After hovering near unchanged for most of the year, stocks rallied from late October through year end as investors’ uncertainty about the US presidential election was finally put to rest.  In May, we wrote, “It looks like Bush will retain all of the states from the 2000 election, possibly pick up a few more, and will win in the Electoral College.”  With the exception of New Hampshire shifting to Kerry, this is pretty much how the election turned out.  We positioned our clients for a Bush win and were nicely rewarded over the last three months.

Our forecasts for 2004 also included:

• S&P 500 up 8%; the final number was a gain of 8.7%. 
• Earnings growth for S&P 500 companies of about 12% for 2004; final number is 19.2% (from FirstCall.)
• Fed Funds 50bp higher at 1.25%; final number was 100bp higher at 1.75%
• 10 year yield over 5%; in fact, the 10 year started and ended the year near 4.25%, peaking briefly at 4.75% in August.
• “The US dollar remains flat to lower, which reduces demand for US dollar denominated investments from non-US investors.”  The dollar moved higher against the Euro through the summer, then fell sharply for a year to date loss of 8.1%.  Against the yen, the dollar fell 4.3%, with most of the loss occurring in the 4^th quarter.
• “Oil prices remain higher than the $25/barrel we had projected earlier this fall (currently oil is around $31/barrel.)  Demand for energy remains solid in the US and is increasing in rapidly industrializing countries such as China and India.”  Our forecast of demand was on target, but numerous supply disruptions pushed oil above $55/barrel, and it closed out the year around $43/barrel.

The only element of these forecasts that surprised us was the 10 year remaining in the 4.25% range.  After a period encompassing 2002-2002 where our forecasts were frequently upset by external events, we’ve entered a period of stability and predictability.  What will happen in 2005?

Politics

Now that the intensity of the election has subsided, so perhaps has the hyperbole.  George Bush pulled out a modest win in the Electoral College (53% of the vote) and general election (51% of the popular vote.)  Aside from the disputed 2000 election, it was the closest popular vote since Carter beat Ford in 1976, and the closest electoral vote since Wilson beat Hughes in 1916. 

The Geographical Electoral Map shows a huge swath of Republican states dominating the country; the Population Electoral Map shows the country evenly divided between the Democratic North East, Industrial Midwest and West Coast states and the Republican South East, Central and Western States.  Since the Geographical map was used most commonly during election night reporting, Americans generally have a distorted view of their own election.  The Electoral Map colored by percent of vote mostly shows purple, with reddish and bluish hues.  Bush got 25% of the votes of Massachusetts; Kerry got 25% of the votes of Texas.  Bottom line, the 2004 legitimizes the 2000 election for Bush, but scarcely gives the Republicans a mandate for radical change. 

The Republicans currently control both houses of Congress, the Presidency and a majority of the state governorships.  However, there is division among Republicans between conservative Southern and Western Republicans and the more liberal Republicans from the coast states and the Mid West.  Add in a high degree of turnover in the current administration, and Bush’s second term agenda boils down to making permanent the tax cuts of the first administration, tinkering a little with Social Security and continuing the war against Al Qaeda.

Social Security

The demographic crisis in Social Security is nearly upon us, with the leading edge of Baby Boomers starting to retire in the next five years.  When first established in 1936, Social Security paid relatively modest benefits (for example, covering only a wage earner, not a spouse or dependents) and the ratio of workers to beneficiaries was 42-1.  In 1940, a 65 year old lived on average to 75.  As the baby boomers move into the current system, the ratio of workers to beneficiaries will fall to 3 to 1, in part because of the demographic bulge, in part because a retiring 65 year old today lives on average to 80.  Combined with projected Medicare coverage, this is a multi-trillion dollar unfunded liability, and the system will fall short in the next 10-15 years.

The Bush administration recently made a proposal to convert part of Social Security funding to private accounts.  We don’t think this will work for a couple of reasons:

1. Most Americans are ill-equipped to properly invest 401K’s, but Social Security is supposed to be a safety net.  Does the government bail out people who make bad decisions with their Social Security investments?
2. Diverting money to private accounts mean coming up with money for current beneficiaries from other sources, primarily by borrowing.  The US national debt is nearing record levels of about $7.5 trillion to which the Social Security proposal would add another $2.5 trillion.
3. US stock market capitalization is currently $13 trillion.  Increasing demand for stocks by $2.5 trillion would no doubt drive stock prices higher at the risk of inflating a new bubble (and we’re still recovering from the bursting of the last bubble.)

Bottom line, we believe that problems with Social Security will be resolved by pushing the age of retirement to 70 and by means testing benefits.  For years, we’ve told our younger clients to assume little from Social Security in their retirement planning.

Oil/Energy

We projected higher oil prices in 2004, butwe didn’t expect the 39% rally we’ve seen year to date, not including the peak jump to $55 (77% gain) in August.  While there’s still plenty of oil in the world, the supplies of cheaply extracted oil are rapidly being depleted.  Oil production peaked in the US in 1970, and is peaking right now in Saudi Arabia.  Despite the huge price increase, the US economy appears to have adapted well to higher prices.   Low income consumers are hit hard by gas at $30/tank, but middle and upper income consumers scarcely notice (gas averages only 5-10% of the operating cost of a large car, pickup or SUV.)  High oil prices do appear to be stimulating research into alternative energy systems and ten years from now may well provide some interesting companies to invest in.

Al Qaeda/War on Terror

Two years ago, the release of a Bin Laden audio or video tape caused markets to shudder; now these tapes are quickly recycled into comedy bits on Saturday Night Live.  Perhaps Americans are becoming dangerously complacent again.  Al Qaeda and its affiliates have struck repeatedly since 9/11 but not once in the US (and we had expected an attack before the November presidential election.)  Possible reasons why Al Qaeda has not attacked again include:

1.      A general clamp down on visas issued to males from the Middle East

2.      A modest increase in port, border and airline security in the US

3.      Disruption of Al Qaeda’s organization by the loss of Afghanistan and hounding of Bin Laden in Pakistan

4.      Increased monitoring of Al Qaeda cells worldwide, increasing the difficulty of planning follow-on attacks

5.      Distraction of Jihadis by the US occupation of Iraq, and subsequent focus of attacks there

6.      Al Qaeda’s desire to stretch out attacks to maximize their impact

7.      Luck

The increased frequency of Bin Laden’s communications with the West increases the chance that he’ll be caught, but it’s also clear that Bin Laden and other Al Qaeda chiefs are receiving protection from elements of the Pakistan government (judging from the content of Bin Laden’s messages, his cave has TV, Internet access and a NetFlix subscription.).  The US can exert only so much pressure on President Musharraf to deliver Bin Laden without destabilizing his government, so stalemate for now.

Al Qaeda has become more aggressive in Saudi Arabia recently, targeting officials of the Saudi government and members of the royal family for the first time.  As Al Qaeda receives most of its funding from Saudi Arabian nationals, this change in tactics may well backfire.  Still, as we commented so time ago, the Saudi Royal family looks as secure as the Shah of Iran in 1978.

The US presence in Afghanistan and Iraq puts enormous pressure on surrounding countries such as Iran, Syria and Saudi Arabia to behave.  However, the US has gotten distracted by the political need to “bring Democracy” to Iraq.  The most sensible course following January’s “election” in Iraq is for the American forces to withdraw to the less populated regions of Iraq in the North, West and South, get back to chasing Al Qaeda using Iraq as a base, and let the Iraqis fight amongst themselves for control of the country.  If the various tribal chieftains believe they can obtain a share of the oil revenues, they’ll take their own measures to eliminate the insurgents who keep blowing up oil pipelines and police stations – call this Mafia diplomacy.

The bigger problem is that, three years after the 9/11 attacks, most Americans still don’t grasp the seriousness of the situation and assume that if Bin Laden is captured or killed, the war is over.  As we have observed before, we believe the conflict between the Western world and the Arab world dates back to 1972 (the year Palestinian terrorists shot up the Munich Olympics,) and, like the Cold War between the West and the Soviets, will continue for at least another generation.  As during the Cold War, the US stock market can grow many times over, but there will be periodic crises that investors have to be mentally prepared for. 

The most critical issue is that the Islamic fundamentalists be denied access to nuclear weapons, which is why Iran’s effort to build nuclear bombs is so disturbing.  Compared to the elephant that is the US economy, overseas attacks are like mosquitoes biting at the ankle, the 9/11 attack was like a bee sting on the eye-lid, but a nuclear attack would be like the severing of a limb.

Currency movements and Interest Rates

Unnoticed by our American clients, but painfully noticed by our European clients, the dollar fell 37% since December 2002, regaining levels last in 1995.  The dollar fell 24% against the yen over the same time frame, touching levels last seen in 2000.  Currency movements are driven by a number of factors.  Currencies appreciate for countries with:

• Higher real interest rates
• Higher economic growth rates, particularly return on investment
• Lower inflation rates
• Lower money supply growth
• Lower trading deficits
• Lower current account imbalances

Rarely do all these factors line up in one direction or another, and traders’ psychology also comes into play, which is why currencies fluctuate over time.  At this point in time, the US economy, which accounts for 40% of world GDP, is also the fastest growing of the major economies.  Real interest rates in the US are higher than in Japan or China, but lower than in Europe.  Inflation in the US and Europe remains low, while inflation in Japan is negligible.  Money supply growth in the US remains high, perhaps too high.  A large percentage of goods are imported, and the US is now importing services as well. 

A certain percentage of these goods and services are obtained from the foreign subsidiaries of US corporations and therefore don’t really count as imports, because payments are repatriated as corporate revenues.  However, the bulk of these payments end up being converted into yen, Chinese yuan, and Euros.  China directly links its currency to the dollar, while the Japanese Central Bank buys up dollars and invests the proceeds back into the Treasury bond market.  Without these purchases, we believe the 10 year yield would have risen above 5% in 2004.  Since the yields remain depressed, the attractiveness of dollar investments to Euro investors also remains depressed, and funds flow from dollars back to Euros, causing the dollar to fall.

A key psychological issue for currency traders is that the US government appears to willing to let the dollar fall (to halt its fall would require a sharp rise in short term rates and a reduction in money supply growth, both of which would kill off economic growth even as job growth remains slow.)  The only question is whether there will be a soft landing (as currency differentials reduce the attractiveness of imported versus domestic goods, and both trade and current account deficits level off) or a hard landing (as international investors bail out of the dollar as a reserve currency and adopt, for example, the Euro.) 

The effective “loan” from the rest of the world to the US is currently about $4 trillion between purchases of US Treasuries and holdings of private securities.  As we have observed, “when you owe the bank a small amount of money, you have a problem; when you owe the bank a large amount of money, the bank has a problem.”  Neither the US nor its creditors can afford a hard landing, so we believe, as US short term rates continue to rise, that exchange rates will settle down at slightly lower levels in 2005.  Indeed, the dollar is not that far from its average trade weighted value over the last 30 years.

Why invest in stocks?

Since 9/11, we have focused a great deal of our commentary on world events and on politics since stocks have fluctuated primarily in reaction to externalities.  Since there is a temporary lull in world events, let us remind ourselves why investing in the US stock market makes sense.  The US economy grew an average of 3.5% since 1945, with most measurements between a loss of 0.5% and a gain of 7.5%.  In recent years, growth and volatility have moderated; since 1980, growth averaged 3.0% with most measures ranging from 0.0% to 6.0%.  We often talk of 3.5-4.0% growth as being the non-inflationary speed limit in economic growth, but doesn’t this imply that 3.5-4.0% is also the natural growth rate of the stock market?

In fact, companies in the S&P 500 represent the most dynamic part of the US economy, and growth in corporate profits has averaged 7.0%/year since 1945, 7.3% since 1980.  Throw in some extra return from dividends, and it’s easy to see how the S&P 500 has grown 7.8%/year since 1945, 10.1%/year since 1980.  1980 is a critical year marking the start of a long bull market in bonds (and therefore, the start of a long period of falling interest rates, which is good for both stock investors and home owners), which we believe is near an end.  So we think the natural rate of growth in the stock market should be closer to 8% or even 7% than 10% for the next 25 years. 

Why doesn’t the stock market yield 8% every year?  Obviously stock market returns are affected by the economic cycle, rising when the economy is expanding, falling when the economy is in recession.  However, there’s another factor independent of the economy which affects stock market returns.  The S&P 500 is a capitalization weighted index, which means that fluctuations in the stock price of a company like General Electric with $386 billion in market capitalization (3.4% of S&P 500) have a bigger effect on total returns than a smaller company like Safeway (market cap $8.8 billion, 0.08% of the index.)  Returns can be further distorted by the fact that different sectors have different weightings.  For example, technology including telecommunications is currently 20.8% of the index.  At the end of the last bull market, technology comprised 39% of the index.  So boom followed by bust in the technology sector amplified both the up and down swings we saw in US stocks from 1996-2002. 

Our core strategy has always been to focus new investments on mid-sized companies (about 50% of portfolios), but also retaining 50% of portfolios in large cap stocks (which tend to have more predictable returns.)  We weight stocks equally in portfolios rather than by market cap, and we invest 75% of portfolios (about 25% each) in the three fastest growing sectors of the S&P 500 (technology, healthcare and financial services.)  We invest in at least 28, as many as 40 companies per portfolio, so that if we’re blindsided by bad new from one company (e.g. Merck and Vioxx) overall returns are not harmed.  The remaining 25% of portfolios are invested in companies with low correlation to the S&P 500 such as energy companies and REITS.  These companies anchor the portfolios when times are tough.

Strategy

Last quarter we wrote, “In all, a benign environment for stocks and we’re overdue to be rewarded.”  We expect the current rally to continue through January, and then peter out as Q4 earnings reports are digested and investors figure out what to do next.  The consensus forecast for 2005 is 8% gains in the S&P 500, 10.5% growth in earnings (versus this year’s 19.2%, although analysts have been underestimating growth estimates in recent years.), 3.5% growth in GDP, plus 5% yields in the 10 year Treasury, oil ranging from $40-$48/barrel through the spring.  In all, a continued benign environment for the companies in our portfolios, and we don’t expect to make major changes.