Market Perspective Full Year 2003 and Outlook
It was an eventful year and a profitable one for investors. Memorable 2003 headlines included the war and subsequent “instability” in Iraq, mutual fund scandals, real and perceived terrorist threats, and accounting scandals. It was also a year of very stimulative monetary and fiscal policies that produced economic growth that was well above expectations and an increase in consumer confidence. As a result, stock and commodity markets around the globe surged. And while longer-term interest rates rose in most developed markets, improved credit quality helped to drive spreads lower. Thus, even bond investors enjoyed modest returns for the year. Finally, the dollar fell sharply against the currencies of most developed countries. This meant even better returns for U.S.-dollar investors in foreign stock and bond markets.
Economic Review
The global economy showed improvement throughout 2003, culminating in fourth quarter reports of near record-setting expansion. In the U.S., all parts of the economy delivered heartening news. Third quarter real GDP rose at the fastest annualized pace (+8.2%) in 20 years, third quarter non-farm productivity had its largest quarterly increase (+9.4%) in 20 years, a prominent survey of manufacturing activity also reached a 20-year high, housing starts reached a 17-year high in November, and the inventory-sales ratio fell to its lowest reading on record. Perhaps the best part of all this good news was that it translated into a 25% year-over-year gain in corporate profits, using the government’s statistics. Also, inflation failed to threaten, which allowed the Fed to maintain its accommodative policy throughout 2003 even as the economy was gathering steam.
Evidence of improvements outside of the U.S. has also been encouraging. These improvements are creating a real possibility that the major economies around the globe will be moving upward together rather than unsynchronized (the latter has typically been the case in the past). Perhaps most importantly, Germany and Japan both made strides in addressing the necessary structural reforms to improve the health of two of the world’s largest economies. In Germany, for instance, Chancellor Schroeder appeared to make progress with his “Agenda 2010” program of tax cuts and structural reforms. Meanwhile, Japan’s manufacturing activity showed hopeful signs of improving late in 2003, although deflation remained a concern. While neither of these two nations actually reported meaningful growth in their overall economies, the improvements were tangible. Other nations benefited from the sharp expansion in the U.S., particularly exporters of raw materials and high tech goods.

The U.S. real estate market soared to new heights in 2003. Home values rose significantly, and the latest price gains came on top of already impressive appreciation in recent years. Real estate strength and consumer spending have been aided by extraordinarily low mortgage interest rates, which moved up only slightly compared with historic lows in 2002. Low rates made it easier for buyers and also continued the mortgage refinance boom begun in 2002.
Equity Review
Stocks rose sharply around the globe in 2003, also concluding with a nice fourth quarter rally. In the U.S., the broad market (using, for example, the Russell 3000, Wilshire 5000, and S&P 500 indices) rose about 30% for the year. By most measures, it was the first calendar year rise for the U.S. equity market since 1999, and its best year since 1997. Performance by quality was one of the more compelling factors throughout 2003. In essence, the lower quality stocks (no earnings, extremely low price, smallest market cap, low quality rating, etc.) were far and away the best performers during the market’s rally. While most stocks rose, as would be expected by the economic improvements, low-quality stocks rose exponentially. This not only raised concerns about the validity of the rally, but it also made it difficult for most fundamentally-focused mutual fund managers to add value above and beyond the investment benchmarks.

Global stock returns are summarized in the following table; please see footnotes for enhanced understanding:
U.S. Stocks  
Annualized Return*
  S & P 500 Index **   28.7%   -0.6%
  Average Diversified U.S. Equity Mutual Funds   31.6%   3.0%
  Russell 2000 #   47.3%   7.1%
  Sector Mutual Funds        
    Technology   55.9%   -3.1%
    Health   32.0%   7.7%
    Communications   41.1%   -7.2%
    Financial   33.1%   7.3%
    Real Estate   36.9%   14.0%
    Natural Resources   32.3%   14.4%
Foreign Stocks          
  MSCI Europe, Australasia & Far East (EAFE) ##   38.6%   -0.1%
  Average Diversified Foreign Equity Mutual Fund   39.3%   4.7%
           
  Regional/Specialty Mutual Funds        
    Europe   37.5%   3.5%
    Diversified Pacific/Asia   36.3%   4.6%
    Diversified Emerging Markets   55.3%   11.1%
             
*
 Mutual fund return data are from Morningstar.
**
 Capitalization-weighted index of 500 very large U.S. companies. The 500 are chosen to achieve a fair cross-section of U.S. industrial and service sectors. Recent median capitalization of approximately $44 billion.
#
 Index of small U.S. companies. Recent median capitalization of approximately $704 million. Somewhat overweighted toward financial stocks.
##
 International stock index indicating return of large foreign companies of 21 major developed countries (Japan, UK, and Germany have the highest weightings). Returns are unhedged and converted to U.S. dollars. No emerging market stocks are included.

During the fourth quarter, stock prices rose much more broadly, suggesting that share price and company performance started to reconnect. Within the Russell 3000, for instance, stocks with earnings rose as high as stocks without earnings. Performance attribution by S&P Common Stock Ranking showed only modest dispersion between high-rated stocks and low-rated stocks.
In 2003, there were moderate performance disparities among the various segments of the U.S. stock market, particularly favoritism for smaller, more growth-oriented companies. Nothwithstanding, there were no real laggards due to the widespread nature of investor optimism.
1. The average growth fund gained 34.8% in 2003, a modest victory over the average value fund, which returned 32.1% (data per Morningstar; value and growth refer to contrasting stock-picking styles). The outperformance of growth styles had roots in the tech/telecom sell-off of 2000-2002: many shares had nowhere to go but up.
2. The market was somewhat discriminating as to market capitalization. The average large cap fund gained 27.8% last year. By comparison, the average mid-cap fund provided a return of 35.8%, and the average small cap fund was up 43.8% (data per Morningstar; market capitalization generally corresponds to and indicates the size and age of a company). Accordingly, large caps trailed smaller capitalization stocks for the fifth year in a row, after a long period of large cap outperformance in the mid-1990’s.
Longer-term data continue to reflect the extent of the 2000-2002 bear market correction, especially among larger capitalization stocks. The table below showing annualized five-year returns indicates the data:
  Value   Growth
Large Cap Mutual Funds 2.9%   -2.8%
Small Cap Mutual Funds 12.7%   6.3%

As noted previously, value stock returns should equal or exceed growth stock returns, and small cap returns should equal or exceed large cap returns in the long run.

After outperformance three of the last four years, the results of active fund managers again beat the S&P 500 index of blue chip stocks; their advantage was about three percentage points. The typical fund holds at least some small and medium cap stocks, and their performance was considerably better than large caps. Thus, management fees were readily overcome in this year’s comparison to the index.
REIT’s and other real estate securities had very good results for the fourth year in a row. Returns were about five percentage points above the average diversified U.S. equity mutual fund.

The robust returns for broad, capitalization-weighted market indexes actually underrepresented performance at the level of individual stocks. In 2003, for the three U.S. stock exchanges combined, 6,517 stocks advanced and only 906 stocks declined. The corresponding advance/decline ratio of 7.19 is unprecedented in the 14-year period we have been tracking. The history of the advance/decline ratio for 1990-2003 years is shown in the table on the next page; returns for the equally weighted version of the Wilshire 5000, a broad market indicator, are included to aid in calibrating the data shown for the advance/decline ratio and reveal that the 2003 level of this unweighted index was also much higher than any other year in the 14-year period.
      Stock Exchange   Three
Markets
Combined 		  Wilshire
5000
(Equal Wtd.)
  Year   NYSE   AMEX   NASDAQ  
  2003   7.87   4.88   7.64   7.19   92.8
  2002   .85   .68   .59   .70   -6.7%
  2001   1.51   1.02   1.10   1.23   28.1%
  2000   1.44   0.60   0.50   0.76   -7.5%
  1999   0.53   0.67   1.12   0.77   38.4%
  1998   0.78   0.59   0.59   0.67   0.3%
  1997   3.19   1.98   1.46   2.03   24.7%
  1996   1.99   1.36   1.36   1.58   21.8%
  1995   3.49   1.76   0.69   1.33   31.3%
  1994   0.39   0.45   0.66   0.52   -2.5%
  1993   2.26   1.84   1.46   1.72   27.4%
  1992   2.18   1.68   2.13   2.09   36.5%
  1991   4.44   2.21   2.66   2.99   66.0%
  1990   0.37   0.37   N/A   N/A   -19.7%

The history shows a significant anomaly in 1999, when the Wilshire 5000 index soared but most stocks actually fell. And in 1994, the index indicated a minor decline but the advance/decline ratio was at its lowest for the years shown.
The upshot is that the advance/decline ratio has its limitations. An important shortcoming of the advance/decline ratio is that it provides no information about the magnitude of the advances and declines. In spite of the statistical issues, the history of the advance/decline ratio suggests that the prices of U.S. stocks may have run too high in the 2003 rally.
Non-U.S. markets also had a strong final quarter and full year 2003. For much of the year, investors pursued the more speculative segments of the foreign equity markets. The MSCI EAFE Small-Cap Index, for instance, nearly doubled the performance of the EAFE Index for 2003. Also, gains in emerging market equities were impressive, as the MSCI EMF Index gained 46.7% in local currencies for the year. Latin America led the way with a 67% return in local currencies. Thus, for the third straight year, emerging markets outperformed the developed world.
For U.S. investors, the foreign markets were even more lucrative given the performance of most foreign currencies versus the U.S. dollar. The euro rose over 20% versus the dollar during 2003, while the British pound and Japanese yen both appreciated about 11%. The currencies of Canada, Australia, and New Zealand rose even more. Thus, U.S. investors who purchased stocks and bonds in these markets had their returns compounded by these currency gains.
Alternative Strategies
The three funds we have been recommending provided a combined return of 10.9% in 2003. The result was about in line with returns achieved by conservative hedge funds as a whole. The results were below the broad market due to the defensive nature of the strategies employed and their low stock market correlation.
Fixed Income Review
A global increase in interest rates in 2003 was one consequence of the improved economic backdrop and increased risk appetite of investors. In the U.S., interest rates fluctuated throughout the year. Yields fell pretty consistently during the first half of 2003 but reversed sharply in July, as rates shot up by 1 percentage point (off a low base of 3.5%) causing July to be one of the worst months for the bond market on record. Rates did settle a little bit in August and September before creeping higher another 25-40 basis points (bps) during the fourth quarter. The net change for the year was a modest rise in rates across the yield curve. For the year, the coupon return from government bonds overcame this drop in rates to deliver a slightly positive return for investors. Meanwhile, the returns from corporate bonds and other spread sectors of the bond market were quite a bit better. The perceived credit quality of corporate bonds in general rose in response to the improved macroeconomic backdrop. Thus, corporates (+6.9% in 2003) offered bond investors satisfactory returns. This improvement in perceived credit quality, the increase in investors’ appetite for risk, and the search for yield in a low interest rate environment all converged to create a near perfect scenario for high yield bonds, which returned nearly 28% in 2003 according to the Credit Suisse First Boston index. The other spread sectors (mortgages and other asset-backed securities) had mixed results relative to Treasuries. The table and footnotes below present fixed income results:
        Annualized Return*
        One
Year 		  Five
Years
  U.S. Bonds        
    Lehman Brothers Intermediate Gov't Bond Index**   2.3%   6.2%
    Lehman Brothers Intermediate Credit Index ***   6.9%   7.2%
    Intermediate Municipal Bond Mutual Funds   4.1%   4.7%
    High Yield Bond Mutual Funds   24.0%   3.7%
             
  Foreign Bonds        
    Salomon Brothers Non-U.S. World Govt. Bond Index #   18.5%   5.2%
             
  * Mutual fund return data are from Morningstar.        
  ** Lehman Brothers index of U.S. Treasury bond total returns (i.e., interest plus or minus change in price). Bonds in index have intermediate maturity of about 4-7 years. No mortgage-backed securities included.
  *** Lehman Brothers index of U.S. investment grade corporate bond total returns (i.e., interest plus or minus change in price). Bonds in index have intermediate maturity of about 4-7 years.

To varying degrees, most developed bond markets around the globe experienced a rise in the level of interest rates. Japan was an exception where rates fell very slightly in the shorter maturity ranges and were basically unchanged in its medium- to longer-term bonds. The net result of all this was a return pattern similar to the U.S.: marginal change in value for non-U.S. governments and more meaningful gains for non-U.S. corporates. Still, U.S. investors in these bonds also benefited from the rise in most developed currencies versus the U.S. dollar (as described above). Thus, foreign bonds were yet another good source of returns in 2003, with some developed countries offering dollar-based returns in excess of 20%.
Outlook for 2004
We don’t favor market predictions, especially in absolute terms. As you know, we argue that the future is unknowable. The interplay of socio-economic and geopolitical factors is just too complicated to predict. Thus, we are against trying to time the market. However, we will identify factors and issues that are important in 2004 and beyond. These are typically historical macroeconomic waypoints and trends which can help us narrow the range of potential outcomes in the future. One example would be the level of U.S. interest rates. Thus, we will venture a general outlook and some comments regarding relative performance.
The first overriding issue for 2004 is the magnitude and nature of U.S. economic recovery, a carryover issue two years ago in a row. The jobless nature of the current recovery is a concern, and much like at yearend 2002, the future course of the global economy and the outlook for corporate profits again remain unclear. On average, forecasters expect continued expansion of the economy as the year progresses, but not at the pace seen in 2003.
The recovery's characteristics will have a significant impact on U.S. stock and bond markets. Further, the U.S. economy is the global engine, and its strength will dictate to a large degree economic and market strength overseas.
A key related issue is how soon will interest rates rise and how much. At historically low levels, they are a major contributor to economic strength. As an example, low mortgage rates have fueled all sorts of consumer spending. Most observers expect an increase, but not until after the national election in November.
The third overriding issue is the impact of the high valuations of U.S. stocks on their potential performance in 2004. Due to the 2003 rally, stocks in the S&P 500 trade at about 27 times their earnings for the past twelve months. This multiple is well above the historic average of 16. Thus, current prices have almost no margin for safety, meaning the future has to unfold very positively for valuations to hold.
I also have to mention the challenging geopolitical situation. This of course includes Iraq. Keeping the peace in Iraq and restoring the country after a successful military campaign are proving vexious to say the least. Overall, Iraq remains a wildcard: protracted problems could be a persistent drag on stock markets. Other international hotspots include Afghanistan, Kashmir, and the continued conflicts across the Middle East.
Another important issue is the strength of the U.S. dollar versus the euro and other foreign currencies. Will the greenback continue depreciating, which allows unhedged U.S. investors to reap currency profits, rather than the currency losses so prevalent during much of the 1990's? The U.S. has been running steadily increasing balance of payment deficits (i.e., we import much more than we export). This huge appetite for imports produces what is called the current account deficit. For years, this deficit in the account for goods and services has been more than offset by a large annual surplus in the investment account (i.e., foreigners have been large net investors in the U.S., including direst investments in real estate and facilities as well as net purchases of U.S. stocks and bonds). As a result, the dollar selling pressure generated by U.S. consumers has been more than offset by the dollar buying pressure of foreign investors. For years demand generally exceeded supply, and the dollar appreciated, meaning the buying power of the U.S. dollar has increased versus the currencies of many other nations.
The on-going risk is that expected returns on U.S. assets aren't high enough to attract sufficient flows to plug the current account deficit. In fact, the tables definitely turned in 2002. It was no surprise that with our economy sputtering, our stock market in a nosedive, and with accounting scandals and the Iraq war mobilization, the dollar was pummeled. However, 2003 was puzzling because the reviving U.S. economy, sizzling U.S. stock markets, and seeming capping of the Iraq situation did not stop the dollar’s decline. We need to be concerned about a snowballing situation, at least in the short-run, wherein the dollar's decline produces currency losses for foreign investors (remember, their currencies are appreciating versus the dollar), leading to a reduction in foreign ownership of U.S. stocks and bonds, leading to less demand for U.S. dollars and in turn further erosion of the value of the U.S. dollar, further reducing the returns and attractiveness of U.S. securities to foreigners, and so on.
The final key issue (every year) is the level of inflation and resource usage worldwide. To a large degree, these levels will determine the fate of tangible asset prices and in turn the returns of real estate and energy funds and inflation indexed bonds. The inflation rate also impacts the financials sector as well as the broader markets for stocks and bonds. The issue boils down to whether strong fiscal and monetary stimuli currently in place are excessive and lead sooner rather than later to resource shortages and reignition of inflation.
In considering these very difficult, interrelated issues, we are swayed, as usual, by what history reveals, namely, that economies and markets are cyclical and seek equilibrium and that investment results regress to the mean. Therefore, historical patterns and averages will ultimately prevail. Keeping in mind the historical perspective and favorable long-term secular trends, here are educated guesses regarding the key issues and outlook:

1. The U.S. economy and the global economy will continue building momentum through at least mid-year. The direction after mid-year is unclear.

2. U.S. stock markets will produce positive, respectable returns. The positive upward momentum, election year dynamics, and continuing fiscal and monetary stimulus should offset the main negative factors, continuing high valuations and the declining dollar.

3. The various stock asset classes will perform comparably over the next year because relative valuations are about in line.

4. The rate of inflation will hold at about current, reduced levels at least through mid-year, but thereafter inflation rates may begin to move upward.

5. With inflation low and economic activity moderate, and investment grade yields also low, we expect positive total returns for bonds, but at the low end of historical averages. Although the risk of price depreciation due to interest rate increases is much higher than in recent years we do not expect actual losses in 2004.

6. The dollar's weakness will continue. Again in 2004, inflows of foreign capital will be inadequate to offset our continuing trade deficit. Therefore, the dollar must give up some value.

7. The outlook is good for foreign stocks and bonds as a result of projected improving economic and market conditions and a reasonable opportunity of currency gains.


As usual, we have found it difficult to develop an outlook for the coming year. Over and over again, we have seen the unreliability of short-term economic and market forecasts and the unpredictable nature of markets. More than usual, geopolitical risks could wreak havoc with these predictions, and as usual, there is always the risk of the totally unexpected. If the concerns expressed below manifest themselves earlier than expected, results in 2004 could be considerably worse than indicated above.
Beyond 2004
As for the outlook beyond 2004, we have increasing concern. The concern stems at least in part from a long career in finance advocating living within one’s means and saving for both a rainy day and retirement security. We are beginning to believe the tax-cut and deficit spree of the last few years, which have juiced up the economy, will likely exact a price in later stagnation. The various potential remedies for our growing debt levels and trade deficits are tax increases, spending cuts, and higher interest rates, in some combination. These remedies will all inflict pain, pain which we are currently deferring. Further, as some 77 million baby boomers begin to retire this decade, U.S. Social Security and Medicare will begin to move into the red as well, eventually by trillions of dollars, according to a report by the International Monetary Fund (IMF). The IMF report predicts no pro-growth strategy can make up such shortages and warns that mounting U.S. debt jeopardizes global financial stability. The Bush administration plans to make permanent tax cuts the “very center” of its fiscal policy. Also, Congress has just enacted a new major entitlement, the Medicare prescription benefit. Treasury Secretary John Snow calls the deficits “entirely manageable.” We shall see.