It is that time of year when all good prognosticators pull out their crystal balls and look intently into the future and begin making predictions. If they are lucky, a few will actually come true. However the sad truth is many fall well short of the mark. We suffered a bit in the past year for not giving the rebound much credibility, and as a result, were much more conservative that we should have been. We did, however, offset that one poor call with a very good one – overweight the small and mid cap stocks. They doubled the performance of the S&P500 and went a long way to repairing our conservative bend on the year. So much for ’03 – what have you done for me lately? We will, over the remainder of the newsletter, outline our views on the markets, sectors and pick a couple stocks that may actually do well in the coming year. We always enter the new year with one resolution – to do better than we did last year. And if successful, we should all be ale to stand a bit taller come this time next year. It is our view that the easy money has been made, and it will likely be tougher to show terrific returns in ’04. We are already contemplating pulling back from our heavily weighted small cap position toward large cap value. Finally, what has been working is not likely to be working at the end of ’04 – adjustments will need to be made to be successful.

The low volumes of the last week (and again this week) will make technical analysis difficult, until everyone gets back from the office parties. So we will begin to lay the framework from which we will be making investment decisions in ’04. First: relative valuations. After being so undervalued vs. large stocks over the past three years, small stocks are now on par to slightly overvalued vs. large stocks – roughly equal to the mid-90’s when large stocks dominated. We will be placing greater emphasis on large stocks in ’04. Second: Our stock model. Based upon interest rates and dividend yield, it has done a relatively good job of making “calls”; it did miss a bearish ’02 but hit ’00 and ’03 correctly. In 56 years, there have only been four back-to-back “positive” readings, such as we are entering in ’04. Only ‘81/’82 did the return in the second year exceed that of the first. With a small data set, we feel somewhat certain that ’04 will not be as good as ’03. Finally: our technical models. While they have generally confirmed the rally this year, they have been developing some divergences that should be monitored. If we look at prior years ending in “4”, the first half is a toss-up, with a strong final quarter. So if the market were to follow our plan, a trading range year that will finish up by no more than 5% is our call.

The bond model has done a fair job of keeping us in bonds when rates fell, and out when they were rising. Bullish through much of the year, it became negative in mid-July, when the long bond was 4.90%, briefly positive during September, negative again until this month. From point to point, the long bond remained unchanged at 4.95%, while short rates, already at 1.2%, fell even further to their current 0.88% rate. Our best call for income clients was to heavily weight junk bonds, however given the tremendous returns in this sector during the year we are likely to pull back on that “bet”. Although the model is not yet calling for it, we expect rates on both the long and short end to be higher a year from now.

In what may best be called a ’99 redo, technology stocks shone during the year. However, unlike ’99, other groups participated, including retail and basic material stocks. Gold stocks shot up 50%, providing prognostications of hyper inflation given the monetary stimulus provided the economy by the Fed and the government. While not likely to continue, it has pushed many of the basic material groups to the head of the class as the year closes. From last year’s top list, gold, consumer electronics and internet services managed to stay on top for most of the year. Among those entering ’03 at the bottom, steel (up 62%) airlines (up 28%) and semi-conductors (up 83%). Although the average return from the top 10 and bottom 10 groups were roughly equal the top group had four times as much variation in returns. So this year we will look to the bottom to gain some insight into ’04. Among the bottom groups are airlines, fixed line communications, telecom, pharmaceuticals, and consumer stocks (beverages, cosmetics and food). If the market follows our plan, the volatility and smaller overall returns will tend to favor income stocks and those that will deliver consistent earnings. We have already begun to build our pharma exposure and are looking at the consumer stocks for new investments.

We are expecting 2004 to be something less than 2003, at least as far as S&P500 returns go. We expect small stocks to at best, match returns of the large stocks. We also expect a relatively small positive return and our investment thesis will be to return to solid and consistent stocks like the pharmaceutical and consumer companies.

© 2003 Paul J. Nolte, CFA
Editorial Archive

The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

CONTACT INFORMATION
Paul J. Nolte, CFA
Director Investments
Hinsdale Associates
630-325-7100
Email