1st Quarter 2005: The Good, the Bad, and the Ugly

First Quarter 2005
Market Commentary

The Good, the Bad and the Ugly
A 2004 Recap, and a Peek Into the Future

The Good

2004 ended with the Dow Jones up 3.2%, the Nasdaq up 8.6%, and the S&P 500 up 9%. Most of these gains were the result of a year-end post-election rally, largely as a result of closure on what had been a very contentious and divisive political campaign that dominated and consumed the first three quarters of the year.

As a backdrop to all this, however, the economy has been unfolding quite nicely. Corporate earnings experienced a very strong 2004 that analysts estimate will end up 5% for the fourth quarter, and close to 20% profit growth for the year, once the numbers are complete. 1

Gross domestic product (GDP) grew at a 4% annualized rate in the third quarter, versus a 3% rate in the second quarter. The final number for the year expected to come in close to 4% as well.

Job growth, while less than many economists would have liked, was nevertheless the best in five years, with over 2.2 million new jobs created (that is from the factory report, which only samples large business, and does not include any job creation by the broader household survey). The later survey, which picks up changes in job growth from families and small business also added to the number of jobs created, and helped keep the overall unemployment rate down to 5.4%, an historically low rate.

Manufacturing has been strong all year, funded by relatively low interest rates, and a pent-up worldwide demand for complex, high quality machinery. The Institute for Supply Management, which keeps tab on manufacturing production, reported that manufacturing activity expanded in December for the 19th consecutive month, and "has significant momentum going into the first quarter of 2005." 2

Retail sales were up for the year, but were somewhat moderate relative to manufacturing. High-end stores did well, on-line sales were very strong, and discount chains continued to gain market share. Overall, the blended results are expected to rise approximately 3-4%.

Finally, consumer confidence has been slowly rising. The (National Industrial) Conference Board reported on December 29th that their survey ended the year on a high note, up 10% from the prior two months, and "has consumers ending the year on a high note." 3

The Bad

We should first clarify that what we list as bad, are actually - for the most part - steps that we endorse and find necessary. We are viewing these factors only from the perspective of how they might affect the financial markets, both equity and debt.

Oil prices, which have been in a strong up trend through most of 2004, have now begun to settle back, but are still in a very high range. During the summer and into early fall, prices rose from $36.00 to as high as $55.00 per barrel, before dropping back to $47.00 currently. This is still significantly higher than a year ago when it was priced at $32.00. Each one-dollar increase in the cost of crude oil acts as a tax on consumers and businesses and is a restraining factor in economic growth. While the price setback is welcome, our opinion is that energy prices will continue to exert downward pressure on the economy.

Our opinion is that there will be a restraint on fiscal stimulus, as Congress will rein in government spending due to concern about the deficit. Defense stocks are already responding to this reality, as programs get pushed out, and orders are cut.

Greenspan has already set the stage for some monetary restraint, having raised interest rates five times since June, and quite probably a sixth by the time you receive this report.

Inflation - The consumer price index rose at a 3.7% annual rate for the first 11 months of 2004, 4 verses a 1.9% annual rate for 2003. Fed Chairman Greenspan in his latest "Beige Book" summary pointed to these figures as a rationale for his interest rate policy.

Slower growth - The stimulus (both monetary and fiscal), which helped drive the economy in 2004, are both slowing down, and the consequence of this will be slower earnings growth in 2005. Preliminary estimates for corporate earnings for this year are slightly above 10% - still good, but below the 20% rate of 2004.

The Ugly

Twin deficits - Our last commentary 5 discussed the bulging budget and trade deficits, running close to $1 trillion annually between them. The restraints listed above are designed to address these problems, but will fall far short of solving them. As a consequence, they will continue to act as a drag on the financial markets, both equities and debt.

Trade - There is one additional thought on the trade balance specifically, that we did not mention in our October report. The headlines that most people read deal with the dollar's fall versus the Euro, which has been significant over the past year and a half. What is not stated is that on a trade weighted basis, the value of the dollar, even after its recent fall, is approximately the same as it was 10 years ago. The U.S. dollar index (which includes the Japanese yen, British pound, Canadian dollar, Swedish krona, and the Swiss franc, as well as the Euro) is a more significant number. Remember that we just passed through a 10-12 year period where the dollar was rising versus other currencies (see chart below).

This isn't meant to modify what is a serious problem, particularly after our government just reported a $60 billion trade deficit for the month of November. But it is meant to put the problem into a longer term perspective. What the U.S. dollar index shows is that the current level of the dollar versus those six currencies is back to its level of 10 years ago, and thus no worse than it was before the previous rise mentioned above.

It's also important to note, however that the largest and fastest growing component of our trade imbalance is with China, which has pegged their currency against the dollar, and is not included in this index. If the Chinese government were to allow its currency to float versus the U.S. dollar, which is what the U.S. is advocating, the dollar would have further to fall vis-à-vis China, but might well rise against our European trading partners. We will comment on these developments further in future reports.

Iraq - Our list of problems would not be complete without mentioning Iraq. U.S. casualties have been increasing in the past couple of months. All we can say is that we hope and pray that there will be a cessation of hostilities, and that the elections due on January 30th proceed successfully.

If that happens, we will see a big upward bounce in the market. Absent that, the results could be negative enough to cause serious problems here and abroad. We will keep you posted on our thoughts as we progress through the year.

A Peek into the Future

Looking forward to the markets in 2005, we see a continuation of several themes we have pursued and commented on over the past year. Foremost among these is our assessment to favor dividend paying common stocks; both high yielding stocks such as utilities, and growth companies which have been raising their dividends. Implicit to our thinking is the 85% tax exclusion of corporate dividends, and the reduction of capital gains tax to 15%.

We view these changes as having a dramatic fundamental effect on the valuation of equities, and note that major corporations, one by one, are lining up to increase their dividends. In fact, there have been more dividend increases in 2004 than any year in recent memory, and 2005 looks to be more of the same.

With the increasing volatility that has played into the market in recent years, particularly after 9/11, investors want more of their returns sooner rather than later, and corporations are responding to these demands.

Social Security

Politically - Here at home - the Bush re-election has set the stage for two items on his agenda that could have far-reaching ramifications on our financial markets. Depending on how the markets and investors perceive these items, and how they play out, they could become good, or bad, or ugly.

The first of these are his proposals to fix social security by allowing individuals to set up private investment accounts, which could invest in common stocks. Our take on this is as follows:

1) It's commendable to at least address the problem. Ever since the late Senator Moynihan of New York passed away, there has been little talk on either side of the aisle of reforming social security, or to face up to what is a serious problem that could implode on us 15-20 years out.

2) Our understanding is that the rate of return on social security funds (those which haven't already been spent or used to offset the deficit) has averaged somewhere in the 1 ½% range - compounded over a number of years. On the other hand, the stock market, with all its volatility and head fakes, has still been able to generate returns over long periods of time in the 9% range.

3) Where Bush's idea falls down, in our judgment, is with individualized accounts. Every money manager in the country was down in the 2000-2002 time frame, and millions of investors got caught with 401k plans that dropped significantly in that period. To assume that John Q. Public will become sophisticated enough to manage his or her retirement in the stock market is probably wishful thinking. Those that choose sound conservative investments should do very well; but there are enough people who will try to earn unrealistic returns that could bring the whole program down - and the government would then have to come in and pick up the pieces.

4) Having said that, we think it is prudent to have a certain percent in common stock, particularly since the fund itself has a long-term duration, and that the probability of higher returns than what we've been getting over a reasonable time period are very high.

5) So where we think it will end up is that Congress will buy into the idea generally, reject Bush's proposal specifically, and start out with a 5-10-15% of current cash flow into stocks; and that it will be professionally managed.

6) Bottom line - the strategy is good, and it may end up with the tactics being good as well. There should be lots of quality parameters if such a plan is passed, which we believe is probable, and should play into our theme of dividend paying growth stocks. As the year progresses, it will help to give support to the market, since even a small percentage of social security funds will create a significant incremental demand for stocks.

7) Having said that, it also is suffice to say that earning a higher rate of return on social security funds is only one part of the problem. They also need to address funding requirements, changes in benefits, and extending the retirement age. Most important, they need to set up an accounting process that recognizes and addresses un-funded liabilities. Watch for this to become one of the major developments in 2005.

The second item that the President is trying to implement is a major change in the tax code. We doubt that much will get done specifically in 2005 on this proposal - but we think it's a major development in that it raises the probability that the 85% tax exclusion and the 15% capital gains rate will both stick. That will allow investors to better plan their investments, should help bring a layer of stability into the market.

Dicentennial Pattern - One other item of note for those of our clients who are interested in trivia, is the fact that every year ending in 5 since 1885 has ended in the up column, and with double digit returns in each occurrence over the past 100 years.

Conclusion - We're obviously not banking on the above statement, however, we note that all the negatives listed above are widely known, and are probably priced into the market.

On the other hand, our assessment is that the underlying strength of the economy is better than most people believe. We think that a combination of fiscal and monetary restraint - while interpreted negatively at the outset - may well wind up as a positive - later in the year. This will occur if investors believe that some form of discipline is being applied to our deficit(s). That is not the case now; any change in that opinion will lead to upward progress in the financial markets.

We also think that interest rates will be somewhat contained. The five interest rate hikes referred to earlier have still not had an impact on longer rates. The 10 year treasury, which has become a proxy for the bond market, is still yielding 50 basis points (1/2%) less than in June 2004. (4.75% then; 4.27% now). While we look for longer yields to slowly raise with further increases in short rates, we do not believe it will be enough to topple bond prices. (So far, it has had the opposite effect). The federal funds rate is now 2.25%; we can envision it rising to 3 ¼% to 3 ½% by year end, along with the 10 year treasury yield possibly rising to the 5-5 ¼% rate.

All of the above lead us to believe that we will have a continuation of a choppy market in the near term, both in stocks and bonds - but that by year end we will see decent returns in the stock market and a flattening of the yield curve in the bond market.

Finally, despite all our problems, America remains the world's sole economic, military, and political super power. That reality should resonate on a net positive with investors as the year goes by.

Happy New Year to all.

Bill Schnieders

Jim Schnieders, CFA

*Please call the office at 626-584-6168 for a copy of the graphs.

[1] Thompson First Call, 1/2/05
[2] Yahoo News, 1/3/05
[3] Wall Street Journal, 12/29/04
[4] Los Angeles Times, 1/2/2005
[5] www.schniederscapital.com - Fourth Quarter Commentary 2004


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