January 2005
Thanks to a powerful fourth quarter rally in stocks and a surprisingly well-behaved bond market, investors should once again feel good when they gaze upon their investment results for 2004.
Despite the war in Iraq, a substantial rise in oil prices, and the horrible devastation in southern Asia, the stock market was able to add on to the generous returns of 2003 instead of giving some of them back. Investors took on risk, got rewarded for it and were not shy about asking for more. The bull seems to be in charge of the market as we enter 2005 but, like last year, we remain cautious. We are not easily finding cheap stocks or bonds after the recent rallies. It all comes down to price and at a time when future growth rates of many companies are in question, we think they are too high. That is why we will continue to focus on protecting our clients' portfolios while searching for attractively priced investment ideas.
Once again, size did matter in the stock market and bigger wasn't better. For the second year in a row, small-cap stocks outperformed their larger brethren by a wide margin. The Dow, which is made up of 30 of some of the largest US companies, had the worst return of any of the popular market indices. It was up a little over 5% after including dividends. That is a paltry return compared to the Russell 2000 Index of smaller companies that rose to all-time highs with a return of over 17%. The days of 15-20% average annual earnings growth seems to be long gone for the icons of Corporate America, such as GE, Coca-Cola, Microsoft and Wal-Mart. The stock market has begun to make the necessary adjustments to their stock prices to reflect this natural slowdown.
The biggest surprise to us in 2004 was how well longer- maturity bonds performed in a growing economy where short-term interest rates more than doubled and inflation showed signs of heading higher. The yield on the 10-year U.S. Treasury note ended the year almost exactly where it started at 4.24% and the yield on the 30-year Treasury bond actually declined from 5.1% at the beginning of the year to 4.8% at yearend. We had conservatively structured our clients' bond portfolios to benefit from the higher interest rates. That event never came to pass in 2004. We think it will in 2005.
Bond investors did earn a decent return from bonds if they were aggressive enough to purchase low-rated bonds, including junk bonds. The yields on these bonds continued to decline in 2004 as investors sacrificed safety for higher income. Investors are now only getting about 2-3 percentage points more in yield for securities that are no doubt far less secure. That is not very enticing to us.
Although we are very happy that both the stock and bond markets provided us with another year to earn ample returns for our clients, we don't think we are in a new bull market for stocks. We think there are four major reasons that the market has limited upside potential from where it stands today. This does not mean we cannot find good investment opportunities. It just means that we have to select them very carefully.
First of all, at the risk of sounding like a broken record, we believe that the valuations of most stocks are too high for the economic environment we see in the future. New healthy bull markets usually start prior to the end of a recession with average price/earnings ratios less than 10 and dividend yields over 5%. This market started to rally almost two years after the recession was over with an average price/earnings ratio near 20 and a dividend yield less than 2%. With the current price/earnings ratio already near 20 and the long-term average price/earnings ratio for the market being about 14, it is very difficult to see how higher valuations can contribute much to stock returns going forward.
Secondly, we see a significant slowdown in corporate earnings growth in the years ahead. American businesses have been very skillful in squeezing more profits out of every dollar of sales over the past few years. We think that trend is coming to an end and companies will have to begin to hire more people and pay them more. Profit margins will also be squeezed by higher energy and healthcare costs. Unfortunately, while more companies are beginning to raise prices to try to cover these higher costs, tough foreign competition will limit those increases and earnings growth should suffer. We think investors will also soon come to the realization that many large companies will simply not be able to grow internally at the kind of rates they have in the past and will need to acquire much of their future growth.
The third reason we think the stock market has limited upside potential from here is because we expect to see interest rates continue to increase and we don't mean only short-term rates. We believe that the economy will be strong enough for the Federal Reserve to continue to raise short-term rates with measured steps. It is our opinion that inflationary pressures will continue to build and we feel that bonds are overvalued. Investors should stay defensive by limiting their average maturities and sticking with quality rather than reach for yield. It goes without saying that a rising interest rate environment is normally not good for stocks, especially when earnings growth is slowing and valuations are already high.
The final reason we are concerned about the stock market is because most people aren't. The majority of investors think that 2005 will be at least as good as 2004 and even see the bull market continuing into 2006. That fact that the recent election rally included the good, the bad, and the truly ugly stocks is a clear indication that this market is not overly concerned about risk.
We are confident that money can be made in difficult financial markets. We also know it takes a different skill set to know when to protect rather than stretch. It strikes us as intelligent investment behavior to simply await better buying opportunities than we see today. Without fail, it always happens when the crowd least expects it.
John W. Gudritz, CFA
john@frontstreet.com