January 2006

Portfolio Comments

Market View

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The Library: articles by Steve TeSelle

2006 Forecast

Portfolio Comments

This is the section where I review how I did on last year’s forecast.

The 2005 return for intermediate-term US Treasury bonds, and for the intermediate-term bond market as a whole, was just a little over 2%. Longer-term bonds did a little better, earning 5-6%; and so did money market funds, which earned about 3%. I predicted 0-5%.

I got very close on the return for US stocks: 4.8% return versus my estimate of 5-10%. Most of that gain came at the end of the year. And this time, I even got part of the foreign markets right. Adjusting for the dollar, Europe returned about 9% and Asian markets returned more than 20%. I predicted 5-10% and 10-15%, respectively. Where I missed again was emerging markets, which includes some of those Asian markets. Vanguard’s Emerging Market Index Fund earned more than 30%. I thought investors might actually get a negative return for emerging markets in 2005.

I underestimated real estate again, but by a much smaller amount than last year. I thought real estate wouldn’t be such a hot investment in 2005, with maybe 0-10% returns. But an index of Real Estate Investment Trusts was up about 12%.

I’m not sure what you do with this information, other than to nod and say ‘hmm.’ Even if I got everything exactly right for 2005, it wouldn’t mean much of anything for my 2006 guesses. The forecasts are just guidelines to work from, and that’s about it.

Source: Vanguard

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 Market View

Where last year we had fairly consistent signals from the stock and bond markets about economic growth, this year the expectations diverge. The bond curve is pretty flat, which means that the interest you earn on short-term debt is about the same as the interest you earn on long-term debt. This isn’t normal. Normally, investors demand a higher rate for holding longer-term debt. Investors in the bond market tend to give us a flat bond curve when they’re pessimistic about the future, when they think the economy is going to slow down.

But the bond market has several segments. And these other sectors of the bond market have a slightly different view. The interest rates on junk and international bonds are at relatively low levels, which tends to happen when investors are optimistic about the future, or when people start to forget about risk.

That optimism puts the junk bond and international bond folks more in line with the stock market folks. The stock market price to earnings ratio is about the same place it’s been the last two Decembers, about 18 or 19, which translates into expectations of healthy growth both for the economy and for company profits.

So either the stock market folks are right and we get solid economic growth, healthy profits, and happy investors, or the bond market folks are right and we get slower economic growth, maybe a recession, profits are lower than expected, and stock investors end up with a frown on their faces. Or more likely, we get some average of the two. Economic growth slows some, relieving inflationary pressure, and allowing the Federal Reserve to stop raising short-term interest rates. Profits aren’t quite as high as some investors hope for, but they’re not terrible either. As you might guess, that’s where I sit, on the fence.

In the currency markets, the dollar got stronger, which just about nobody predicted. If the dollar maintains its strength, that will help to keep a lid on inflation. If the dollar weakens again, that will help companies that export, but it might reignite inflation fears and force the Federal Reserve to keep raising rates. With the current account deficit as big as it is, I tend to think that the dollar will get weaker in 2006.

Even though I sit on the fence regarding economic growth, there are sectors of the US stock market that have me worried. Ford and General Motors have so many problems, I think it’s best to steer clear of those companies. They might fix themselves, and give anyone who holds on great returns. But the risk is so high, that I don’t think the potential returns justify an investment.

In my fence-like way, I’m holding onto the oil and gas companies we own, not because I think the price of oil is going to $100 a barrel, but because the investment is a good hedge against inflation.

And in the ‘I don’t understand’ category, the price of large drug companies baffles me. The drug industry has very strong finances, a growing market, and patent protection. Here, I think investors have become overly pessimistic on an industry with a solid future.

Of course, there is always risk, and there always will be. Life is not predictable, nor is the stock market. The Middle East seems to be a likely source of a nasty event, and other unseen nasties could also do some damage. There are also unforeseen good things. For example, who predicted the peaceful transition from apartheid in South Africa over the last decade? And not many people predicted that Japan would finally start to turn itself around. So there are unseen goodies out there, too.

Because of all those unpredictable bits, I recommend, as always, that investors stick to their long-term asset allocation strategies and retain a diversified stock portfolio.

Sources: The Economist, Wall Street Journal, Value Line

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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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  2006 Forecast

  An Insight Into Dorato’s Investment Style

  In an effort to set some reasonable expectations for 2006, I will once again wade into the risky world of forecasting.

  Since I’m primarily a stock investor, that’s where I’ll start. Based on a Price to Earnings (PE) ratio of 18-19, US stocks seem to be priced reasonably, if a little high. A lot like the last two years, in fact, when we got returns of 11% (2004) and 5% (2005). The current price level implies an expected annual return to stocks in a range of 5-10%. However, this year, in a nod to the pessimistic bond market folks, I think there’s a possibility for negative returns, which is a nice way of saying that you can lose money.

  Foreign stock markets have similar return potential to the US market. If the dollar weakens, you’ll get a boost from foreign investments. On the other hand, if something fearful happens, expect people to rush out of foreign markets, especially emerging markets, and into the US Treasury market. I think it’s fine to have ten to twenty percent of your portfolio in foreign stocks, but I wouldn’t go much higher. I expect a 5-10% return from European stock markets and 10-15% from Japan.

  Emerging markets had another good year in 2005, which makes three years in a row of above-average returns. You’re now starting to see more articles about why you have to own emerging markets. I admit that I’m a curmudgeonly contrarian, but articles like that get me worried. If you already own emerging markets, I don’t think you need to sell, but if you don’t own any yet, I don’t think you need to rush out and buy. Better to sit tight.

  Bonds haven’t generated big returns in the last couple of years. But remember, the reason to own at least some bonds is to reduce the risk of your overall portfolio. Even people who consider themselves aggressive investors should have some bonds. The Federal Reserve is just about finished raising rates, so the 4% yield on short-term debt is your expected return for the year. Longer-term debt is likely to return 0-5% in 2006; you’ll get the lower end of the range if long-term interest rates go above 5% (if interest rates rise, the value of bonds falls). Just like last year, 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 2005, around 2-3% 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), did better than US stocks in 2005, but by much less than in previous years. The key for this sector will be the direction of intermediate-term interest rates. If 10-year rates stay steady, REITs can have an average year, in the 5-10% range. If 10-year rates move higher, REITs could lose money

  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 think I'm getting the hang of this forecasting business."

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