSE: PDS).

The option strategy: lower volatility and flatten payout profile. In view of economic Scenario 1 (a modest probability of stationary market) we will be covering positions that are approaching profit targets with covered calls. Additionally, for our more aggressive Vega Equity?™ accounts, we may write limited number of naked put options on market pullbacks. Both of these strategies are geared at increasing profitability in stationary markets, especially under higher volatility conditions.

Vega Fixed Income Strategy Update

Fixed income investing is ultimately about interest rates. We do not mean interest rates in terms of a single number—such as, for example, Fed funds overnight rate or benchmark 10-year treasury rate—but rather the complex interaction between various parts of debt market and overall economy that eventually results in different rates assigned to different debt market segments. And with respect to these interactions, we are currently traveling in uncharted waters. Indeed, never before in the US debt market history had such interest rate structure been seen—both in terms of how low the underlying benchmark rates are and in terms of overall economic environment. Indeed, while the rates are some of the lowest we've seen in history, there are very worrisome economic signs—such as mounting consumer debt and huge current account deficits. But do these really matter?

Some of the most prominent economists—such as St. Louis Federal Reserve Bank president Bill Poole, do not think so. In one of his most quoted recent speeches, he likened US economy to a corporation that borrows to finance growth, and concludes: "whether continuing infusions of financial capital are sustainable depends on how the financial capital is employed.²" This statement is certainly true for a corporation, but is the comparison really valid? Indeed, the borrowing market for the corporations is rather efficient and quite liquid. However, if US economy is to be compared to a corporation (and scaled to the proportions of the US debt market) it would be a corporation with debt structure that is bigger than the combined debt structure of all the companies in the Dow Jones index!

We are not questioning the economic theories of Bill Poole or his opponents (though we tend to generally agree with Mr. Poole); however when managing our clients' fixed income portfolios, we would rather err on conservative side. Remember those Dow 36000 theories from late 1999—early 2000? Similarly to the current speculations on why the interest rates (and inflation) can stay low forever, these were based on the theories that the volatility of equity prices can stay low forever. The low volatility theories ultimately proved to be wrong (and dramatically so!). The low inflation theories appear to hold so far… Whether they will hold forever we do not know—but we certainly will be watching.

Meanwhile, we are taking a very conservative approach to fixed income investing—staying with the shorter duration securities, employing conservative instruments (such as debt with interest payments linked to inflation), and hedging some of our interest rate exposure with derivative products. Conservatism, unfortunately, has its price—lower yields. Thus, our Vega Safe™ (investment grade) and Vega Wise™ (high yield) products tend to yield on average 3.2% and 5.8% respectively—quite low by historical standards. We firmly believe, however, that fixed income portfolios are not the right place to take on additional risks. For those speculating on low interest rates forever there are instruments that target exactly these theories—such as recently issues Lehman Aggregate Bond index tracking ETF (AMEX: AGG). We do not endorse these products for an average investor—in fact, we believe that these are only to be used in special circumstances as a hedging instrument.

Vega Alternative Strategy Update

For the information on performance of our hedge fund products please contact us directly as by SEC rules we are not allowed to make such information publicly available. In general, however, our hedge fund strategy follows the same guidelines as our equity portfolios enhanced with additional instruments such as short positions and derivatives.

Yuri Drozd, Chief Investment Officer
Dr. Vladimir Naroditsky, CFA, Head of Research

¹Vega Capital Group LLC ("Vega") is an independent adviser registered with the Securities & Exchange Commission. The performance shown reflects actual performance for representative accounts. One representative account is selected for each strategy. The selection of representative account is based on the following factors: cash flows into or out of account for the reporting period, size of account sufficient to be representative of the strategy, average trading expenses. Performance of other accounts managed under the same strategy may vary. The firm maintains a complete list of its' accounts performance, which is available upon request. Past performance is not indicative of future results. Accounts under Vega's management are not insured against loss of principal, and may loose value. The U.S. Dollar is the currency used to express performance. Returns are presented net of management fees and include the reinvestment of all income. In addition to an advisory fee, performance shown includes any additional custodial or service fees. The advisory fees are calculated as follows: for Vega Equity Plus accounts, the fee of 0.5% per quarter is charged quarterly, in advance, based on the closing balance on the last date of the previous quarter; for Vega Equity Star accounts the quarterly fees consists of management fee of 0.375% per quarter charged in advance, based on the closing balance on the last date of the previous quarter plus performance fee, charged in arrears equal to the 10% of investment gain for the quarter above all relevant watermarks and hurdle rates for the account. Vega's schedule of advisory fees vary based on product and type of client and is contained in Form ADV-II. Additional information regarding the policies for calculating and reporting returns is available upon request.

² William Poole, "A Perspective on U.S. International Capital Flows," Nov 14,2003, Tucson Chapter of the Association for Investment Management Research (AIMR)