Year-end stuff is always hard to fit in around the holidays, vacation etc. So, this will serve as the last newsletter of the year, the presses will once again begin printing January 3^rd with our forecast edition. Once Greenspan makes his decision (with the support of the Fed – of course), he too will be hitting the eggnog. However, not before raising rates one more time to cool the…. (What again was he cooling?). Our best guess for the reason behind the rate hikes are to eliminate the discount that interest rates are currently experiencing to the rate of inflation. Also, there is some desire to flatten the yield curve, the difference between 30-year bonds and short-term t-bills. What makes the rate hikes unusual this time around, is a lack of credible and persistent strength in the economy. Inflation remains low, save for the very volatile oil component (now approaching $40/bbl), capacity for expansion remains voluminous and employment can not generate jobs at a pace approaching anything we have seen during past recoveries. What will be important for the markets will be the comments from the Fed, do they copy last month’s commentary or come up with some new way to describe the current economy. Once past this Friday – a quadruple “witching” (options expiring), we expect the remainder of the year to go quietly into the good night.

We believe we have already seen the Santa Clause rally (better described as a turkey rally this year) and the markets are beginning to set themselves up for the turning of the calendar. If so, the beginning of ’05 could begin fairly bumpy, especially in OTC names. Unlike the past three months, we are beginning to see volume favor declining days, unable to generate significant volume on advancing days. Also, up to last week, the majority of volume was concentrated in advancing stocks, a situation that tends to ebb and flow over time, so to persistently stay at or above 60% only happens during early phases of a new bull move. The figures are less severe on the NYSE, however are in the upper reaches of “overbought”. The weekly data does not provide much consolation, as they are in the early phases of turning lower. While it usually takes anywhere from 6-9 months for the weekly data to move from one extreme to another, it may be forecasting a tough beginning to ’05. Finally, oil and the dollar: oil price momentum seems to be on the downside, while the dollar may have temporarily ended its own decline.

The huge decline in commodity prices (up only 5% year/year) combined with the still declining 30-year bond, has pushed the bond model back to a favorable status with 4/5 positive (after 5 weeks in “negative” territory). Even though the Fed will raise rates again this week, and according to the pundits that watch this stuff, also again at their next meeting in the first quarter, the 30-year bond is up in price (down in yield) for the year. The lack of economic strength in the economy and still low inflation rates has served to keep a lid on long bonds. Since the Fed operates at the short end of the yield curve, they are effectively taking the yield curve from a historically steep 4 percentage point spread to its lowest level in three years – a yet still steep 250 basis points. We expect that the yield curve, when all is said and down, will be in the 100 to 200 basis point range during ’05, taking out much of the juice that has been enjoyed by financial intermediaries that have been borrowing short and lending long to capture that fat spread. If the goal of the Fed is to flatten the curve, then indeed another rate hike is in the offing early in ’05.

With oil prices getting ready to cross below $40/bbl, it should come as little surprise that oil stocks and groups are falling hard in our ranking of industry groups. Since they have not hit the cellar, we expect oil issues to remain weak into early ’05 before finding a bottom, maybe around $35/bbl. Metal stocks are also beginning to show weakness, helping the CRB index decline over 5% in just two weeks. While good for the consumer, we don’t expect it to translate to renew spending by the consumer who may find a few extra bucks in their back pocket. Retail issues are also making their way to the lower echelons of the ranking system as well, as Christmas shopping is coming in a bit below expectations and many are looking at a VERY tapped out consumer without the benefit of another refinancing cycle, tax cuts or lower interest rates. So where are investors hiding? In the usual “safe” places, consumer “non-durable” and the very beaten down healthcare sector. After spending much of the past two years as the punching bag of investors, ’05 just might be the year of healthcare issues. While clouds still remain (especially surrounding big pharmaceutical companies) the purchase attempt by JNJ of Guidant (GDT) may be an indicator of how cheap the sector has become. While even some big pharma names now sport yields twice that of money market funds, investors have stayed away from these historically fine companies. We will be reviewing our outlook for ’05 in the next newsletter – until then, enjoy the holiday season with friends and family.

We expect a bit of volatility this week around the Fed meeting, where it is expected they raise rates. We are not going to make any changes in client accounts before yearend, as we are happy with our focus on international stocks and domestic value names. We remain focused on bond that mature in the 5-10 year range, as they should be unscathed by the Fed machinations. While we have more than usual still in small stocks, we may be in the early phases of a shift toward large stocks that may become the investment story in ’05 – stay tuned!

© 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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