Market Perspective Full Year 2005 And Outlook

January 27, 2006

Commentary and Planning Ideas, Market Perspective, and Market Review are
written and published quarterly by Preston Caves, CPA, CFA, MBA

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.

Achieving outperformance six of the last seven years, active fund managers again beat the S&P 500 index of blue chip stocks; their advantage was almost two percentage points (6.7% versus 4.9%). Thus, management fees were readily overcome in this year’s comparison to the index. The explanation is that the typical fund holds at least some mid-cap stocks, which had performance considerably better than large caps.

REIT’s and other real estate securities had very good results for the sixth year in a row. Returns were approximately five percentage points above the average diversified U.S. equity mutual fund for the third year in a row. They were also an astounding average of over 16 percentage points per year above the diversified stock average over the latest five years because REIT’s and other real estate securities actually had positive returns during the 2000-2002 bear market.

In 2005, the below average returns for broad, capitalization-weighted market indexes were representative of performance at the level of individual stocks. For the three U.S. stock exchanges combined, 3,495 stocks advanced and 4,077 stocks declined. The corresponding advance/decline ratio of .86 lands in about the lowest third of the 16-year period we have been tracking. The less than robust ratio is consistent with the downtrend of stock prices since the strong rally in 2003. The history of the advance/decline ratio for 1990-2005 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. Additionally, it is a purely technical indicator and does not involve evaluation of myriad fundamental factors such as economic conditions, corporate profitability, and geopolitical considerations. In spite of the issues, the history of the advance/decline ratio correctly suggested that the prices of U.S. stocks had run too high in the 2003-2004 rally. With advances somewhat trailing declines in 2005, some adjustment has occurred, and the stage may be set for U.S. stocks to improve in 2006.

Outside of the U.S., equity returns were much better in 2005, particularly in local terms. The MSCI EAFE Index, which covers developed markets outside of the U.S. and Canada, returned 29% in local currency terms. This was driven by a more-than-40% jump in Japan's stock market as well as healthy gains from much of Europe. While the European economy was sluggish, many of its companies were successful at raising productivity and/or cutting costs and thus enjoyed share price gains. For U.S. investors, these gains were diminished by the rise in the U.S. dollar throughout 2005. For the year, the dollar appreciated about 4.7% verses 19 currencies tracked by the J.P. Morgan Dollar Index. Furthermore, the U.S. dollar gained about 15% versus both the euro and the Japanese yen and over 11% versus the British pound. Thus, U.S. dollar returns from the equities of those markets were reduced by a comparable amount. Despite the currency adjustment, foreign equities were among the most rewarding investments for 2005. As indicated in the data table below, the average mutual fund investing in international stocks returned 15.6% for the year.

Outperformance versus U.S. stocks was especially true within the emerging markets, which did very well in 2005. The MSCI Emerging Markets (EM) Index jumped 35% for the year (in local currency terms), driven in in part by the surge in commodities prices but also due to the vigor of the global economy. Unlike the developed markets, currency was less of a concern as many emerging markets currencies are either pegged to the U.S. dollar or simply held up better in 2005. Indeed, the U.S. dollar return for the MSCI EM Index was 34%.

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

Alternative Strategies

The four funds we have been recommending provided a combined return of about 2.4% in 2005, above the returns for most bonds but below those for U.S. stocks. Two conservative strategies employed, merger and convertibles arbitrage, were again 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. Results for the two stock-oriented strategies were somewhat below the broad market due to the defensive nature of the strategies employed and their low stock market correlation.

The funds generally underperformed versus results for indexes of hedge fund performance compiled by Credit Suisse/Tremont. The range of underperformance ranged from 1-4 percentage points for the year. Reasons for the underperformance were some noncomparability versus the Tremont indexes, performance-enhancing leverage employed by many funds included in the indexes, and probable actual inferior execution by management of two of the four funds.

Fixed Income Review

Non-mortgage longer-term interest rates changed little during 2005. Although a strong economy and aggressive rate hikes by the Federal Open Market Committee (FOMC) will typically cause rates to rise, there was enough demand for dollar-based assets by foreign investors to keep longer-term rates in check. Also, the modest level of core inflation and certain asset/liability matching considerations on the part of institutional investors also limited the increase in long U.S. rates. Thus, the yield on the 10-year U.S. Treasury rose by only 18 basis points to a still low 4.4%. Because longer-term interest rates inched higher, and shorter-term rates rose significantly, the return for bonds (as measured by the Lehman Brothers Aggregate Bond Index) was only 2.4%. This was the third-lowest annual return for the index over the past 20 years and the lowest since 1999. Meanwhile, the corporate bond market lagged Treasuries during 2005 notwithstanding good corporate profits and creditworthiness. However, corporate bonds (especially high-yield bonds) had performed extremely well over the prior few years and thus offered less compelling valuations (typically measured by yield spreads) heading into the year.

Additionally, the high-profile downgrades of GM and Ford (deserved as they were) startled many investors.

For developed market bonds outside of the U.S., the changes in longer-term yields were comparable. For U.S. investors, though, these bonds were also hurt by the aforementioned rise in the U.S. dollar. Thus, the Lehman Brothers Global Aggregate Bond Index excluding the U.S. was down more than 8% in U.S. dollar terms.

The table and footnotes below present fixed income results:

Key Issues and Outlook for 2006

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 2006 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 global economic strength, energy price trends, Chinese currency policy, and the level of foreign investment in U.S. assets that allow us to finance our on-going 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 issue for 2006 is the direction of the U.S. dollar, which not only avoided a crisis in 2005 but rebounded after having fallen 16% against a basket of the U.S.’s trading partners’ currencies over the previous three years. If the greenback continues appreciating, unhedged U.S. investors must bear the burden of currency losses as occurred in 2005.

A second key issue is the strength of the U.S. and global economy, an important issue every year. 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 moves of the various central banks, including the Fed, EU, and Chinese authorities. On average, forecasters expect a moderation in growth of the domestic economy as the year progresses resulting in annualized 3.5% growth in U.S. GDP over the first half of 2006 and 3.1% annualized growth over the second half. These figures are not even near recession territory, but some forecasters, including PIMCO, see an even greater slowdown as the year progresses. PIMCO makes a reasonable, albeit general point, that those who have grown the fastest and have tightened the most will slow down, while those who have grown the least and have tightened the least will pick up. The former is a reference to the U.S. and the latter includes Japan and the Eurozone.
PIMCO is also concerned about a slowdown in the housing market, which could seriously dampen U.S. economic activity.

As indicated last year, the global ramifications of China’s currency policy and stupendous economic growth are a major factor in evaluating the outlook for 2006 and beyond. As products made in China overwhelm the world, China’s trade surpluses cause it to accumulate huge holdings 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. Many have labeled this as a co-dependent or symbiotic relationship, and PIMCO has coined the phrase “stable disequilibrium.” 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 continuing surge in oil prices in 2005, and the Chinese economy must remain strong for continuing health on the part of the global economy.

The outlook for interest rates and the shape of the U.S. yield curve are also significant issues heading into 2006. Most observers feel the Fed is nearing the top of its tightening cycle, so minimal further increases in short term rates are expected. As to longer-term rates, on the one hand, the low level of “core” inflation and continued demand for U.S. bonds makes a case for long-term rates to remain low. On the other hand, the outlook for continued economic health and pressure from both twin deficits argue for higher rates. Meanwhile, the borderline inversion of the yield curve further complicates the analysis.

I also have to mention the challenging geopolitical situation. This of course includes the tenuous situation in Iraq, the heightened tension over nuclear proliferation, now in Iran, and on-going in North Korea, the incapacitation of Israel’s moderate leader, Ariel Sharon, the recent victory of Hamas in Palestinian elections, the decline of democracy in Russia, and on-going instability in many Muslim countries. Overall, the Middle East remains a wildcard: protracted problems could be a persistent drag on stock markets.

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) a depreciating dollar raising import prices, assuming that occurs, and 3) world economic growth, particularly in China, putting upward pressure on the price of oil and other industrial commodities.

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 many favorable long-term secular trends, here are educated guesses and supporting rationale regarding the key issues and outlook:

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! Additionally, you may have noticed the outlook is very similar to last year’s. 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 2006 could be considerably worse, or at least different, than indicated above.

Beyond 2006

As for the outlook beyond 2006, we have the same increasing concerns expressed in previous years. The first 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 several years, which have juiced up the economy, will exact a price in later stagnation. At present, there seems to be no end in sight to U.S. deficit spending. 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.

The second concern stems from the global imbalance of aggregate demand and investment versus saving. We have exported some of our strong demand for products and services to bolster the world’s economy, and foreigners have returned the favor by deferring their consumption and increasing their savings to offset our lack thereof. How long this “co-dependency” or “symbiotic relationship” can last is one of the larger uncertainties facing the global economy.

The on-going risk is that expected returns on U.S. assets aren't high enough to attract sufficient investment flows to plug the current account deficit. In 2005, the Fed tightened more than other major central banks. The increase in U.S. interest rates on a relative basis provided the necessary attraction of foreign funds to actually boost the U.S. dollar. Nonetheless, over the longer run 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. Put more simply, the massive granting of credit to the U.S. cannot go on forever, hence the second word in PIMCO’s phrase “stable disequilibrium.”

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. We plan to keep bond maturities shorter than normal. Because bond investors are not being adequately compensated for the risks born, we plan on increasing the allocation to cash. We will also attempt to profit from a declining dollar. We are bullish on oil and gas for the long run 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:

Outlook Scorecard and Impact on Results

Last year was the seventh 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 eight main economic and market predictions. Each year one major surprise lurks. In 2004, it was the surprising strength of U.S. bonds. In 2005, it was the surprising strength of the U.S. dollar. As a result, two of the eight predictions were entirely wrong. One was of course the predicted downward direction of the dollar. The other was the return of unhedged international bonds: they were very negative performers in 2005 mainly due to currency losses, which was completely at odds with our forecast of a good outlook for their performance.

The other six predictions for 2005 essentially came to pass. It could be quibbled that international stocks were also hurt by currency losses, but as noted above, such losses were more than offset by strong local market performance. Additionally, the overall returns for U.S. bonds were properly forecast as poor, but the relative performance of short-term and long-term bonds was not as predicted because the yield curve inverted mildly rather than increasing primarily at the long end as predicted.

Portfolio strategies were largely successful in 2005. During the year we did hedge about 30% of the total international bond position, thus partially avoiding the negative results for unhedged international bonds. Additionally, overweighting of international stock positions was particularly beneficial. Further, during part of the year we underweighted bonds. Also, portfolios benefited modestly from eliminating our usual overweight of U.S. value stocks, and we kept an appropriate allocation to high-performing mid-cap U.S. stocks by compensating for style drift by several mutual funds held in client accounts. Nonetheless, our use of alternative strategies for diversification did hurt results because they lagged considerably, as described above. Finally, mutual funds we employ in client portfolios remained highly rated by and large.

It is also noteworthy that our 2005 outlook was conspicuously silent about energy prices. Notwithstanding, during the year we kept our tangibles allocation above target and revised the composition of the tangibles allocation to increase oil and gas and decrease real estate securities. Both were favorable moves.

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.