Now that the year has officially begun, the markets have fallen (at least the Dow), correcting the excesses of ’03, let’s make it two in a row for higher prices! While we are forecasting a higher Dow and S&P500 close for ’04, it should not be as relatively straight up as the last three months of ’03. The economy seems to be actually building steam, as indicated by the ISM survey, with readings at seven-year highs. Those filing for unemployment are fewer than they have been in a long while and bullish comments abound with the outlook for the election year. Expectations are for no rate increases from the Fed during the year (remember, Greenspan is a Republican and would NEVER raise rates during an election year – just ask Geo. Bush Sr.), continued weakness in the dollar, (albeit at a less rapid clip) and a still booming economy. From this the markets should trend higher as earnings finally catch up to expectations (and prices) and the currently high PE of the market remains relatively stable. That is the prognosis, however, as usual, we respectfully disagree. We foresee a poor first half of ’04, as the markets fully digest their gains from ’03 and maybe worry a bit about the election. We do see rates getting bumped higher in ’04, but a fairly strong yearend rally should push the market to gains for the full year. For now we remain a bit defensive.

Another week of vacation volumes and positive price action gave the equity markets their first gains in four years. While we far from disappointed in the market’s performance for the year, it strikes us that stocks that were the ugly ducklings coming into ’03 (poor or no earnings, levered balance sheets and poor “quality” rankings) were the swans exiting ’03. We believe that quality will win out during ’04 and are beginning to upgrade the portfolio toward those type of names – pharmaceutical and consumer stocks remain high on our list of issues that we are interested in. Also, we feel that the energy sector could have a run, as rig counts remain high and rising, oil prices also remain high and are also rising and many investors are underweighted this particular group. Getting back to the technical condition – the market remains in overbought territory, and a correction should be on the horizon (not much new here). What will be interesting to see are the volume patterns early in January, as the market had generally low volumes throughout the year, actually falling below ’02 levels. Institutions will be bolstered in January with retirement inflows and will need to find a place to invest. Currently the “dumb” money, or the small investor, has been a heavy buyer of equities over the past two months and may be disappointed with returns early in ’04.

The bond model slipped just a bit last week, as rates on the 30-year bond backed up in the face of a “rallying” economy. The CRB index remains remarkably stable at higher levels, with gold, oil and grains taking up the slack from a weaker meat complex (thanks to mad cow, the livestock prices fell hard during the week). The interest rate market is likely to be driven more by economic news in ’04, as expectations have been raised for further growth. If the past week is any indication, interest rates could by higher by 50 basis points, especially the long end, by yearend. For the last nine quarters, the short term Treasury has been under 2%, and under 1% for the past six months. We expect that to change during ’04.

While the markets moved higher over the last two weeks of the year, the low volume may be hiding some shifts in the industry groups that we will be watching early in ’04. Among the best of the lot during ’03 were housing stocks. Low rates provided the fuel and “the only good investment” for the past four years the reason to keep buying the group. After correcting during mid-’02, this group has been non-stop since. However, maybe confirming the housing weakness has been tandem drops in REIT and building material stocks. Still rising through the ranks are more cyclical groups like rails, tires, paper and auto stocks. While the two extremes of our group rankings were relatively stable over the holiday weeks, there were a few notable changes. First are the food retailers. After enjoying the limelight during the bear market, the 66% decline in Winn Dixie (WIN) and strikes at Safeway (SWY) stores as well as competition from Wal-Mart have hurt the group. We may be seeing the beginnings of their return from the dead, as Albertson’s (ABS) and A&P (GAP) may be following the smaller grocers higher. So far, the supply chain is strong, with Sysco (SYY) still performing well and niche players like United Natural Foods (UNFI) and Whole Food Markets (WFMI) remaining strong.

We are willing to watch the first full week of trading in ’04 before passing judgment on whether stocks will correct early or late in January. We continue to see signs of fatigue in the broader averages, however remain respectful of the continued rise. We are also expecting to reduce our heavy small cap exposure during the first quarter.

© 2004 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
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