INVESTMENT OUTLOOK – 2005
Written May 2 through 13, 2005
Forecasting
We take a sanguine view about trying to predict the future. Much of it is guesswork. The fundamental picture is affected by events that cannot be predicted, and actual results may vary significantly from a forecast. Yet, investing is a future discounting process and the asset allocation process. Ignoring forecasting is tantamount to malpractice. Warren Buffett had this to say in his 2003 Berkshire Hathaway Chairman’s Letter:
“…...I should note that the cemetery for seers has a huge section set aside for
macro forecasters. We have in fact made few macro forecasts at Berkshire,
and we have seldom seen others make them with sustained success.”
Although Buffett pokes fun at forecasting, he has in fact done very well anticipating the direction of the economy.
Economic Growth
The current positive US business cycle which started in October 2002 is two and one-half years old. Positive cycles last three and one-half to four years. US GDP growth in Q1 2005 was 3.1%, the slowest pace in two years. That’s down from the 3.8% rate in Q4 2004 and 4.5% a year ago. Durable goods orders fell and other order statistics are basically flat. The Institute of Supply Management’s index fell to 53.5 from 55.5 in March (above 50.0 means a growing economy). Also, the ISM’s index of new orders fell to 53.7 from 57.1 in March. Construction spending rose .5% in April.
The slowdown we started to think about in January may be in evidence. GDP, manufacturing activity, and retail sales are all in decline. Construction spending remains robust, however. Forecasts of growth are being revised downward. GDP growth for Q2 2005 is forecast to be 3.2%, down from the earlier 3.7% forecast. However, remember that in January only 12 of the 56 economists surveyed by the Wall Street Journal thought a recession in 2006 would be a possibility. In addition, job growth was robust (see below), casting doubt on recent economist’s opinions.
The current reading of the Index of 10 Leading Economic Indicators is a positive 0.7. A neutral reading is 0.0. The index has fallen 7 out of the last 10 months and fell .4 in March after being up .1 in February. A negative reading three months in a row signals a recession. The current reading signals a weak, vulnerable economy, a weak stock market, but a possible halt in Fed interest rate hikes.
In the previous Investment Outlook letter we reported that growth in Asia was continuing to surge but that it was expected to slow in 2005. It is now a realty with China, India, Korea, and Japan all experiencing slowdowns. Despite that, we believe that most emerging nations will continue to outgrow and outproduce the US. We continue to remain invested in Matthews Asian Growth and Income Fund and Matthews Asia Pacific Fund.
We are cautious about US stock investments at the present time, and bargains are hard to find.
Job Growth
April nonfarm payrolls rose by 274,000 jobs, more than 100,000 above March. Of that total, 22,000 were in the retail industry. In addition February and March job growth was revised upward by 93,000 so that the 1st quarter averaged 240,000 per month. Hopefully this is not just seasonal, but that it means businesses can no longer meet demand solely through productivity growth and overtime pay. The unemployment rate remained at the low 5.2%, unchanged from March. There is apparent inconsistency between job growth, ISM indices, retail sales, orders, and the GDP growth rate. Will job growth be curbed by high energy prices, high commodity prices, and lower retail sales? Stay tuned. In the meantime, these employment figures cast some doubt on whether there is really an economic slowdown.
The Consumer
Most economists think the consumer will spend less in 2005. Consumer confidence index in April was 97.7 versus 103.00 in March. Can an actual decrease in spending be far behind? If business spending doesn’t fill the gap, there could be a pause in growth. Even so, we like consumer stables and energy stocks if they can be purchased at a reasonable price.
Consumer credit as a percentage of personal income was 21.97% in 2003, 21.75% in 2004, and 21.15% for Q1 2005. It’s high by historical standards, but it’s not increasing percentage wise. However, consumer credit does not include home equity loans, and household debt has risen 80% since 1990 while median household income has risen 11%, adjusted for inflation, according to www.Economy.com.
According to the Bureau of Economic Analysis, the personal savings rate was just 0.6% of personal income for Q1 2005 versus 1.6% in Q4 2004. Personal consumption expenditures increased 0.1% in Q1 2005 versus 0.4% in Q4 2004. Maybe everybody is paying off Christmas bills and we need not worry about there being enough future consumption capability to sustain the economy.
Inflation
The annual unadjusted rate of inflation was 3.1% in March, compared with 1.7% a year earlier. The consumer price index unadjusted was 193.3 in March compared with 191.8 in February and 187.4 a year ago. As reported in the last Investment Outlook letter, consumer prices rose 3.5% for the twelve months ended November 2004. Commodity price increases may be finding their way into manufactured product. We are all too familiar with crude oil prices.
One of the restraints on the effects of inflation is productivity. On May 5, 2005, the Bureau of Labor Statistics reported that productivity in the business sector during Q1 2005 grew more slowly than Q4 2004, 2.1% versus 3.7% as revised (seasonally adjusted annual rates). Unit labor costs rose 2.2% versus 1.1% in Q4 2004. Productivity is one of the keys to neutralizing the effects of wage inflation.
Interest Rates
The Federal Reserve is raising rates to forestall inflation, as reported in the last Investment Outlook letter. The Fed funds rate increased by 25 basis points in April and again increased another 25 basis points on May 3rd. Their initial statement said they will continue to raise rates at a “measured pace”. It also said that “the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices.” Then, in an unprecedented move, just before the market closed, their initial statement was revised to say that long-term inflation is contained. We are not sure if the Fed had any particular message; maybe just a clerical omission in the original statement.
In January a consensus of 56 economists predicted the Federal Funds rate would go to 3.5% by December 2005. However, with current super high debt levels, will they risk plunging the real estate industry, consumer spending, and the general economy into a recession, again? We think the Fed will raise the Fed Funds rate to approximately the long-term inflation rate, which, given the unpredictability of inflation, doesn’t give us much of a clue about the future of Fed rate increases.
Twelve leading investment strategists gave their forecast for the 10-yr T-bond yield as being in a 3.85% to 5.8% range with seven predicting a 5% to 5.5% range (mortgage rates are pegged to the 10-yr T-bond yield). As I write, the 10-yr T-bond yield is 4.201%. If that rate tracks the next four predicted increases in the Federal Funds rate of 25 basis points each, that would put the 10-yr T-bond rate at about 5.20% by December 2005. Mortgage rates typically key off the 10-yr T-bond rate.
For those of you who are thinking about what type of home mortgage to have, adjustable rate mortgages may be a little risky right now. Anyone with an adjustable rate mortgage might want to think about restructuring their debt.
Investing in domestic bonds for 2005 will involve more risk than reward. Foreign bonds however may offer greater reward for less risk, as foreign interest rates may be closer to their highs, plus the declining dollar offers some protection against loss of principal should foreigners decide to push rates up. In May the European Central Bank left their prime rate unchanged at 2.00% because their economies are very slow and inflation is not a major problem. Nevertheless, we elected to sell virtually all of our Fidelity New Market Income bond mutual funds in April because we had questions about their performance. PIMCO Emerging Market Bond fund did not have quite the same volatility and we may consider that fund in the future if the interest rate picture settles down.
Money Supply
There is an old saying: “Just as the party gets going, the Fed takes away the punch bowl.” Just as the economy is showing signs of sustainability, job growth, and earnings growth, the Fed has quietly been reducing the growth of the nation’s money supply. The Fed buys Treasury notes and bills to increase the money supply and sells notes and bills to take money out of the supply. According to the charts of M1, M2, and M3, the rate of growth of the money supply has been decreasing since June 2001, measured on a year over year basis. M2 and M3 growth rates are around 4%, from around 10% in June 2001. History shows that, over time, when money growth decreases, the economy and the stock market decrease.
Earnings
It is possible that 2005 S&P 500 company earnings growth will slow as energy and commodity prices take their toll. Foreign company earnings growth may also slow, but Asia, Canada, Latin America may continue to outpace the rest of the world.
Energy
Oil futures closed at $49.72 per barrel on Friday April 29, 2005, down from a high of $57.46 per barrel on March 21, 2005. T. Boone Pickens, manager of a commodity edge fund and former CEO of Mesa Petroleum, thinks the trading range is $40 to $60. The price has bounced up from the $40 support level several times in 2004, and from a $50 support level in 2005.
Refining capacity is at 82 million barrels a day and demand is something north of 84 million barrels per day. Approximately 22% of production is light sweet crude, which everyone wants for clean gasoline. The rest is heavy, sulfur rich crude, more expensive to process, and is typically used for other purposes. Coal tar sands in Canada hold roughly the equivalent of the Saudi oil fields, but production has not been ramped up, since it has been only recently that it has been profitable to produce it. Depending on which expert is opining, oil reserves are adequate or declining.
During 2005 we added Conoco Phillips and Valero Energy to portfolios around April 6 as Standard & Poors upgraded them. Since then they have declined, but we think that they will recover as this seasonal weakness in oil prices turns to strength. Valero is a refiner of heavy sour crude, which is increasingly a larger percentage of total crude stocks. Valero bought Premcor after our investment to expand their refining capacity, but Wall Street didn’t like it. We are sticking with it, not wanting to second-guess Valero’s long-term strategy.
The research contained in the book “The Oil Factor” by Stephen Leeb makes a convincing and scary case that the supply of oil is declining and prices will top $100 per barrel at some point in the future. The energy problem is not going away despite the seasonal decline in the price per barrel during the week ended May 13, 2005.
US Current Account Deficit
The US is buying more from the world than it is selling to the world by about 61 billion annualized, as of last week (Barron’s May 9, 2005). In fact, the US encourages China to keep shipping those cheap goods and the Chinese are only too happy to oblige. The US accumulated current-account deficit at September 30, 2004 was 5.6% of GDP, a rate which economists do not think is sustainable. Some predict the rate will come in at 6% of GDP sometime in the near future.
This works fine as long as the world buys US Treasury notes and bills, or the dollar depreciates against the world’s currencies, or their currencies appreciate. The question going forward is whether foreigners will decrease their purchases of dollars, because of reduced purchases of US Treasury bonds and reduced imports of US goods. Reduced purchases of US Treasury bonds is a risk factor for US interest rates. A sharp drop in purchases of dollars could severely affect the housing market and consumer spending.
Last March Korea said it was thinking about cutting back on US debt purchases because it didn’t like the depreciation of the value of those notes and bills due to the declining dollar. The 10-yr Treasury note yield went from 4.20% to 4.6% in a couple of days, which tells us what might happen or worse if the world suddenly stops buying our debt. In addition, the stock market dipped as well. Eventually, these debts have to be repaid somehow.
The Fed’s measured pace of rate increases may keep the dollar strong and our debt desirable, but we are still maintaining positions in the Tocqueville Gold fund and cash just in case.
US Current Account(Budget) Debt
In 2005 the government debt totaled 4.7 trillion versus 3.3 trillion in 2001. Is this why the Treasury is thinking about issuing the 30 year bond again, starting in February 2006? Frankly, there is a real question as to whether February 2006 will be the right time for investors to be long on bonds. If the Treasury does go ahead with their plan, will long-term bond rates go up and short-maturities go down? Or will the opposite happen, as holders of short maturities sell those notes to invest in the 30-yr bond? Will the 3, 5 and 10 year note yields go up? What will the effect be on mortgage rates? Stay tuned.
Ageing Population
While the ratio of retirees to workers is increasing and the social security program may require tax increases, there could be continued growth in the health care sector. The rewards outweigh the risks in this sector, we believe.
A somewhat related area is the trend of obesity, which continues despite a plethora of dieting regimens. We have not decided how to play the obesity factor.
Stock Market, Long-Term
We think the market will track the economy and S&P earnings growth somewhat, but there will be periods of irrational exuberance followed by irrational despair. Typically, the November 2004 to March 2005 time period has exuberance or rally potential, and the May 2005 to October 2005 period has irrational despair potential. Historical returns have been 10.3% since 1929, but that could be reduced to a 7% to 8% range in the coming years.
Currently, businesses seem to be either fairly valued or overvalued. We believe a pull back is needed to flush out some bargains from our watch list. The current bull market rally which started in October 2002 is looking old. The median bull market since 1900 has lasted about 27 months, according to Leuthold Weeden Research. However, in recent years, a bull market has tended to last 2 ½ to 3 ½ years, according to State Street Global Markets, a Boston brokerage firm.
We think the 18 year bull market from 1982 to 2000 could be followed by an 18 year secular bear market, with intervening rallies...lower highs and lower lows. Buy-and-hold will be replaced by buy-and-watch. Active portfolio management will be essential to success during the coming years.
Stock Market, Short-Term
We are about to enter (as if we hadn’t already) the “sell in May and go away” period when because of lack of fresh retirement monies to prop up the stock market the market meanders lower on low volume. A simple case of too much supply of stock for too few dollars chasing them. Together with the Fed’s “measured pace” of interest rate increases and increasing inflation, this summer doesn’t look promising which is why we have high levels of cash and a position in the Prudent Bear Fund as a hedge. Countering this seasonal trend is the large cash positions of institutions. If the fears about a soft economy are quelled, a small rally before fall is a possibility.
Stock Market, Technical Indicators
On May 3rd the S&P 500 Index at 1161 was just over the 200 day average of 1156. It rose midday over 1164, the 38.2% Fibonacci retracement level on the daily timeframes, but closed below it on April 20. The intraday low was 1136.15, which might be the low point for the year.
Fibonacci levels are shown in the following table. On the daily timeframes the S&P 500 never quite made it down to 1125, but the year is not over yet. Fibonacci retracements have proven quite reliable historically, and they work for most markets. For example, the S&P 500 Index reached 1146.18 intraday on Friday May 13, 2005. That’s close enough to say the 50% retracement support level has been met on the daily timeframes. On the weekly timeframes, the index would have to fall 101.46 points or 8.8% from Friday’s close of 1154.05, to complete a 38.2% retracement since the start of this bull market run.
Intraday highs and lows of the
latest runs of the Russell 2000 Index
| Weekly Timeframe
| Monthly Timeframe | October 11, 2002
| | 768.63 | March 11, 2005
|
| 1228.11 | August 13, 2004
| 1060.72
| | March 7, 2005
| 1229.11
| | | 38.2% retracement | 1164.78 | 1052.59 | | 50.0% retracement | 1144.91 | 998.37 | | 61.8% retracement | 1125.04 | 944.15 |
Fibonacci levels for the Russell 2000 Index, representative of the small cap market are shown below. On April 29, 2005, the intraday low was 570.03, nearly completing a 61.8% retracement on the daily timeframe. On the weekly timeframe, the index may have further to fall in order to complete a 38.2% retracement of the start of this bull market run. That’s about a 9.0% drop from Friday’s close of 582.02.
Intraday highs and lows of the
latest runs of the Russell 2000 Index | Monthly Timeframe | Weekly Timeframe | | October 11, 2002 | | 324.90 | March 11, 2005
| | 656.11 | | December 31, 2004 | 515.90 | | | May 19, 2006 | 656.11
| | | 38.2% retracement | 602.55 | 529.59 | | 50.0% retracement | 586.00 | 490.50 | | 61.8% retracement | 569.46
| 451.42 |
Other technical indicators forecast further weakness. As of May 3rd, the relative strength reading was 48.1, indicating about neutral, neither overbought nor oversold. The slow stochastic reading was also neutral at 51.41. The five-day ARMS indicator was at 6.01, indicating a temporary bottom. The 10 day advance/decline ratio was neutral at plus 50. Daily volume levels on both the NYSE and the NASDAQ are low, indicating lack of buying pressure to push up stock prices.
The Russell 2000 Small Cap Index was below the 50 day, the 200 day, and the 25 day averages on May 3rd. The relative strength, slow stochastics, and other indicators are lower than the S&P 500, suggesting that if the market does rally here, the small caps will outperform.
Stock Market, Sentiment Indicators
As of December 31, 2004, the AAII Index percentage of bulls was 57.7%, the percentage of bears was 17.5%, and the percentage of neutrals was 24.8%. Since a high percentage of bulls to bears is a contrary indicator, the upward movement is not encouraging for the short-term. For the week ended April 29, 2005, the AAII Index percentage of bulls was 29.8%, the percentage of bears was 34.7%, and the percentage of neutrals was 35.5%.
The Chicago Board of Exchange’s VIX or volatility index finished the week ended April 29, 2005 at 15.31, indicating higher than normal fear. The VIX ranged from 11.10% on February 15, 2005 (the height of the market indices) to 19.34% on August 6, 2004 (the low of the market indices). A VIX over 25 indicates fear, a contrary indicator, and a possible buying point. (The VIX is derived from two month of prices of all quoted at-the-money and out-of-the-money S&P 500 Index puts and calls.)
We are in the midst of the pullback predicted in our last Investment Outlook letter.
Foreign Stock Markets
At a seminar last Friday May 6th, a representative from Julius Baer Global mutual fund showed correlation between US stocks and foreign stocks to be approximately 90%, meaning that the 90% of the performance of foreign stocks can be attributed to performance of US stocks. If US stocks fall $1.00, foreign stocks should fall by $ .90 cents. However, he gave other reasons to invest in foreign markets. Valuations are more reasonable. Opportunities for growth are greater. Foreign consumers do not have as much debt; therefore they have more sustainable consumption patterns. We tend to agree.
Housing Market Bubble
Lately, there has been much debate about whether there is a housing bubble. Since 1929 the average annual increase in real estate has been 5.3%. Since 1968 the average annual increase has been 6.2%. In 2004 the increase was above 10.0% in many areas versus around 5.0% in the 2000 to 2002 timeframe. Properties in coastal areas have risen at a greater rate than 10.0% recently. In Q1 2005 prices in the Northeast were 14.1% above those of 2004, according to the National Association of Realtors. Prices in California, Arizona, New York, Maine, Rhode Island, and New Hampshire during Q1 2005 have risen by double-digit amounts. Prices in Florida were up 45.6% during Q1 2005. New home sales are up in 2005. Prices are being driven by low interest rates, low down payments, loss of objectivity on the part of realtors, appraisers, and mortgage brokers, shortages of desirable land, high immigration rates, speculative activity, and lack of supply (of good homes and land). Household or personal incomes are not keeping pace, pushing affordability down. In our view, anytime prices are rising faster than the historical average, there is the potential for a bubble. The present rates are not sustainable, irrespective of whether there is a bubble in a particular area of the US. If the average investor buys stocks at their highs, why shouldn’t he (she) be consistent, continue the irrational behavior and buy houses at their highs, assuming they are at a peak?
Will the year 2006 be a good time to buy a home or rental property investment? Maybe, if the Fed jumps interest rates 2.0% to 2.5% from the present 3.0%, killing the housing market, and a recession develops, the rosy scenario could change quickly. Then we might see some bargain prices.
Valuations
At any one time, the market is either overvalued or undervalued. We believe it is never precisely fairly valued as so many commentators will say from time to time. When Robert J. Shiller published Irrational Exuberance in 2000, he thought the market was clearly overvalued. He still thinks so today. High prices, relative to average, have been followed by lower prices, regardless of fundamental factors. In every market, reversion to the mean takes place.
According to Jeremy J. Seigel in Stocks for the Long Run 3rd edition, the real return on stocks from 1802 to 2001 was 6.9%. Add inflation of 3 to 4% and you get a total return of somewhere north of 10%. Seigel argues that the price of an investment should equal the present value of the future stream of dividends, including buyback of shares from retained earnings. Whether you get a 10% return depends in part on the the price you pay for the investment and the dividends it pays. This bring us consideration of the price-earnings ratio or PE ratio.
According to Seigel, the historical PE ratio of “the market” from 1871 to 2001 has been 14.45. Divide that into the average value of “the market” and you get a figure called the earnings yield, 6.8%, which nearly matches the 6.9% real return, cited above. Seigel says that “the market” represents the entire market value of all stocks of all companies, both large, medium, and small in size. That makes comparisons difficult with individual indices such as the DOW, the S&P 500, the DJ Utilities, the NASDAQ, and the Russell 2000. As of May 13, 2005, the PE ratios for all these indices are all higher than 14.45, (but individually there is variance). Seigel argues that a stable economy, low trading costs, low inflation, and lower taxes justifies PE ratios in the low 20’s, for an earnings yield of between 4 and 5%. Using the historical 14.45 ratio suggests present market overvaluation. Using a PE ratio of 20 suggests only the NASDAQ and Russell 2000 may be overvalued.
For 200 years, the equity premium in the earnings yield of stocks over the rate of “safe” long-term government bonds has been about 3.5%. Since 1926, the equity premium has been about 5.0%. Seigel argues that the future equity premium should be between 2.0% and 3.0%. The earnings yields on the DOW, the DJ Utility average, the S&P 500 Index, and the S&P Industrial Index are all lower than either the 10-yr Treasury note yield of 4.12% plus 2.0% and the 30-yr Treasury bond yield of 4.49% plus 2.0%. Again, this suggests present market overvaluation.
Historical dividend yields have been in the area of 3.0%. Prior to 2004, dividends received by individual taxpayers were taxed at their marginal tax rate. Today, qualified dividends are taxed at a maximum rate of 15.0%. Dividend yields could conceivably be in the area of 2.4% and still be at the historical level. The dividend yield for the S&P 500 Index is presently at 1.89%. Companies aware of the desirability of paying dividends are increasing them, narrowing the gap between historical and present yields. Again, this suggests present market overvaluation.
Gold
We like gold as a long-term hedge against inflation and the declining dollar. Our portfolios have anywhere from a 2 to 5% position in a gold mutual fund. It is possible that gold mining shares could proceed upward to a blowoff top sometime in 2005. As of May 11th the current account deficit was down to 55 billion and the dollar continues to strengthen. Gold in the short term is not attractive as it is moving opposite to the dollar. It will be interesting to see if Warren Buffett covers his $21 billion bet against the dollar. We continue to hold a position in Tocqueville Gold Fund.
Bonds
During the period January 1 through April 29, 2005 we liquidated or substantially reduced almost all bond positions because of a heightened risk of inflation and interest rate increases, and increased money market cash. Due to the flight of capital from stocks to bonds, and the resulting decrease in yields, our move looks ill-advised. We hope the future will validate the decision.
REITS
REITS have outperformed all other asset classes over the last five years, but that trend could be coming to an end. Higher interest rates can be fatal to that trend, as also a slowing economy could be. In January the Green Street newsletter estimated that REITS were carrying a 12% premium over the fair market value of underlying assets. Normally, they carry a 7% premium. Yields have come down from 9% to 5%, generally. We will be patient with investments in this asset class, although we have added a couple of apartment REITS recently, mainly for potentially increasing dividend income. During this four month period, some REITs increased in value because of investor desire for yield.
The Iraq War
Like or not, the costs of the Iraq war are affecting the economy and the budget deficit with no clear end in sight. Moreover, oil production has sagged from 3.0 million barrels a day to about 1.8 million barrels a day, according to Barron’s May 16, 2005, causing high prices for gasoline and heating oil.
SEC Probes and Class-Action Suits
We think bad corporate behavior will continue, but at a reduced rate. We will continue to look for problems in this area as opportunities to short the stock of the problem company. We did take some profits in AIG during the period.
Prudent Bear Fund
Our reasoning for purchasing Prudent Bear Fund was to act as a hedge, along with large cash holdings. At this writing, we have not inquired/investigated as to why the fund is down almost 2%. We will be selling some or all this fund in the very near future, and will look for another hedge that is effective.
Our focus is long-term. We see this correction as short-term. We think the economic weakness will not deteriorate into a recession, but will level off sometime this year. The market will rebound or at least level off, permitting asset allocation into equities.
We tend to focus on dividend yields, sustainable growth, a reasonable price at time of purchase, understandable businesses, and trends in the economy. We have a value approach, generally. We buy both individual stocks and mutual funds. For those accounts with margin, we short stocks occasionally.
Cash
We expect to carry higher than usual cash positions in 2005. We have struggled to find good businesses at reasonable prices to invest in. The current pull back could continue for awhile (see Stock Market, Technical, above). In addition, domestic bonds may be an unrewarding place to be in 2005, thereby contributing to a higher cash position. We are hopeful that our current cash position and defensive-type equities will serve us well in sustaining a reasonable level of portfolio value.
We appreciate the trust and confidence you place in us to manage through the difficulties to date. Source of index information was the online website www.finance.yahoo.com
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