4th Quarter Economic Commentary

Mike Kauffelt, CFA, Chief Investment Officer

Each quarter, we provide an economic and market update for our discretionary accounts. This is a copy of the end of the year update, which also provides a brief outlook for the year to come.

Summary of the Quarter and Year

Both the prior quarter and the entire year of 2003 were a well-earned reward for the long-term investor. Those who were diversified and invested in assets other than cash earned rates of return that were well above historical averages, especially in equity categories. Last year’s returns were significantly higher than the dark period from 2000-2002. In general, when investment markets bounce out of a cyclical trough, small-cap stocks perform better than large-cap stocks and lower-quality investments initially perform better than higher-quality investments; 2003 was no exception.

Looking first at stocks, we will review the performance for the major equity asset categories. The S&P 500 Index (large-cap stocks) was up 12.1% for the quarter (typically a good year in itself!) and 28.4% for the entire year of 2003. Mid-size stocks, measured by the S&P 400 Midcap Index, were up 13.2% for the quarter and 35.3% for the full year. The Russell 2000 Index (small-cap stocks) had the best year among broad-based domestic stock indexes. It was up 14.5% for the quarter and 46.9% for the year. This followed the historical trend that small stocks emerge from most bear markets much faster than large stocks. All stocks did well and a diversified portfolio should have benefited from a move in both categories. Finally, foreign stocks, as measured by the Morgan Stanley EAFE Index, had a great year due primarily to the weakening of the US dollar. They finished up 16.8% for the quarter and 35.3% for the full year.

In order to explain some of the bond statistics, we will use a brief analogy that works well for both stocks and bonds, but more so for fixed income investments. Assume you have two families living side by side in a neighborhood that have four people per household (two of whom want to work) and similar lifestyles, except for two crucial differences. Family 1 has two people employed and absolutely no debt, family 2 has only one person employed (although two want to work) and lots of debt. If the economy improves and family 2 finds a second job, which family improves its balance sheet the most? Most likely, family 2 will get the most immediate help to their family balance sheet. Family 1 already had a clean balance sheet so the improving economy helps them less than family 2 who was underemployed and financially overextended. Similarly, the lowest-quality bonds (based on credit ratings) performed much better than the highest-quality bonds in 2003.

For the year, US Treasuries (using the five-year bond as an average) eked out a positive quarter of 0.4% and were up a meager 0.5% for the year. Investment-grade corporate bonds were up 0.7% for the quarter and 8.3% for the year. Meanwhile, high-yield bonds (junk bonds) had the best performance; they were up 5.9% for the quarter and 28.1% for the year. The performance of the bond categories followed the above analogy very closely. The bonds with the best credit rating (balance sheet) performed least well, while the bonds with the worst credit rating (balance sheet) performed best. Left out of our analogy were municipal bonds. Because of their unique tax-free status, they do not conform as directly to the analogy on a performance basis, but even with municipals, credit ratings are key; ask any California bond holder. Municipals, in general, were up 2.5% for the quarter and 6.2% for the year.

Looking Forward at 2004

The good news is that we think the economy and the markets are poised to deliver good news well into 2004. Current estimates by most economists are calling for growth in the economy in the range of 4.5%. If business profits are correspondingly strong, then stock prices have more room to rise from their current levels. Bonds may not have more room for price appreciation, but if inflation stays tame, they should still have positive real returns as their coupon payments are returned to bond holders. Of course, there are always a few flies in the ointment. We still have a huge conflict to manage and a government to transition in Iraq. We also have underinvested in energy infrastructure as a nation and could face an energy crisis, not because of a lack of a commodity (oil or gas), but due to our lack of ability to process and refine enough energy to meet demand. Historically, election years are good for the markets regardless of the party in charge or the party that wins, so 2004 should be strong. Is it too early to start to worry about 2005?

Data sources: Baseline, Bloomberg, Ned Davis Research and Wall Street Journal.