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Past Commentaries

Current Commentary, Review and Outlook
January 14th, 2005

To My Clients, Friends & Observers:

In the long run real earnings growth of the aggregate market cannot exceed real economic growth, GDP. To the extent that stock valuations do or don't in any given period reflects either optimistic or pessimistic speculation. So it behooves us to measure the market against the aggregate economy and assign it a weighted valuation. Is the market expensive or cheap?

Because of the riskier nature of equities to bonds investors typically demand a premium above and beyond bond yields to invest in stocks. That premium can be valued in either earnings or dividends. We call this the equity risk premium. This was negative back in 2000, meaning investors insisted on paying more to be in the riskier asset class.

If we measure the risk premium by dividend growth - which I favor because we're talking about cash paid to us, not held in earnings by the corporation - we would add the starting dividend yield of 1.73% today to a growth rate of 2.5% - which is accurate for the last four years but declining - for a sum of 4.23%. Subtract the ten year bond yield of 4.7% and we still have a negative risk premium of -.47%. It was -.9% in 2000.

If we measure the risk premium by earnings yield the picture is brighter. The E/P is 5%, a premium of .3% over the ten year treasury bond yield. When the earnings yield surpasses the bond yield valuations are relatively cheap.

Flat share prices in a period of improving earnings with low bond yields means that the equity risk premium is rising as it should. This will continue because investors demand it. Public policy has grown more accommodative to the market as public participation and reliance on financial assets have grown. Taxation of dividends at 20% is an example.

Corporations are so flush with cash that they are either giving it back to shareholders, as in Microsoft's recent $3/shr dividend, or buying back their own shares, as GE is doing with $15 billion over the next 3 years. GE also enacted a dividend increase of 10% recently. These are actions that raise share prices. The average annual return of the S&P of -.25% for the last four years will likely, finally, correct to the plus side this year. Falling oil prices would contribute enormously to this probability.

GDP is anticipated at 3.5% in 2005. I would not expect to see the Fed Funds rate above 3% this year. The last time the Fed was on a hiking binge was in 1999. At that time, Mr. Greenspan said it was a necessary response to the inflationary effects of oil prices. In my opinion it had more to do with an impending election than with oil. The Fed is not politically immune. So from June '99 to November 2000 the Fed raised rates six times as oil rose from $18 to $35 a barrel. A global recession followed which was far more severe abroad than here. Nobody wants that again. Opposite the last cycle, oil prices are falling now, albeit from historic highs.

The Fed has raised five times since June 30th. They are raising from a much lower base, 1% to 2.25% , than in 2000. I cannot invest much in Fed sincerity about inflation fighting. They continue to print money in excess of GDP demand. As of mid-December M1 was +5%, M2 was 5.5%, and M3 was 5.9% in growth year over year, for an economy that was growing at 4.3% and slowing. That is more than accommodative. Should the yield curve threaten to invert the Fed will have room to start cutting rates again.

Buddy, can you spare a dollar? (I don't take Euros)

It is axiomatic in economics that as a currency falls its debt rates rise. What then of the U.S. Treasuries market which hasn't even blinked in the face of the dollar's decline? The bond market is telling us that the U.S. is the most secure, stable place to invest. Who gains from a cheaper dollar? The world that pays for oil in dollars. U.S. exporters of manufactured parts, switches, pumps, motors and thousands of other products. American manufacturing is not dead. China doesn't care about a falling dollar - its currency is fixed to the dollar. That will have to change for fair trade to occur between America and China. A billion upwardly-mobile Chinese consumers must be allowed to benefit from their stronger currency by buying American products at a fair exchange rate. If not, the Chinese laborer is greatly disadvantaged. Presently China has an economy the size of Texas. But the Chinese economy grew over 40% last year. That is almost catastrophic growth.

What can Europe (at least as represented by France and Germany) do with a strong currency but an ossified economy? A dollar drop of 15% from here is far worse for Europe than for the States and in fact the EU is close to panic about the dollar. There will be no run on the dollar but likely more declines. That's not a bad thing. The Euro may be ignored. It is immaterial because it is dwarfed by the volume of trade executed with U.S. dollars, which are supported by U.S. laws, which are enforced by U.S. military strength.

Should the globe split into three distinct trade zones, European, Asian and American, it would create the potential for yet another world war. The day will come when the rest of the economic world will not care if the American consumer is willing and able to buy more cars, electronics, food, furniture, toys and clothes. Hopefully, we will all care that everybody is able to buy these things as global standards of living rise. In a free-trading world we may all benefit peacefully.

For the New Year

I don't look for huge returns from the major indexes. I do from our own managed portfolios however. Some stock favorites and new positions include Marshall & Ilsley, Countrywide Financial, National Fuel Gas, Davita, BankAmerica, FPL Group and St. Joe.

In a difficult year to pick stocks I did pick my share of winners. Best in 2004 were: Overseas Shipping Group (+61%); Lawson Products (+52%); Questar (+46%); Fidelity National Financial (+41%) and Chevron Texaco (+26%). Among many others, of course.

Best regards,