4th QUARTER 2005 MARKET COMMENTARY & OUTLOOK

 
 
JANUARY, 2006
 
Wow!! Another year has come and gone! The change in the Dow Industrial average, which moved less than 1% (-.61%) for the year, belies the economic and market activities that transpired during 2005. As a Barron’s reporter observed:   “STOCKS TRADED ON 252 days last year.   Three quarters of a trillion shares changed hands... Yet, in the end, the Dow Industrials did as close to nothing during 2005 as they have in nearly 80 years.”
 
Other U.S. stock market indices did not fare much better. The S&P 500, a much broader gauge of the market (500 stocks versus 30 in the DOW Industrial average) appreciated 3% (total return including dividends was 4.9%) while the NASDAQ, a measure of smaller stocks, with a heavy bent towards technology, appreciated 1.4% for the year. International investments performed well, with the MSCI world index ex-US up 14.9%. Commodities were big winners in 2005, with oil up 40% in 2005 and gold rising 18%.
 
Once again our clients experienced the benefits of active management over a passive index approach. Focusing on specific market sectors and specific securities while underweighting or ignoring other sectors has been the key to outperforming the markets since 2000.  We think the challenge and the opportunity in the markets in the coming year will be a combination of industry and stock selection combined with an ability to take advantage of market volatility.  As events that shape the economy and the markets in 2006 unfold, investment opportunities will be created.  Below is a brief discussion of the year just past and how it shapes our perspective for the coming year.
 
In the year just ended we experienced $70+/barrel of oil, rising short term interest rates and some of the worst natural disasters in our nation’s history. Yet our economy grew at a 3.5%-4% rate and created, on average, 200,000 new jobs a month. Consumer spending remained strong and corporations continued to generate strong cash flows and increase dividends paid to shareholders. As the year came to a close, a protracted inversion of the yield curve seemed to be imminent. (“Inversion” means that short-term interest rates move higher than long-term interest rates.) Fortunately, comments by the Federal Reserve indicating they were nearing the end of short-term rate increases calmed the markets, and the yield curve adjusted. Generally an inverted yield curve portends a pending recession as it is anticipated that long rates will have to rise to return the yield curve to its normal state. The rise in rates can set off a series of events that can ultimately choke off spending and leads the economy into recession. While we do expect longer rates to rise, relative to history we believe that longer rates will remain low due to continued strong demand for our debt by foreign investors. (Remember, interest rates and bond prices move in opposite directions, so as demand bids up prices, interest rates decline.) In addition, since the longer-term 10-year bond began the year at a 4.4% yield, a slight rise in long rates could temper corporate and consumer spending but we do not believe it will lead us into recession. 
 
As we move into 2006, we see a few themes unfolding. First, we expect cash on corporate balance sheets and continued strong corporate cash flows will result in increased business spending in the coming year as companies reinvest in their businesses, spend on technology and capital equipment, and complete mergers and acquisitions. Technology companies and capital goods manufacturers will benefit as well as investment banking organizations that consult on merger activities. We also expect energy companies to continue to do well as energy prices remain at levels that make reinvestment in drilling activities attractive.

Conversely, we are less interested in investing in consumer-related companies unless there is a unique circumstance surrounding the company. We expect consumer spending, which has led the economy for the last several years, to be less robust. There is not a great deal of pent up demand by the consumer. In addition, a rise in interest rates may begin to spell the end of the significant housing price increases since higher rates mean larger mortgage payments, presumably reducing the affordability/demand that supported the increases in home prices. Consumers have used the increase in home prices to fuel spending as they borrowed funds by leveraging the equity in their homes. Higher rates, at least at the margin, should curb such borrowing/spending. Exceptions to our theme of disinterest in the consumer would be in the areas of leisure and entertainment, as well as in technology, where new products will continue to drive demand.
 
International markets will continue to provide attractive investment options. We continue to be less optimistic about Europe and more interested in Asia and some of the developing markets. In 2005, investors in international markets saw their investment values rise as strong emerging markets combined with areas of strength in both Europe and Asia fueled performance.
 
The one area that is less clear to us is the bond market. We do not expect the yield curve to truly invert. However, when new Federal Reserve Chairman Ben Bernanke assumes his role in February, there will be a time period before which he establishes his credibility as an inflation fighter. During that time short rates could remain slightly higher than they might otherwise be. This, combined with the unknowns of a new leader, may unnerve the bond market for some brief period of time. As we stated earlier, however, over the course of the year we expect long rates to rise. Maintaining bond positions at the shorter end of the yield curve in client portfolios will continue to serve clients well and provide flexibility should rates move more than we anticipate.
 
In summary, we continue to believe that opportunities in the equity markets will continue to exist for those who continue to focus on sector and stock selection. We will see higher interest rates as we move through the year which may decelerate our current economic growth rate of 3.5%-4% but not send us into a recession. Under this scenario we believe our philosophy of seeking out companies with improving profitability and solid growth prospects will serve our clients well as we move forward into 2006.
 

 

    

INDEX
©2007 Spero-Smith Investment Advisers, Inc. All rights reserved.

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