January 2007

Portfolio Comments

Market View

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The Library: articles by Steve TeSelle

2007 Forecast

Portfolio Comments

The only market I predicted correctly was the bond market. The 2006 return for intermediate-term US Treasury bonds, and for the intermediate-term bond market as a whole, was about 4.5%. Cash and short-term notes earned about the same. Junk bonds did better, earning 7-8%.

I underestimated the return for US stocks: 15% return versus my estimate of 5-10%. As in 2005, most of that gain came toward the end of the year. Foreign markets did even better. Vanguard’s foreign stock funds, whether for developed or emerging markets, increased 25-30%. Only the Pacific index, at 11%, earned less than the US market. I predicted 5-10% for Europe and 10-15% for Asia. I thought emerging markets would be in the same range, or that they might even lose money.

I underestimated real estate again, by a lot. Vanguard’s REIT index returned more than 30%. I thought real estate would produce maybe 0-10% returns.

There’s a lesson here. Predicting returns for various investments is terribly difficult (or I’m terribly dumb; I prefer to think it’s the former). If you could have predicted what happened in 2006, you would have thrown all your money at real estate and foreign markets. The problem is, I don’t think you can predict those things. What’s more, you might have panicked in May, when some emerging markets dropped 20%. The future might not have seemed so clear just then. So please just take these predictions as a reasonable but necessarily flawed guide to dividing up your assets for 2007.

Source: Vanguard

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 Market View

Last year, I wrote about the flat curve of the US bond market: interest earned on cash was roughly the same as the interest earned on 30-year bonds. That market persists, which is strange for two reasons. First, investors normally want a higher rate of interest for longer-term debt. Second, a flat or inverted yield curve has historically been a temporary phenomenon. How long can this go on? I don’t know, but it’s not normal. My guess is that imbalances caused in part by the US bond market as a safe haven and by the dollar’s role as a reserve currency are keeping US interest rates, especially longer-term rates, lower than they would usually be.

To make the curve slope upward, either short-term rates need to drop, or long-term rates need to rise. Long-term rates could rise from some combination of a falling dollar, US inflation, and strong economic growth in the rest of the world. Short-term rates could fall, led by the Federal Reserve, if inflation looked tame and, probably, if US economic growth stagnated. The stock and junk-bond markets seem to be counting on a happy variation of the latter.

For the third year in a row, the price to earnings ratio for the US market is about 18 or 19, which translates into expectations of healthy growth both for the economy and for company profits. The problem with this view is that the US economy is slowing down. That means profit growth should also slow down. A price to earnings ratio of 18 makes sense when profits are growing strongly, as they’ve done since 2002; it doesn’t make as much sense when the economy slows down. What investors appear to hope for is that the Federal Reserve will cut interest rates at the right time, so that the economy can continue to grow at a healthy enough clip to keep profits growing.

The junk bond market has a similarly rosy view. The spread (the additional interest that riskier borrowers have to pay) over US Treasury debt is historically low, as it was last year. This is an indication of how investors are willing to take on more risk in order to get a higher interest rate. The lower the spread, the riskier investors are willing to be. A low spread makes sense if the economy continues to chug along and bankruptcies are kept to a minimum.

In the currency markets, the dollar has fallen a bit, more against the Euro than against the Yen. Many currencies do not trade freely against the dollar, including countries that have made a bundle of cash from oil. If the dollar can keep up an orderly decline, especially against Asian currencies, that will help support the rosy view.

Thailand imposed restrictions on foreign investors, and the Thai stock market promptly fell 15%. A day or two later, the restrictions were rolled back and the market jumped 11%. This is a reminder that investing in emerging markets is risky, particularly markets that can change the rules on you with no warning.

As you may have been able to guess by now, I’m skeptical that the rosy view implied by current stock prices will prove to be correct. The worst case I can imagine right now is a slowing US economy combined with some kind of financial crisis (probably emanating from the debt markets) or terrorist event. This sounds scary, and it is. But I also want to remind you that this scenario occurred at the end of 2001. We’ve lived through it before.

And I’m not saying that the sky is falling. Foreign economies are strengthening, particularly Japan and Germany. Since many US companies sell to a world market, profits can remain healthy even if the US economy slows. Also, hedge funds and private equity investors seem to make new takeover announcements every week. These investors should help to provide a floor on stock prices. What I am saying is too keep your expectations reasonable, and don’t be surprised if things get bumpy.

Because the future is so hard to predict, 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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  2007 Forecast

  An Insight Into Dorato’s Investment Style

  So here goes my 2007 forecast:

  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 three years, in fact, when we got returns of 11% (2004), 5% (2005), and 15% (2006). The difference this time is that the US economy is slowing. A slowing economy means lower earnings growth. So I expect some bumps and bruises among US stocks, perhaps a 5-10% return, with a higher possibility than the last couple of years of negative returns.

  Foreign stock markets have similar return potential to the US market. A weakening dollar would give US investors a boost from foreign investments. On the other hand, if we have some sort of crisis, expect people to rush out of foreign markets, especially emerging markets, and into the US Treasury market. That would strengthen the dollar and subtract from foreign returns. Ten to twenty percent of your portfolio in foreign stocks is fine, but unless you have confidence in your valuation of foreign securities, I wouldn’t go much higher. I expect a 5-10% return from European stock markets and 5-10% from Japan.

  Emerging markets had a very good year in 2006, which makes four years in a row of above-average returns. These things tend to go in cycles, so if you’re invested in emerging markets for diversification, that’s fine. If you’re loading up on emerging markets to make big returns, you should think twice.

  Bonds have generated single-digit returns in the last several years. The trick to forecasting returns in the bond market for 2007 is in guessing what will happen to the yield curve. I’m guessing that we won’t see a dramatic change, even though a flat curve isn’t normal; perhaps slightly lower short-term rates and slightly higher long-term rates. This translates into 4-5% returns for short-term bonds, and 3-4% returns for longer-term bonds. That’s not spectacular, 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.

  Tax-exempt state and local debt returns should be about the same as in 2006, 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. You should not own tax-exempt bonds in IRAs or 401ks.

  People who know real estate can rightly ridicule me for lumping all real estate together. While residential real estate slowed considerably in 2006, office space and retail space did quite well. Still, the point here is not to dissect the real estate market, but to consider realistic return expectations. With a slowing US economy and slightly higher long-term rates, the outlook for real estate is not great, perhaps 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.

  
  "You have to admire the guy for being consistent."

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