January 2004

Portfolio Comments

Market View

Dorato Services

The Library: articles by Steve TeSelle

2004 Forecast

Portfolio Comments

Since this is sort of a forecast edition of the newsletter, perhaps I should review how I did on last year's forecast.

I hit it pretty close on bonds. The 2003 return for intermediate-term US Treasury bonds was 2.5%, and for the intermediate-term bond market as a whole was 4%. I predicted 3-4% and 5-6%.

I underestimated the return for US stocks: 25% return versus my estimate of about 10%. I seriously underestimated foreign stocks, in no small part because of the weaker dollar. Riskier markets, euphemistically called emerging markets, performed best. I estimated about a 10% return for foreign markets, with slightly higher returns in emerging markets; returns were more in the 20-50% range, with Brazil, Argentina, Thailand, and Venezuela providing greater than 100% returns.

Forecasts are useful for setting expectations, and for considering how your assets are allocated. But it's also important to know how your portfolio has performed. If I manage an account for you, you know how you're doing for the quarter, the year, and since you started with me. If you fall into that vast category of people who's assets I don't manage, and you'd like to see a summary of how I've done, you can go to my web site and click on "Corporate Performance."

I tend to write about things I could do better, or mistakes I've made. There's always room for improvement, and the world doesn't really need another person yammering on about short-term performance. Still, performance since 2000 hasn't been too shabby.

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 Market View

At the end of 2002, some people were optimistic about stocks, but quite a few were more pessimistic than Eeyore. Bill Gross, manager of the PIMCO Total Return Fund (a bond fund), predicted that the Dow would fall to 5000. It's now above 10,000.

At the end of 2002, we also heard about deflation. The fear was that the US was set to enter a period of falling prices and shrinking demand, as happened in Japan in the 1990s. While we still hear murmurings of deflation, few think it is a concern for the foreseeable future.

People have all kinds of good reasons for their beliefs. Indeed, if the Federal Reserve hadn't quickly expanded the money supply and lowered interest rates, those predictions could have come true. But I recite these examples because when times are bad, you'll read lots of stories about why the bad times will continue. And when times are good, there will be lots of optimistic stories (Dow at 40,000, from 1999). The stories make for fun reading, but they're not anything you want to get your knickers in a twist about.

There's no prevailing good or bad theme these days, which is probably a healthy sign. One of the worries is a weak dollar, brought on by US trade and budget deficits. The worst scenario is that the dollar plummets against other currencies (it's already fallen by more than 25% since early 2002), which causes inflation in the US, slams the brakes on other countries' growth, and causes foreigners to flee US investments. Yuck. But a more hopeful scenario is that the dollar stabilizes or maybe drifts lower, US inflation remains in check, and other countries think about how to stimulate internal growth rather than counting primarily on exports to the US. I expect closer to the happy scenario than the yucky scenario.

The S&P 500 rose about 25% in 2003, in part due to improving earnings, and in part due to investors willing to pay more per dollar of earnings. When people are optimistic, or willing to take on more risk, they pay more for riskier assets. When people are scared or worried, they don't want to own riskier assets, so prices fall. Prices of riskier assets, such as stocks, junk bonds, and stocks and bonds in developing countries, did well in 2003. Venezuela's market, one of the best in 2003, doubled. Yet Venezuela isn't exactly a paragon of stability.

Will investor's confidence continue? I don't know. People's perceptions can change pretty quickly. My view on stocks is that as a group they are priced a little high, but not beyond reason. Investors appear to be pricing in happy times, but not the nirvana of the 1990s. After large increases in riskier assets, and a drop in less risky assets (bonds, since late Spring), I suggest investors review their portfolio to make sure they're allocations to stocks and bonds aren't out of whack.

The bond market is saying we're in a recovery, and that they expect interest rates to rise before long. The Federal Reserve can control short-term rates, and keep them low, but investors control longer-term rates, and they're moving rates higher. In fact, rates would probably be higher still if China and Japan weren't buying US debt as they try to keep their currencies from rising against the dollar.

The rise in the price of gold from $250/oz. in 2000 to over $400 today is an indication of concern about inflation and the falling dollar. But messing around with gold and other commodities has always been a dangerous game. It makes sense to own commodities (gold, oil, steel, aluminum) if you're worried about inflation, but commodities are risky because they fluctuate in price so much. My guess is that momentum investors are messing around with gold. Most of us should steer clear.

As always, I recommend investors stick to their long-term asset allocation strategies and retain a diversified stock portfolio.

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The Library: articles by Steve TeSelle:

• College Savings Options
• Retirement: What's the Target?
• Fun Facts About Taxes
• Understanding Your Finances
• Risk, Anyone?
• A Primer on Asset Allocation
• Debt, Friend or Foe?
• Life Insurance Basics
• Calculating a Return

  To read them online, simply click on the title. To obtain a printed copy, please call us at 303-733-4999, or e-mail me at steselle@doratocapital.com.

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  2004 Forecast

  An Insight Into Dorato’s Investment Style

  It is time for the annual forecast. I remind you that I do this not because I think I have special forecasting powers. Rather, I do this to compare the expected returns of several types of investments in order to set a reasonable asset allocation.

  Once again, I'll start with stocks. Based on a Price to Earning (P/E) ratio of about 19, US stocks seem to be priced reasonably, if a little high. Prices are a little high because the US economy is growing nicely and because Japan and Europe appear to be picking up. If we're in for several years of solid growth, the prices are justified. If we have growth hiccups, prices could suffer. The current price level implies an expected annual return to stocks in a range of 5-10% -- not great, but better than a lot of other options out there.

  Foreign stock markets may have slightly higher return potential than the US market, but I don't expect as much of a fillip from a weakening dollar in 2004. The dollar should hold its value against the Euro, which means about a 10% return from European stock markets. The dollar may still weaken against the Yen, so returns from Japan may be in the 10-15% range.

  Emerging markets had a wonderful 2003, but that makes me skeptical about 2004. I make a precarious prediction that emerging markets will return 15%, plus or minus 30%.

  Bonds have been a wonderful diversifier over the last several years as they moved in the opposite direction of stocks. If we have a rise in inflation and rising interest rates to combat it, both stocks and bonds will suffer. Both the bond market and the commodities market are showing signs of worrying about inflation. I tend to agree, even though the official inflation numbers continue to show no cause for concern. I expect intermediate bonds to return 0-5% in 2004, with not much of a difference between US government bonds and corporate bonds. Investors should keep to the shorter side of duration (don't load up on 30-year bonds).

  Tax-exempt state and local debt yields around 3-4% for intermediate-term debt. These are attractive yields for taxable investors in high tax brackets, given the low yields in the US government and corporate sectors.

  Real estate, as measured by an index of REITs (Real Estate Investment Trusts), performed well in 2003: up more than 30%, much higher than my prediction of 8%. The stronger economy appeared to outweigh higher interest rates. Also, REITs may be trading more like stocks than real estate, which reduces some of their attraction as a diversifier in asset allocation. We'll see. For now, I expect total returns from REITs to be in the 5-10% range.

  As for asset allocation, stocks continue to hold the key to long-term growth. To keep up with inflation, especially inflation in areas such as health care and education that might not show up in official figures, investors should maintain at least 40-50% of their portfolios in stocks. To provide income and diversification benefits, investors can add bonds and/or real estate. I don't see any sectors offering whopping returns, which argues for a balanced asset allocation and an attention to keeping costs down.

  Sources: Economist, Value Line, Vanguard.
  

  

  "I'm forecasting higher employment in the US for 2004. The bad thing about that is that we'll probably get fewer walks. The good thing is we'll get to spend more time on the sofa."

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