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Dear Shareholder:
The stock market: In the opinion of Logan Foster, who takes many of our shareholder calls, stock-buyers are going to have to quit looking on stocks as a lottery ticket and begin to regard them as a long term investment. The marketplace is still full of folks who are sure that stocks will recover, and by that they mean the Dow will go right back to its former January 2000 high, and they don't want to miss the boat!
Of course, this completely ignores the fact that corporate earnings have dropped. It ignores the fact that when the Standard & Poors 500 was at 850 (approx.) in late July, 2002 the index was still trading at about 28 times 12 month trailing earnings. In other words, based on historic PE's, stocks were still not a great buy at those levels. But there's the rub; "historic" is an out of fashion word. There still are many who believe in a brave new world. Old rules are out! New rules are in! …………..I don't think so.
The bond market: For a few months the bond market has moved inversely to the stock market; that is, stocks go down, bonds go up, or the other way around. So there are a growing number of voices that think the bond market is a little top heavy.
Well, the first twenty years of my business experience saw rates much lower than current rates and periods of inflation much higher than today. So higher rates (a lower bond market) is possible but not a given. In the current climate much depends upon perception. If the market believes the economy will recover, then it believes the Fed will start to raise rates and, hence, the bond market (and the price of our shares) should decline a little. So the economy is what needs to be watched if we want a leading indicator on bonds. And that's not an easy or obvious call either.
These comments, however, are only of interest to a short term investor in a bond fund. A long term bond fund investor knows he/she is going to get a relatively stable tax free income check month after month regardless of what the bond market does. This same long term investor is aware that over the years he will see the price of his shares rise and fall as interest rates change. But a short term investor is only OK as long as his share price is stable or rising. He will exit as soon as the share price starts falling. Usually, the greatest number of short-term-investor redemptions comes just at the very bottom of the market, indicating that most of these folks are mostly wrong most of the time.
The short term investor seems to treat his regular tax-free income as if it doesn't exist. Using the Kentucky Income Series as an example, the typical investor in stocks (or short term investor) will often judge his success in our fund based upon the last five years as follows:
Price: June 30, 1997 $7.47
Price: June 30, 2002 $7.48 (Gosh! I've made just one penny!)
Forgot your tax-free dividend? If your tax-free dividend had been reinvested over those five years, then:
Price: June 30, 1997 $7.47
Price: June 30, 2002 $9.54 Tax-Free!
That's better? Well, it's still not all. If it had been a stock the gain would be subject to a 20% Federal Capital Gains tax and a 6% State Capital Gains tax. So the result, considering before tax results, which is the way we all think of our stock gains, is as follows:
Price: June 30, 1997 $7.47
Price: June 30, 2002 $10.27 Before Tax-Equivalent
(Actually, since we are an open-end investment company, you would have more shares, rather than a higher price per share.) The results are the same or better for folks in our other state series.
If you could have bought the S&P Index for $7.47 five years ago what would it be worth today? Would you believe $7.72? (But it would have paid a little over a 1% taxable dividend during that time as well.) You would have been a lot luckier if you were in bonds!
Speaking of luck, about fifteen years ago I drove my banker to our state capitol for a meeting, about 45 minutes from Lexington, and on the way back as we were ascending a small hill the car stopped. Out of gas! But it kept rolling to the top, eased over the crest at about five miles per hour and then rolled down the hill about a half mile where there was a filling station. Brakes weren't needed as we stopped by the gas pump. When I got back into the car after paying for the gas, banker Will looked pensive. "Tom", he said, "I want you to come in the bank tomorrow and we are going to loan you our limit." "Well, I don't need to borrow any money, Will. But why do you say that?" "Because, Tom, we would rather loan money to someone who's lucky, than someone who's smart".
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