January 2005

Portfolio Comments

Market View

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The Library: articles by Steve TeSelle

2005 Forecast

Portfolio Comments

This has turned into the forecast edition of the newsletter, which prompts a review of how I did on last year’s forecast.

The 2004 return for intermediate-term US Treasury bonds was 2%, and for the intermediate-term bond market as a whole was 3%. I predicted 0-5% for both categories. I find I’m more likely to be right if I pick a large range. I was wrong, however, about long-term bonds. I thought those would fare worse than intermediate bonds in 2004. In fact, they were up about 6%.

I got very close on the return for US stocks: 11% return versus my estimate of 5-10%. I underestimated foreign stocks again. Excluding the effect of the exchange rate, foreign markets were up about 10-15%; I predicted 10%, with slightly higher returns in Asian markets. But the weaker dollar bumped up returns to the 20% range for a US investor. Riskier markets, which mutual fund marketing people have cleverly named emerging markets, performed best. Investors in China’s stock market, however, lost about 10%.

My biggest miss was real estate. I thought real estate wouldn’t be such a hot investment in 2004, with maybe 5-10% returns. But an index of Real Estate Investment Trusts was up about 30%.

Forecasts are like power tools. You shouldn’t try to do too much with them. Forecasts are useful for setting expectations, and for considering how your assets are allocated. But if I really knew what was going to happen in the future, we’d all be fabulously rich. So please remember that forecast is just a fancy word for guess.

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 Market View

I think it’s helpful to look at various markets, to see if they’re giving consistent signals. At first glance, the stock and bond markets are sending a consistent sign for economic growth. The US stock market has a price to earnings ratio on the high side, which means that investors are fairly optimistic about future profits. The bond market has an upward-sloping yield curve, in which short-term interest rates are about 3% lower than long-term rates. We tend to have upward-sloping yield curves when bond investors think we’ll have decent economic growth. So the signals from the stock and bond markets are pretty consistent regarding economic growth.

There are conflicting signals, however, if you dig a little deeper into the stock market. Commodity-based stocks, such as metals companies and oil and gas companies, have done very well. This is because the prices of commodities have risen dramatically in the past year or two. Normally, a rise in commodity prices should translate into higher inflation. Either we get higher inflation, or, if companies that use these products can’t pass the higher costs on to consumers, we get lower profits. Maybe commodity prices aren’t as important in our economy as they were three or four decades ago, but they don’t have zero importance.

If we do get inflation, then the bond market is being overly optimistic. Bond investors are currently pricing an inflation expectation of about 1-2% over the next five to ten years. If we don’t get inflation, then the stock market is probably overly optimistic because company profits will be reduced by higher costs.

To complicate things a little more, currencies haven’t been terribly stable. Currency investors have been pushing the dollar down, probably due to our less-than-exemplary Federal budget and our large trade deficit. A weak dollar can help the profit picture for companies that do business overseas, but a weak dollar is also more likely to lead to inflation because imports are more expensive.

So which is it? Are bond investors the ones who are overly optimistic, or is it stock investors? I think the answer is a little of both. My guess is that the Federal Reserve will have to keep raising short-term interest rates, maybe by another percentage point in 2005, both to prove that it’s serious about fighting inflation and to help protect the value of the dollar. And bond investors will want a little more inflation cushion, which will cause longer-term rates to rise as well. This will put a crimp in economic growth, but not bring it to a complete stop. So bond returns will suffer a bit from rising interest rates and stock returns will suffer a bit from lower-than-expected profits.

Another sign that perhaps investors are a bit too optimistic is the spread, or difference in interest rates, between risky and safe investments. The spread between US Treasury debt and either junk bonds or emerging market bonds is only several percentage points, low by historical standards. Spreads tend to get low when people are more worried about the size of their return than the safety of their return. Low spreads tend to give warnings of excessive optimism for both the bond and stock markets.

Of course, there are all kinds of events that could give markets a big shove one way or the other: on the negative side, a coup in Saudi Arabia, a recession in China, the failure of a large hedge fund or bank; on the positive side, stronger-than-expected consumer and business spending in Europe and Japan. I mention these not to scare anyone out of investing or to encourage you to add to your account, but to remind everyone that the future is not as predictable as a TV sitcom.

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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  2005 Forecast

  An Insight Into Dorato’s Investment Style

  It is time for the annual forecast. I do this to compare the expected returns of several types of investments in order to set a reasonable asset allocation, not to start a new career in fortune telling.

  Once again, I’ll start with stocks. Based on a Price to Earning (PE) ratio of about 19, US stocks seem to be priced reasonably, if a little high. A lot like last year, in fact. Prices are a little high because the US economy is growing nicely, because of solid growth in China, and because of decent growth in Japan and Europe. It’s a little easier to justify a high PE ratio when the economy is coming out of a recession and earnings have been abnormally low. It’s a little harder to justify when earnings have already recovered. The current price level implies an expected annual return to stocks in a range of 5-10%. This year, I think there’s a slightly higher risk of a loss for stock investors if some of the optimism gets squeezed out of the PE ratio.

  Foreign stock markets may have slightly higher return potential than the US market, but with two years of very good returns behind them, I don’t have high expectations for 2005. I don’t think the dollar will lose much more against the Euro, so investors shouldn’t expect a boost from a lower dollar in 2005. However, the dollar probably still has further to go against Asian currencies, which should help US investors in those markets. I expect a 5-10% return from European stock markets and 10-15% from Japan.

  Emerging markets had a good 2004 to follow up on a wonderful 2003, all of which makes me cautious about 2005. I was cautious about 2004, too, so what do I know? But really, I think there’s more risk in these markets than there has been for several years.

  Bonds gave investors a few percentage points of return in 2004. I expect the same in 2005. The Federal Reserve is likely to keep raising short-term rates in 2005, and I expect long-term rates to creep up as well. Intermediate bonds should return 0-5% in 2005, with not much of a difference between US government bonds and corporate bonds. There’s more risk of negative returns if you own longer-term bonds.

  Tax-exempt state and local debt returns should be about the same as in 2004, around 3-4% for intermediate-term debt. These continue to be 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 very well in 2004: up more than 30%, much higher than my prediction of 5-10%. This sector has more risk of a loss in 2005, both because interest rates are likely to rise and because REITs are trading at high prices, whether you look at dividend yield or funds from operations. I know I’ve seriously underestimated returns for two years in a row, but be cautious here. I expect total returns from REITs to be in the 0-10% range.

  As for asset allocation, stocks continue to hold the key to long-term growth. To keep up with inflation, 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 prefer bonds over REITs at this point. As always, I suggest investors maintain a balanced asset allocation and an attention to keeping costs down.

  Sources: Economist, Value Line, Vanguard.

  

  "I appreciate your forecast for stock returns, but I was kind of hoping for something about my love life."

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