Market Perspective Full Year 2004 and Outlook

It was an eventful year and a profitable one for investors.  Memorable 2004 headlines included increased problems with the insurgency in Iraq , subway train bombings by terrorists in Spain , a surge in the price of oil, President Bush’s re-election and the increased Republican majority in Congress, and tragic loss of life from the Southeast Asian tsunami.  The generally positive economic backdrop globally treated investors to solid calendar year returns from major U.S. equity indices and most foreign markets as well.  And while shorter-term interest rates rose in many developed markets, particularly the U.S., the lack of a surge in core inflation and the measured policy responses of the Fed resulted in little reaction by long-term interest rates.  Thus, even bond investors enjoyed positive returns for the year.  Finally, the dollar fell sharply for the third year in a row 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 U.S. economic recovery from the 2001 recession, which went into high gear in 2003, continued into 2004.  Growth of U.S. Gross Domestic Product (GDP) was about 4%.  Meanwhile, Chinese officials tried in vain to slow down their economy, and the growth of GDP was a very strong 9.5%, an increase over the 2003 growth rate.  Together, these twin engines of economic growth pulled along the rest of the world, but large increases in the price of crude oil hampered all oil-importing countries, limiting growth of GDP, especially in countries with minimal domestic reserves such as Germany and Japan .

Overall, the healthy economic activity benefited U.S. corporations.  Reuter's compilation of the latest earnings estimate indicated that companies in the S&P 500 would have profit growth of more than 18% during 2004.

U.S. consumers’ strong appetite for foreign goods continued apace.  Imports rose dramatically, outpacing the overseas demand for U.S. exports.  Net foreign investment in the U.S. did not fill the gap, and the dollar demand/supply imbalance caused the exchange rate for the greenback to decline about 5% on a trade-weighted basis.

U.S. manufacturing moved out of the doldrums in 2004. The Federal Reserve’s annual production data show that total industrial production grew 4.1% last year – the first increase since 2000. And after two years of nearly jobless recovery, U.S. job creation increased dramatically, though still below the levels in previous recoveries.  The typical early-cycle productivity gains moderated, and employers needed to increase labor input to produce a growth in output.

A surge in the cost of gasoline and other energy products pushed consumer prices up by 3.3% in 2004, the biggest jump in four years. Fortunately, this “oil shock” was not accompanied by sharp rises in long term interest rates or core inflation (which excludes the index’s volatile food and energy components). Apparently, employment growth did not accelerate sufficiently to create worry among investors about the potential for a tight labor market.

During 2004 the U.S. economy turned the corner from a Fed dependent recovery to self-sustaining expansion.  Previous to 2004, the Fed fought the recession and the dreaded fear of deflation with an extremely accommodative monetary policy.  In so doing, it pushed short-term interest rates to 40-year lows.  In 2004, the Fed shifted from an accommodative to neutral monetary policy stance to promote sustainable growth and reduce the risk of an overheated economy.  Short-term rates were raised five times during the year.  It should be noted the raises were minimal at .25 percentage points each and started from a very low level.  Real short-term rates, after subtracting inflation, remained near zero.

The U.S. real estate market soared to new heights in 2004.  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 in 2004 compared with historic lows in previous years.  Low rates made it easier for buyers and also continued the mortgage refinance boom begun in 2002.

Equity Review

The bulk of stock funds returns came in the fourth quarter, as U.S. share prices surged after being held back for nine months by the Fed raising short-term interest rates, record high oil prices, and nervousness over the presidential election, Iraq , and terrorism. The S&P 500 Index rose 10.9% for the full year with a 9.2% gain in the fourth quarter. This was the second straight year of gains for U.S. stocks after a three year bear market. For the sixth consecutive year, small capitalization stocks outperformed large-cap issues. Value again topped growth in 2004, marking the fifth consecutive year of leadership for value-oriented stocks. And for a third straight year, foreign stock funds in general beat U.S. funds, helped by the falling dollar. The average foreign fund rose 18.7% in 2004, according to Morningstar.

The S&P 500’s respectable overall return for 2004 concealed a fairly wide divergence in sector results. Natural resources skyrocketed (28.4%) on a 33.6% rise in the price of crude oil, which ended the year at $43 a barrel. Real estate and utilities also did well. At the other end of the spectrum, the technology sector gained only 3.8% during the year.

Global stock returns are summarized in the following table; please see footnotes for enhanced understanding:

In 2004, there were relatively moderate performance disparities among the various style segments of the U.S. stock market.  The market did however show particular favoritism for smaller, more value-oriented companies. 

1.         The average growth fund gained 10.2% in 2004, underperforming the average value fund, which returned 15.1% (data per Morningstar; value and growth refer to contrasting stock-picking styles).  The outperformance of value styles had roots in the tech/telecom upward spike of 2003: many investors were cautious because of high valuations achieved in the prior year.

2.         The market was somewhat discriminating as to market capitalization.  The average large cap fund gained 10.0% last year.  By comparison, the average mid-cap fund provided a return of 14.7%, and the average small cap fund was up 15.9% (data per Morningstar; market capitalization generally corresponds to and indicates the size and age of a company).  Accordingly, as mentioned above, large caps trailed smaller capitalization stocks for the sixth year in a row, after a long period of large cap outperformance in the mid-1990’s.

3.        Longer-term data continue to reflect the extent of the 2000-2002 bear market correction, especially among larger capitalization and growth-oriented stocks.  The table below showing annualized five-year returns indicates the data:

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 four of the last five years, the results of active fund managers again beat the S&P 500 index of blue chip stocks; their advantage was somewhat above one percentage point (12.3% versus 10.9%).  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 fifth year in a row.  Returns were almost five percentage points above the average diversified U.S. equity mutual fund for the second year in a row.  They were also an astounding average of over 20 percentage points per year above the diversified stock average over the five years because REIT’s and other real estate securities actually had positive returns during the 2000-2002 bear market.

The solid returns for broad, capitalization-weighted market indexes were representative of performance at the level of individual stocks.  In 2004, for the three U.S. stock exchanges combined, 4,740 stocks advanced and 2,760 stocks declined.  The corresponding advance/decline ratio of 1.72 lands about in the middle of the 15-year period we have been tracking if we ignore the outlier in 2003.  The middling ratio is not much help in evaluating the direction of stock prices in 2005.  The history of the advance/decline ratio for 1990-2004 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.

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 2003-2004 rally.

Non-U.S. markets also had a strong final quarter and full year 2004.  The MSCI EAFE Index of developed foreign markets returned 10.2% in local currencies.  Also, gains in emerging market equities were impressive, as the MSCI EMF Index gained 13.2% in local currencies for the year. Thus, for the fourth straight year, emerging markets outperformed the developed world.

For U.S. investors, foreign markets were even more lucrative given the performance of most foreign currencies versus the U.S. dollar.  The euro rose almost 8% versus the dollar during 2004 and marked the third significant annual gain in a row, producing appreciation of over 52% for the last three years.  The British pound and Canadian dollar both appreciated about 7.5% for the year, and the Japanese yen appreciated about 5%.  Thus, U.S. investors who purchased stocks and bonds in these markets had their returns compounded by these currency gains.

For the year, the dollar declined about 5.2% verses 19 currencies tracked by the J.P. Morgan Dollar Index.  The decline would have been worse were it not for support of the dollar versus the yen by the Central Bank of Japan and efforts by other Asian countries to keep their currencies competitive in support of their export industries.  Additionally, the Chinese yuan and Hong Kong dollar are pegged to the dollar, and the Chinese government recirculated billions of U.S. dollars earned through huge trade surpluses back to the U.S. by purchases of our Treasury securities.

Alternative Strategies

The four funds we have been recommending provided a combined return of about 4.9% in 2004. The result was about in line with returns achieved by conservative hedge funds as a whole; such conservative strategies as merger and convertibles arbitrage were hurt by market conditions, increasing interest rates, and too much money chasing too few deals due to the dramatic growth of investment in private hedge funds.  The results were also below the broad market due to the defensive nature of the strategies employed and their low stock market correlation.

Fixed Income Review

The Federal Reserve raised short-term interest rates and the bond market not only survived, it thrived (at least compared with the negative outlook going into 2004). Losses predicted by experts across the board in the beginning of 2004 did not materialize. Every category of bond funds posted a positive total return for the year according to Morningstar. The big surprise was the flattening of the U.S. yield curve, such that long-term interest rates fell for the year, even though the Federal Reserve began to raise short-term rates for the first time since 2000. The benchmark 10-year Treasury note yield ended the year at 4.22%, down from 4.25% at the beginning of 2004.  There were a number of factors that ultimately supported bonds including muted core inflation and insatiable foreign demand for U.S. fixed income investments amid fierce competition for yield in what has become a low return world. The Lehman Brothers Aggregate Bond index of U.S. investment grade bonds returned 4.3% for the year.  The return on high yield (non-investment grade) bond funds was 9.9% for the year.  As the perceived credit quality of corporate bonds in general in response to the improved macroeconomic backdrop. The table and footnotes below present fixed income results:

To varying degrees, most developed bond markets around the globe experienced reasonably good results for the year in local currencies.  Additionally, U.S. investors in foreign 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 2004, with some developed countries offering dollar-based returns in excess of 20%.

Key Issues and Outlook for 2005

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 2005 and beyond.  These are typically historical macroeconomic waypoints and trends which can help us narrow the range of potential outcomes in the future.  Examples involve such key factors as the price of oil, Chinese currency policy, and the level of U.S. foreign borrowing to finance its balance of payments and Federal budget deficits (also known as the twin deficits).  Thus, we will venture a general outlook and some comments regarding relative performance.

The first overriding issue for 2005 is the potential for a U.S. dollar crisis.  Given the dollar has fallen 16% against a basket of the U.S.’s trading partners’ currencies over the past three years, a growing chorus warns that the U.S.’s gaping twin deficits will lead to a crisis in which the dollar falls even more sharply due to a crisis of confidence, driving up interest rates and squeezing our economy.  Clearly, our twin deficits would sink the currency of lesser nations, but the U.S. is a special case, being the world’s largest customer, strongest democracy, and only superpower.

Put less dramatically, 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?  As I have reviewed previously in the last few annual outlooks, our 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 direct 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 can be offset by the dollar buying pressure of foreign investors. 

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.  The on-going decline of the dollar since then should also be no surprise.  Even through the U.S. is among the most credit-worthy borrowers, and the strength of our economic recovery and corporate earnings exceeds other developed countries, our twin deficits have continued to grow dramatically absolutely and as a percentage of GDP.  Of course, being seemingly mired in Iraq has not helped, since the cost of this special emergency appropriation ultimately adds to the Federal deficit. We need to be concerned about a snowballing situation, 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.

A second key issue is the strength of the U.S. and global economy, a carryover issue three years in a row.  The future course of the global economy and the outlook for corporate profits will have a significant impact on global stock and bond markets.  The course depends to a considerable extent on the abilities of the Fed and Chinese authorities to achieve “soft landings” for their respective economies (soft landings result from a deft touch by government officials: just right slowing of economic growth without excessive braking, which would cause a recession).  Though job growth improved in 2004 versus the prior year, the pace remains slower than in prior economic recoveries.  The slower pace should help the Fed smooth the economic cycle.  However, the falling dollar significantly complicates the Fed’s job.  On average, forecasters expect continued moderate expansion of the domestic economy as the year progresses resulting in about 3.5% growth in U.S. GDP.  We’ve seen no authoritative forecasts, but our hunch is the Chinese economy will remain very strong for at least another year or two.

The global ramifications of China ’s currency policy and stupendous economic growth are a major factor in evaluating the outlook for 2005 and beyond.  As products made in China overwhelm the world, China ’s trade surpluses cause it to accumulate huge holding of foreign currencies which it has recycled by equally huge purchases of foreign securities.  Thus, China has been a big facilitator of our deficit spending, has substantially mitigated downward pressure on the dollar, and has a big stake in the economic health of its largest customer.  Meanwhile, part of China ’s trade surplus is used to finance large purchases of oil and industrial commodities to fuel its economic growth and modernization.  The Chinese demand is at least partly responsible for the surge in oil prices in 2004.  To maintain competitiveness, China has pegged its currency to the dollar.  Were this not the case, its undervalued currency would surely appreciate, causing a rise in the price of its products and diverting foreign investment and outsourcing to other countries.  Apparently, Chinese officials fear the negative impacts on job growth and economic expansion.  At present, experts disagree whether the inevitable upward revaluation of the yuan will occur in 2005 or 2006.

We cannot evaluate investment prospects for 2005 without wondering how soon long-term interest rates will rise and how much.  At historically low levels on a nominal and real basis, 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 that was also the case a year ago, and the observers were wrong.

Another issue is the impact of continuing high valuations of U.S. stocks on their potential performance in 2005.  Due to the 2003-2004 rally, stocks in the S&P 500 continue to trade well above historic averages.  Thus, current prices have a limited margin of safety, meaning the future has to unfold very positively for valuations to hold.  S&P 500 stocks also trade above price multiples on many foreign markets.

I also have to mention the challenging geopolitical situation.  This of course includes the tenuous position of the interim government in Iraq .  Overall, Iraq remains a wildcard: protracted problems could be a persistent drag on stock markets.  Other international hotspots include Afghanistan , and the continued conflicts between Israelis and Palestinians, instability in many Muslim countries, and the nuclear threats of North Korea and Iran .

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 the Fed can walk a fine line, not strangling the economy, but also strongly constraining the impact of 1) previous fiscal and monetary stimuli (tax cuts and low interest rates), 2) the depreciating dollar raising import prices, and 3) world economic growth, particularly in China, putting upward pressure on the price of oil and other industrial commodities.

The ongoing globalization of production and distribution capabilities to an ever-broadening array of goods and services suggests that the secular reduction of the world economy’s inflation propensities that emerged over ten years ago remains in force.  At the same time, however, the accumulating impact of the dollar’s multi-year slide suggests that there is more upside for inflation than in the second half of the 1990s, when an appreciating dollar acted to restrain inflation.  The dollar’s weakness has boosted import prices, which feed into broad price indexes commensurate with imports’ share of domestic demand.  Import price inflation has an important indirect effect as well, giving domestic producers of import-competing goods greater latitude to raise prices.   As this process progresses, it layers on and reinforces the inflationary pressures of economic growth.  These include higher capacity utilization rates, resulting in some increase in production efficiency, a declining unemployment rate that underpins wage acceleration, and faster growth in unit labor costs in an environment of moderating productivity growth. 

As if all these issues were not enough, 2005 follows a Presidential election year.  For those “into” statistical patterns (instead of, or in addition to, fundamental analysis), history indicates that U.S. stock market results are typically below average after such an election year.

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:

  5.      As usual, we have found it difficult to develop an outlook for the coming year.  We have limited time and resources for the relevant research.  Also, the outlook makes a number of assumptions, which may prove incorrect.  The outlook puts considerable faith in sound decision-making by government officials!  Finally, it selects certain factors for emphasis which may prove to be wrong.

Over and over again, we have seen the unreliability of short-term economic and market forecasts and the unpredictable nature of markets.  As usual, geopolitical risks could wreak havoc with these predictions, and there is always the risk of the totally unexpected.  If the concerns expressed below manifest themselves earlier than expected, results in 2005 could be considerably worse than indicated above.

 Beyond 2005

As for the outlook beyond 2005, we have the same increasing concern expressed last year.  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 believe the tax-cut and deficit spree of the last few years, which have juiced up the economy, will 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.  Some analysts predict no pro-growth strategy can make up such shortages and warn that mounting U.S. debt jeopardizes global financial stability.  Key parts of the second term Bush administration agenda include making permanent tax cuts enacted during the first term and shoring up Social Security.  The latter is receiving extensive media coverage and think tank commentary.  My salient observations are:

1.         The problem is greater than most perceive because Social Security surpluses designed to “plan ahead” for baby boomers have already been spent on other government expenditure programs.  Rather than actually having assets such as real estate, stocks, or non-government bonds, the Social Security Administration (SSA) has IOU’s from the U.S. government.  When annual surpluses turn to deficits, the SSA cannot just sell assets; it must collect on its IOU’s.  To pay off the IOU’s, the Federal government must pursue the painful remedies listed above, namely, either increase taxes, reduce spending on other government programs, or borrow (assuming the latter is feasible given government debt levels and all its other borrowing needs at the time).

2.         President Bush’s proposed personal retirement accounts drain inflows which would go to the SSA.  The diverted employment taxes must be made up from somewhere or else Social Security benefits would need to be cut.  The needed make up has been estimated to be in the trillions.

3.        The Medicare financial situation is even worse than for Social Security!

In conclusion, there seems to be no end in sight to U.S. deficit spending.  We’ve just announced a record deficit for the Federal government’s fiscal year ending October 31, 2005 .  This record comes on the heals of the record set for fiscal 2004.  Even allowing that these records are partly wartime in nature (i.e., Iraq ), domestic needs are lurking to replace wartime expenditures, and experts agree the war on terrorism will take decades.  Finally, these deficits are occurring at a time of fairly strong economic activity.  Heaven forbid if we had a recession in 2006.

Implications for Asset Allocation

Because an outlook is to a considerable degree an attempt to have a crystal ball, which is impossible, we plan to maintain stock and bond allocations approximately at long-term targets and avoid making active bets, except to keep bond maturities shorter than normal and also attempt to profit from a declining dollar.  We see the inflation risk increasing in the next few years, so we will maintain positions in tangibles stocks and inflation-indexed bonds. 

Relevance of Market Review and Outlook for the Strategic Allocator

Before concluding, let’s address the relevance of a review and outlook and clarify why we are planning only fine-tuning and not major allocation changes, as follows:

1.         Asset allocation is a long-term approach utilized to manage long-term money according to long-term historical evidence.  Asset allocation defined in this manner requires a disciplined adherence to a relatively fixed asset mix.  It is also quite contrarian, because when an asset class proportion declines due to relatively poor performance, the asset allocator buys more.  Hence, asset allocation entails periodically selling your winners and buying your losers to maintain the strategic balance.  This rebalancing is done periodically and “religiously” and is definitely not “market timing” or “chasing performance.”  Therefore, near-term outlooks are of little interest to the strategic asset allocator. 

2.         An outlook is really a best guess over 6-18 months, which is not a long-term period.  Thus, most outlooks support tactical maneuvering for short-term gain.  Most outlooks are also trend following, not contrarian.  It is human nature to expect continuation of recent trends.  It takes a brave soul to predict a reversal.  We try to develop our outlook to avoid this common problem, but we are human, too. 

3.         As described in the Outlook Scorecard section below, our outlook is not too reliable.  Thus, it is not a sound basis for big bets.  We could make cohesive, plausible arguments for predictions that would be both much more negative and much more positive than those above. 

4.         Caves & Associates prepares a market review so we do not blindly follow history or ignore the markets.  We also stay abreast of the latest research that might shed new light on historical bases for portfolio design.  We monitor market trends, but mainly to be able to properly evaluate mutual fund managers’ performance and explain the performance of client portfolios.  Finally, we prepare an outlook because the exercise has a small possibility of allowing us to foresee major problems requiring extraordinary strategies.  Thus, it's prudent, and part of our responsibility to clients.

Outlook Scorecard and Impact on Results

Last year was the sixth time we attempted something resembling an outlook.  A scorecard is in order to see if we are gaining anything from the effort. 

Our past report cards have been generally favorable:  we have had more predictions right than wrong, and our errors have not been harmful to returns. 

Last year, we made seven predictions; most pertained to 2004 as a whole, but some were qualified as only reliable through mid-year.  For the scorecard, we’ll treat the latter as if they were unqualified. 

For 2004, all predictions but one were correct, at least to a degree.  Those with respect to economic strength, inflation, the dollar, U. S. bonds, and foreign stocks and bonds were quite accurate.  However, the predictions somewhat underestimated the strength of U.S. stock returns.  The prediction of comparable performance among the various U.S. stock asset classes was off the mark, because small caps outperformed large caps and value outperformed growth by about 5 percentage points in 2004, not an inconsiderable amount.  Though this prediction was inaccurate, it was not detrimental to clients.  We kept small caps and value stocks over weighted versus market weights according to our customary approach. 

Portfolio strategies were largely successful in 2004.  During the year, some overweighting of international positions was particularly beneficial.  Nonetheless, our enthusiasm for alternative strategies did hurt results because they lagged somewhat, as described above.  Finally, mutual funds we employ in client portfolios remained highly rated by and large.

We believe the scorecard highlights why we recommend strategic asset allocation rather than tactical allocation or market timing.  Over the long run, we are convinced that correct predictions will be largely offset by incorrect predictions, especially when the predictions have to deal with such a broad scope as global stock and bond markets.  Thus, the effort adds little or no value but can reduce returns by increasing capital gains taxes, transaction costs, and management fees if the effort induces a short-term, tactical approach.

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