Several trends have occurred over the last 4 months that could play a significant role in the performance of the stock and bond markets for the remainder of 2004. These events include the situation in Iraq, the Presidential election here in the US and the increased likelihood of the Federal Reserve raising interest rates. I will explain each of these and then look at their effect on stock and bond investments.

The handover of power from the Coalition Provisional Authority is set to occur on June 30th—little more than 60 days away. There are serious questions about who will take authority and the impact it will have on the success of democracy in Iraq. This uncertainty will impact the financial markets in the U.S.

Back in the U.S., the outcome of the 2004 Presidential election is far from certain. Senator Kerry is proposing significant changes to the way corporations are taxed, the repeal of the dividend and capital gain tax cut and the repeal of the tax cut on those earning $200,000 or more. There is concern among investors that, if elected, these changes would impact corporate profits and investors’ interest in stocks.

At the same time, the economy continues to recover resulting in the increasing likelihood that the Federal Reserve will raise interest rates sooner than expected. One major impact of rising interest rates is on what is called the ‘carry trade’.

The ‘carry trade’ takes place when financial institutions such as banks and brokerage firms borrow money at a low rate and invest that money at a higher rate. For instance, for quite some time these institutions have been able to borrow money at about 1.25% and reinvest it in 10 year Treasury Notes at about 4%, pocketing the difference. This has resulted in substantial profits for these companies.

Rising interest rates will cause these institutions to unwind these positions by selling the bonds they have invested in. The effect of this selling will be to drive down bond prices and increase bond yields.

How does this affect you and what should you do about it? That depends on whether you are invested in stocks or bonds.

Many of you may own mutual funds or closed-end funds that invest in Government Guaranteed, investment grade corporate or high-yield bonds. If you own any of these you will have seen their value decline over the last few weeks.

If you have not done so already, you may want to reduce the portion of money you have invested in bonds. For some of my private wealth management clients I am further reducing their bond allocation because of the risk of loss in these investments.

For those that own stocks or mutual funds that invest in stocks, the returns on equities this year may not be as high as you thought while their volatility may increase. For instance, my firm is still anticipating an 8% return from equities for all of 2004. It’s possible that won’t be achieved.

If you are retired or near retirement then you will want to keep an eye on your stock-oriented investments. This is not the time to throw your investments in the drawer and forget about them. If you are uncomfortable with your investments declining in value, determine the level at which you would take action to prevent additional loss. If that level is reached, sell the investment and wait for conditions to improve.

Regardless of whether you own stock or bond oriented investments, you should reduce your short-term expectations. And don’t panic. These are short-term events that should straighten themselves out over the next 6-12 months.

Lastly, many investors are taking the drastic step of locking their money in Equity-Indexed Annuities for 10-15 years because they fear additional losses. Don’t make a long-term investment decision based on short-term events—especially when you won’t have the ability to change your mind without losing a significant portion of your investment through surrender charges.

Nationally-syndicated financial columnist and Certified Financial Planner® Jeffrey Voudrie provides personal, in-depth money management services and advice to select private clients throughout the USA. He’ll answer your financial question – FREE at http://www.guardingyourwealth.com