FSO Contributor: Paul Nolte, CFA "Nolte Notes" for 01/03/2005

For investment gurus, the first trading day of the year is always a bit melancholy, what has gone in the past has been erased and absolutely everyone is back at the starting gate. What has gone before wasn’t too bad, back to back gains in the SP500 and better gains in small and foreign securities. Even bonds performed well, as many flocked to the security of government bonds. Some “odd” securities, like gold and oil were among the best performing assets during 2004, with gold building on a good 2003. So what does 2005 hold for investors? Economically speaking, it could be an inflection year, with tax breaks and easy money ending in ’04, consumers’ maybe tapped out, and a weak currency to boot. As it is not nice to fool Mother Nature, it is also detrimental to one’s investment portfolio to count out the consumer. For the past 15 years, the consumer has continued to spend, even though earnings growth is below inflation, healthcare costs are rising, oil prices are rising, jobs have moved elsewhere and everyone’s in debt up to their ears. Even though the savings rate is nearly zero, we just cannot count out the consumer, with more tricks up their sleeves than Bullwinkle, this just may, once again, be the year of the consumer. If not, it could be a tough year for investors of any stripe, domestic or foreign, equity or income.

While we may be a bit more on the side of the half-empty glass, the reality is that the markets will continue to go higher, until they stop doing so. And so far, there has been little evidence that the markets are ready to stop doing so. We enter 2005 with a few historical comments: first, it is true that over the past 130 years, those years ending in “5” have ALWAYS gone up. It is also true that the first year of a presidential term is usually the worst of the four years. Further, for those re-elected the first year is (with the exception of Clinton and Reagan) a negative year. So, if our crystal ball is at all clear about anything, what does 2005 have in store? Based on our analysis of both current trends of the markets and likely economic and earnings news over the course of the year, we are prognosticating that 2005 will be fairly close to the zero line, with the first quarter of the year to be the best part of an otherwise flat to negative year. We were just under the market returns for ’04, and had the “outline” of the year pegged well (lousy until the last quarter), but if ’05 is indeed an “inflection” year, we could indeed be on a roller coaster ride.

The story of ’04 in bonds was the flattening of the yield curve, forced by an aggressive increase in short rates by the Fed, while still maintaining a relatively quiet picture on inflation. The current “spread” between long and short rates is at its narrowest in over three years and is on its way, we believe, to a more normal spread of around two percentage points. If correct, the intermediate and longer-term bonds should hold up relatively well, while short rates provide little in the way of real return. Since September ’02, commodity prices have been increasing at a year-to-year rate of over 10% (save for a few weeks here and there). This huge and consistent gain in basic material prices has not found its way to either the producer or consumer level, where those rates of “inflation” remain well under 5%. We believe what is occurring and we will see more of during ’05 is companies absorbing the raw material increases and forcing margins lower and unless sales continue to grow, earnings that will either flatten or decline from ’04 levels. Since the Fed’s goal is to get rates over the inflation rate, we are expecting more increases early in ’05 – that will also force the flattening of the yield curve.

Oil, gold and consumer related issues did very well during ’04, and should take a back seat during ’05 to other groups that may yet (finally?) begin to bloom. We highlighted utilities early in ’04, along with industrial and material stocks – all of which performed well. We missed the continued resurgent technology sector (especially the poorly financed ones!) and hailed the recovering healthcare sector a few too many times. The sector work has done well over time, but the week to week movements become merely noise in an otherwise trending market (lower for 9 months, then higher for three). At SOME point the healthcare area will take the fore, if not the big pharma, then the ancillary companies. We are seeing some of the smaller stocks and related businesses do well and valuations of some stocks are down right cheap. However, cheap stocks can get cheaper still, and that is why we look to our rankings to help us determine when a group is finally making its way out of the cellar and may be the early phase of a good long-term move. Finally, we will comment briefly on the large stocks vs. small stocks. We have seen out performance by small stocks that has run four consecutive years – and by a wide margin. We believe that ’05 may finally be the year for large stocks. Valuation measures between large and small show small stocks overvalued by their largest amount in over 10 years. Also, growth, for the first time in 10 years, actually looks cheap compared to value. It may also be that ALL market sectors are overvalued – especially when you look at a 50-100 year perspective.

Until small and value investing stops working, we are going to stay with it. We feel that much needs to go right for ’05 to be a decent year, and the risks remain on the downside vs. upside. As such, we are STILL cautious toward the market, but allow for a decent first quarter. The dollar should continue to decline, making foreign investing profitable again. Without fiscal and monetary stimulus in ’05, an economy that is still laboring hard to grow and a tapped out consumer, ’05 should be an exciting year to watch unfold. We will be here every step of the way!

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