2005 Outlook

Tom Beilstein, CFA, Portfolio Manager

Now that 2004 has come to a close, we will review some investment themes that are currently affecting the markets and present some thoughts for what may be in store for 2005.

Interest Rates and Bonds

We strongly believe that the Federal Reserve will continue to raise short-term interest rates. In 2004 the Fed Funds Rate, which began the year at 1.00%, was raised five separate times to finish the year at 2.25%. This usually spells bad news for bonds, since when rates rise, bond prices fall. But instead of rates rising across the board as the Fed raised short-term rates, the yield curve flattened, sparing intermediate- and long-term bonds for the time being. To illustrate what happened to yields, the yield on the 2-year Treasury began the year at 1.83% and ended the year at 3.09%, moving almost in tandem with the Fed Funds Rate. However, intermediate-term bonds, as measured by the 10-year Treasury, began the year at 4.25% and finished it at 4.26%, almost unchanged. The same phenomenon happened with long-term bonds where the 30-year Treasury began the year yielding 5.07% and was actually lower at 4.86% on December 31. This flattening of the yield curve allowed most bonds to produce good returns in 2004, despite their low yields. We do not feel this will continue in 2005. The spread between the 10-year and 2-year Treasury, which is the difference in their yields, has fallen from 2.52% to 1.27%, respectively. Although the spread is still above the historical average of 0.76%, it is hard to justify spreads tightening much more. If this proves to be the case and the yield curve does not flatten further, each move the Fed makes will be felt across the full spectrum of bonds. In general, longer-term bonds are more sensitive to interest rate moves than shorter-term bonds, which is why we have shortened our bond portfolios over the past 18 months. While we may have been a little premature in making this move, we felt it prudent considering one of the main reasons we own bonds is for capital preservation.

Equity Rally to Continue?

In 2004, the S&P 500 returned 10.9%. This was a very competitive return and well above the expectations of most experts going into 2004. Although 2004’s returns approximated historical averages, it was not a typical year. The S&P started strong, gaining 4.0% through March 5th, when the market began to muddle along through the spring and summer as an uncertain election and swelling oil prices left the market flat through October 26. Then, spurred by falling oil prices, the market rallied into the election and has not let up. We feel 2005 will have a lot in common with 2004. We are uncertain if the market will give us returns that approach 2004’s, but we do expect higher volatility and the returns the market does earn should come in bits and spurts. Due to supply and demand considerations (including 401k contributions and year-end bonuses), we expect the fourth quarter rally to continue well into the first quarter, after which time it will take a breather. From there, barring any major setbacks in Iraq or on the terrorism front, corporate earnings will drive the market. Thus far, the economy remains strong, which boosts prospects that corporate America will continue to grow earnings. If GDP grows the 3-3.5% that most economists are expecting, that should equate to approximately 10% growth in corporate profits. This would in turn equate to an approximate 10% gain in the market if P/E multiples remain constant. The S&P 500’s P/E ratio was 17.1 as of December 31, based on next year’s earnings. Over the last 25 years, the S&P 500’s average P/E ratio was 14.5. So based on history, the market is slightly overvalued. Yet with interest rates low and the economy strong, we do not expect to see a contraction in the P/E multiplier, which would eat into returns, but the risk does exist.

Small-Caps

In 2004, small-cap stocks outperformed large-cap stocks for the sixth straight year. At the beginning of 2004, we became skeptical that this trend would continue. The reason for our skepticism was, and still remains, valuations. For the first time since late 1997, small-caps are expensive relative to large-caps. Over the past 26 years, small-caps have traded at 2% premium to large-caps, based on their P/E ratios. But as of the end of 2004, the P/E on small-cap stocks (Russell 2000) was 19.2, while the P/E for large-cap stocks (Russell 1000) was 17.0. This shows small-cap stocks trading at approximately a 13% premium to large-cap stocks. This is a significant difference. If interest rates rise as expected, the environment will also point to large-cap stocks, since it will be more costly for smaller companies to finance future growth. However, with all this being said, small-caps continue to hold the momentum card and investment trends tend to go past their median point. In other words, large-caps did not begin to outperform small-caps the day they became relatively cheaper; last year was an example of that. Instead, the trend continues until the valuations begin to approach extreme levels. Right now, large-caps are approximately one standard deviation cheaper than small-caps. However, in early 2000, it was not until small-caps were more than two-and-a-half standard deviations cheaper than large-caps that the trend turned towards small-caps. What does all this mean? Large-cap stocks are relatively cheaper than small-cap stocks and will more than likely outperform small-caps over the next few years, but it may not begin in 2005. We are maintaining a neutral position in regard to these two asset classes and are waiting for other indicators before taking advantage of the difference in valuations.

International Markets

For the third year in a row, the MSCI EAFE Index outperformed the S&P 500, 17.59% to 10.88%, respectively. A weak U.S. dollar has been the leading factor in international equities’ leadership. To demonstrate this, the EAFE Index would have only returned 10.18% in local currencies. The results were similar in 2002 and 2003, when the EAFE returned much lower in local currencies. Will the dollar continue to depreciate against other currencies? The consensus feels it most definitely will. The best hope for the dollar to find support is the raising of U.S. interest rates. If rates rise high enough so that the differentials between our rates and foreign rates are substantial, foreign investment may lead to support of the dollar. However, many other economic factors, including an ever widening trade deficit, point to the dollar’s continuing slide. If this happens, international stocks will probably outperform U.S. stocks for the fourth consecutive year.

High-Yield Bonds and Real Estate

In 2003, two of the best asset classes to own were high-yield bonds and Real Estate Investment Trusts (REITs). 2004 was no different. In 2004, the CSFB High-Yield Index was up 11.95% and the Dow Jones Wilshire REIT Index was up 33.16%. Will these two asset classes continue to shine in 2005? Maybe, but I would not count on it. Before high-yield bonds began to rally in 2003, a year they returned 27.93%, they were an undervalued asset class. One way to determine if high-yield bonds are undervalued is to look at spreads between them and the 10-year Treasury bond. When spreads are large, high-yield bonds are undervalued, but when spreads are small, high-yield bonds are overvalued. At the beginning of 2003, high-yield bonds were yielding approximately 10% more than Treasuries. This difference was far greater than the long-term average of 4.89%. Since that time the spread has fallen to 2.53%, the lowest level since 1998. High-yields do have one thing going for them and that is a strong economy. When the economy is strong, the default rate of issuing companies tends to be lower and this has a positive impact on the high-yield market. However, with interest rates expected to rise and spreads this tight, it is difficult to imagine high-yield bonds approaching the returns of the last two years.

REITs began their string of strong performance back in 2000, when they returned 31.04%. Since that time, REITs have averaged 22.54% per year. In hindsight, one could see that REITs were extremely undervalued near the end of 1999 when they were trading at a 28% discount to their Net Asset Value (NAV). Trading at a discount is not reason enough to invest in REITs, since in 1998 they were trading at a discount and investors still lost 17.00%. But when other factors come into play, like falling and low absolute interest rates, REITs can present an opportunity. It appears this opportunity has passed. REITs are now trading at a 13% premium to their NAV and higher interest rates should stall the five-year rally.

Conclusion

At Bill Few Associates, we do not attempt to predict where the market, inflation or interest rates will finish in a given year. However, we do feel it is beneficial to continuously analyze market and economic conditions and make subtle portfolio alterations as the investing environment changes. To this end, we will continue to monitor the markets, making changes to portfolios where appropriate.

Sources: Ned Davis Research, Baseline