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January 2005
Dear Clients and Friends,
The past year closed with a strong seasonal rally in the
stock market, accounting for most of the gains for the year.
At the end of September the S&P 500 was up only 1.5%,
but finished the year on a high note with a gain of 11%. The
major stock indices broke out on the upside in mid-November
after the elections were decided. At the same time, the price
of crude oil, which had soared above $55 per barrel, broke
its uptrend ending the year at $43. Stocks were quite resilient
in 2004, finishing in such a positive position. They overcame
the spike in energy costs, the huge trade and federal deficits,
financial industry scandals, elevated commodity prices, a
"soft patch" in the economy and five increases in
the federal funds rate. Real estate values, with the help
of very low interest rates, recorded remarkable gains as the
median home price in the third quarter rose 7.7% from one
year earlier. The bond market also fared reasonably well with
the interest rate on ten year U.S. Treasury Notes ending very
close to year ago levels, in contrast to expectations that
called for them to yield nearly 1% higher than the 4.2% year
end rate.
The U.S. economy advanced at a good clip despite some headwinds
and is expected to show a gain in Real GDP of 4.4% for the
year. Rising energy prices had a negative effect on growth
and may continue to do so over the coming months, but a survey
of economists calls for a 3.5% advance in 2005, close to the
long-term average of 3.3% since 1954. The year should also
see oil prices dipping below $40, core inflation trending
slightly higher, further incremental increases in short term
interest rates, and corporate profits gaining 6% or more.
This moderate growth, low inflation environment presents a
positive background for stocks and bonds; yet slowing earnings
and the Federal Reserve's commitment to further increases
in short term interest rates have caused investors headaches
in the past and cannot be brushed off.
After three years of reflationary fiscal and monetary policy
in this country, a shift to restraint has begun. Federal Reserve
officials are reported to believe that inflation risks are
increasing. They cite slowing productivity growth, the declining
dollar, high energy and commodity prices, and growing evidence
of businesses raising prices to pass along the surge in raw
materials costs. The Consumer Price Index (CPI) was up 3.5%
year over year in November and up 2.2% excluding food and
energy. Excluding the sizable rent component of the index,
the gain measured 4.1%, the highest since March 2000. Even
though most economists do not foresee a problem with inflation
this year, the Fed's actions will have a significant impact.
Moreover, the investment markets will have to adjust to the
fact that Chairman Greenspan will be stepping down within
the year. At this point, however, the markets are expecting
no major economic problems as evidenced by the extremely narrow
yield spreads on low quality corporate bonds over U.S.Treasuries.
Despite high energy prices, large debts and a low savings
rate, consumers have continued to spend. They have been encouraged
by an improving jobs market, rising incomes and growing net
worth as real estate prices have elevated. The latter has
become a major source of "savings" as consumers
spend virtually all their income and then some with borrowings
against appreciating property values. Some analysts believe
there is a new "bubble" in real estate prices, which
could be in the process of cresting as interest rates rise.
The consumer's extended position contrasts with Asian and
OPEC countries that have been described as being "awash
with savings." The U.S. trade deficit has left them with
large sums to invest. Even though some funds are moving into
the Euro as the dollar has declined, the objective for foreign
central banks is to keep their currencies from climbing too
high, thereby pricing their goods out of the market.
Corporations are also sitting on large quantities of cash.
The economic recovery of the past few years was notable for
widespread cost cutting and low employment growth resulting
in expanded cash flow, record high profit margins and greatly
improved balance sheets. Although bearish commentators warn,
"It doesn't get any better than this." such a strong
financial position creates a number of opportunities that
should be good news for shareholders. Cash dividends have
been increased materially, encouraged by lower tax rates.
Share buybacks are growing and mergers and acquisitions are
also accelerating. Corporate debt to net worth is the lowest
in thirty years. Corporations have the cash to boost spending
and increase hiring if the "animal spirits" among
managers move them into action. In addition, changes in the
tax laws will now allow U.S. corporations to repatriate an
estimated $300 billion in foreign profits at a 5.25% tax rate
in 2005.
Stock market strategists project moderate gains for the averages
this year, most within a range of 5-10% for the S&P 500,
in line with the estimated increase in earnings. This growth
contrasts with the four back-to-back quarterly earnings gains
in excess of 20% through June 30, 2004, but is consistent
with an economy transitioning from recovery to a more sustainable
rate of expansion. Although there are many uncertainties ahead,
equities seem more attractive than other asset classes over
the next few years even without a return to the "irrational
exuberance" of the late 90's. The stock market begins
the New Year with strong momentum as investors continue to
commit fresh cash to equities. As some stocks become fully
priced, profit taking seems prudent as does the maintenance
of cash reserves to take advantage of unpredictable drops
during the year. High quality companies with solid dividends
and some with international exposure should perform well in
2005.
Sincerely,
John L. Simpson, CFA
Chief Investment Officer
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