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1.1.2005 2004-Fourth Quarter Client Leter
Economic Update: Moderate Growth
In the 3rd quarter 2004, real GDP increased at an annual rate of 4.0%, up from 3.3% in the 2nd quarter 2004 and down from 4.5% in the 1st quarter 2004. As the following chart predicts eight months in advance, the economy should begin slowing down in the next two quarters.
Market Update
Over the past couple of years we have discussed the historical returns of the stock market as it relates to the four years of the U.S. Presidential term. The third year of the four year term is typically the best for the stock market with an average return near 20%. This came true in 2003, as the stock market was up over 20%. The fourth year is typically the second best year with an average near the overall historical average of 10%. In 2004, the market almost exactly returned its average return of 10%.
Since Presidential cycles so accurately predicted the last two years, I thought it was worth mentioning the historical average return of the first year. Historically, the first year is the worst of the four as the stock market has returned 4.8%, or 5.5% less than its average of 10.3%. In theory, the Executive Branch does everything in its power to present a positive economic environment prior to the election. The reality of these decisions or hype sets in during the beginning of the next term. The good news is that the market typically does better if the incumbent party is re-elected.
Since the election, the equities markets are up double digits. Euphoria has set in! But be cautious; euphoria breeds complacency, and complacency is a breeding ground for violent capital markets. One of two things can occur: investors become skeptical of the market on their own; or the market makes them skeptical with violent declines. Complacency can ease over time with investors becoming more skeptical. If investors don’t change their expectations, the market will. If the market sells off, then investor’s lackadaisical behavior will change. Investment losses cause investor’s emotions to change, and exacerbates the downward pressure on the market.
Portfolio Updates
High Yield Bonds: We have decided to liquidate our high yield bond holdings. Investors have flocked to high yield bonds in search of higher income. As predicted, high yield bonds have delivered double digit returns in 2003 and 2004. High Yield bonds are only yielding 2.6% more than US Treasury bonds. To put this in perspective, the spread between high yield and treasuries was 10.1% in late 2002. This leaves no room for error as the risks are greater than the reward.
Gold: We began buying gold stocks as a hedge against a decline in the value of the dollar and an increase in inflation. Both of these occurred: the dollar declined in value and inflation is higher. As a result, the value of gold increased. All seemed well, except the gold stocks went down. If the positive environment for gold continues, the gold stocks should follow upward.
This market has high expectations built in. This “all-in” mentality by investors leaves much vulnerability. The upside is limited, while the downside is greater. Any surprise in economic indicators, corporate earnings, or terrorism could cause a significant sell off. Therefore, we will continue to have a cautious allocation to the equity market.
Thank you for your continued trust and support.
Trevor K. Holsinger, CFP
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