End Of Year Letter

Stocks spent most of 2005 going nowhere! The Dow Jones Industrial Average was down -0.61%, the S&P 500 was up a bit over 3% and the NASDAQ Composite closed with about a 1.4% gain. 2005 will be remembered by investors as a year of skyrocketing energy costs with inflation as an uncertain part of the economic equation. The economy had to handle the aftermath of Katrina and the ongoing Iraq war continued to fester. Worse for investors who owned securities with fixed income, the Federal Reserve {hereafter the Fed} kept ratcheting up yields which made the market value of these investments decline. These economic headwinds kept stocks volatile but ultimately little changed. Stocks have now carved out a narrow albeit slightly rising base for the past two years.

Investors have voted with their feet. The U.S. stock market has not experienced the same influx of capital as other investments such as real estate, or even foreign equities. Investors can point to the history of this decade to justify their lack of confidence since all of the major averages still show losses from their 1999 highs. In fact one has to go back to the early 90’s to find a time when the major averages spent so much time doing so little. Yet I have been arguing since July for a more positive market going forward. I wrote then that stocks had the potential to rally, that a sea change in equity performance might occur going forward and that I was becoming less defensive in my outlook. (You can find a reprint of this @ http://lumencapital.blogspot.com/2005_07_01_lumencapital_archive.html) Let’s add to that letter’s conclusions today.

I want to show you two parallels to our current market atmosphere. Let’s first look to the 1970s. That was also a time when our economy was attacked by inflation, problematic energy supplies, a crisis of confidence in Washington, the residue of a foreign war (Vietnam) and a problematic Middle East. Today one could argue that the world's economic health is much better, and inflation, while still a concern, is lower than what we experienced 30 years ago as are interest rates. The S&P 500 declined at an annual rate of about 2% between 1970-1976. The S&P has lost a similar amount through the end of last year. The rest of the 1970’s were much better for stocks. It also set the stage for the great bull markets of the 80’s & 90’s when stocks in the S&P 500 advanced at an annual rate in excess of 17% PER YEAR.

Markets similarly went nowhere from the beginning of 1993 to the end of 1994. That too was a period where the Fed began an aggressive campaign of raising interest rates, which again were higher in that period then than they are now. Then interest rates were raised 7 times and like now the market was consolidating the run up that occurred in stock prices after the 1st Gulf War. When the Fed completed its work, the S&P 500 rallied 54% in an 18 month period from December of 1994 through May of 1996. That period also set the stage for the explosive markets that occurred later in the decade.

Now let’s look at the two primary missions of the Fed and why it matters so much to the stock market. The Fed’s primary mandate is price stability in order to keep inflation tame. Its second job is to formulate policies that maintain an environment conducive for sustainable growth in the United States. The Fed uses two basic tools to facilitate its policy goals: It can regulate the money supply and it can regulate interest rates. It affects interest rates by increases or decreases on the rate it charges banks to borrow short-term money or to borrow at the front end of the yield curve. Money added to the banking system plus lower interest rates are the tools of an "accommodative" Fed; a Fed trying to spark economic growth. However, if the Fed decreases the nation's money supply and raises interest rates, it is "tightening;" trying to slow the economy and stave off inflation. With today’s interest rate increase the Fed has raised interest rates 14 times in the past two years. Rates are now near a five year high. Investors will look for clues that the Fed is close to finishing its current tightening cycle. Once this is finished stocks could be primed for a much larger rally than many currently believe. History shows that stocks are usually higher 12 months after the Fed finishes raising interest rates.

Why would we revisit a position that we started talking about last summer? For one thing stocks are more attractively valued today than they were several years ago. The forward price earnings ratio on the S&P 500 is about 15 times next year’s earnings. While not as cheap on a going forward basis as some would like, it is an area of valuation from which stocks have rallied in the past. It is also worthwhile to note that this level of valuation is even lower on many larger capitalized companies that have essentially gone nowhere in the past two years. An end to interest increases could also expand the price-to-earnings multiple even more. Business conditions in the United States are generally good when one looks at the overall economy and much of the global economy is currently experiencing at least moderate, if not strong growth.

Now as usual a few caveats. The preliminary 4th Quarter GDP report issued on January 27th showed much slower than anticipated economic growth. The Middle East is again signaling that it will be a foreign policy concern and the growing economies of China & India are competing with the West for natural resources. This last point leads to a fear of a repeat of the inflationary cycle seen in the 1970s. While most analysts agree that any inflation worries could be a bit overdone, others argue that surging commodity prices (especially oil and gold) clearly signal higher prices. The aftermath of Hurricane Katrina could still exacerbate matters although history shows that price surges after natural disasters rarely continue for long. Finally 2006 is an election year. I think there is a larger possibility than most that the Democrats will recapture either the House of Representatives or the Senate and their doing so could insert an element of political uncertainty into the investment equation.

If I could use one word to describe stocks for most of the past two years it would be boring. Let’s face it. With the exception of a few narrow sectors in the market and a few well hyped companies, stocks have not stirred the investment juices for most people. However, I am hoping that we have shown by the above cited examples that boredom can be an investor's good friend as the long slow basing like we have experienced often sets the stage for significant price appreciation in the future.