How to Handle a Tough Market

Stocks packed a substantial correction into the first two weeks of January. Most indexes and sectors absorbed significant declines both in absolute terms and when compared to their 2004 gains.

The S&P 500 gave up 25% of its 2004 gains in the following two weeks. The transportation index saw 17% of its substantial 2004 returns disappear. The Nasdaq gave up 38% of its prior year gains. Small company stocks, market leaders for the last few years, were hit hard. They lost a whopping 33% of their 2004 gains.

We anticipated a correction in last month’s issue, raising our sell signals and lowering our “buy below” prices. After the strong stock returns from late October through the end of 2004, stocks were due for a rest. Also, there was rampant optimism by the end of the year, which usually is a sign of a short-term market top. The final straw was the new-found fears of inflation, triggered by the release of the minutes of a recent Federal Reserve meeting.

The good news is that the correction was not accompanied by any of the other factors that indicate a longer-term decline is likely to be in the offing.

Corporate earnings might not grow at the same rate as in 2004, but they should grow at a healthy rate in 2005. Profit margins also should hold up as higher interest rates do their work and hold down commodity prices. Corporate balance sheets are in the best shape in some time. Corporate executives report being optimistic about 2005. Overall, the economy should be healthy.

While stock market valuations are not cheap, they are not in the highly overvalued range that characterized 1999 and early 2000.

There always are wild cards that could roil the markets. China might devalue its currency. There are a number of international political or military events that might occur. Inflation could be higher than expected, especially if events in the Middle East cause an oil price spike. The list of potential problems goes on. The possibility of such events is why we invest with a margin of safety and frequently have sell signals on our Managed Portfolio investments.

The January correction looks like a normal decline in the Meandering Market we’ve been describing for several years. I continue to expect that for an extended period that began around 1998 the market indexes will have mini-bull and -bear markets but little or no net gain. We’ll continue to earn solid gains for the period by seeking undervalued opportunities in the stock market and elsewhere and by avoiding large losses in the bear markets.

Sector and Balanced Managed Portfolios

The biggest mover in these portfolios has been Cohen & Steers Realty Shares. The fund earned 37% for us in 2004, after returning 5.7%, 2.79%, and 38% in each of the three previous years. One of the top-returning funds of the last few years became one of the worst-performers in the first two weeks of 2005. Yet, as we went to press the sell signal had not been triggered. (The $68.38 sell price in our January 2005 issue had to be reduced by the Dec. 23 distribution of $5.23.) If the sell signal is triggered, put the sale proceeds in money market funds until the next issue. Remember, sell signals apply only to Managed Portfolio holdings, not to Core Portfolios.

We’ve benefited from diversification. In the second week of January as U.S. stocks continued declining, we had gains in our international holdings because the dollar resumed its decline. That generated some modest gains in American Century International Bond, Tocqueville International Value, Driehaus Emerging Markets Growth, and Dodge & Cox International Stock.

We could very well be nearing the end of the dollar’s decline. You can see from the chart on the first page of our Investment Portfolio Supplement that the dollar’s rapid decline at the end of 2004 just about brought it to previous lows. That’s why we’ll keep sell signals on all these funds.

There are few real values in the investment markets. Even after the January correction, U.S. stocks in general are not cheap. The large company, higher quality stocks are relatively cheaper than the rest of the market. Larger companies have a lot of cash and reduced much of their debt the last few years. They are in very good financial condition and are likely to begin distributing some of that cash to shareholders this year.

For now, we’ll stay with our diversified portfolios and invest in U.S. stocks through the proven, value-oriented stock pickers at Torray and Oakmark funds.

Income Growth and Income Managed Portfolios

There is little opportunity and a lot of potential danger for income investors in 2005. That also was the case at the beginning of 2004, but the risks didn’t materialize. Now, there is less opportunity and more risk.

Interest rates are going to rise. Either the Federal Reserve is going to increase short-term rates steadily during the year, or inflation will cause the market to increase all rates. Either way, treasury bonds do not look like a good place to be for at least the first half of the year.

I do not recommend venturing into corporate, high yield, or emerging market bonds, despite their higher yields. The spread between the yields on those bonds and on treasury bonds is very small, well below the long-term average. That means you aren’t being paid enough for the risk of investing in these securities.

My fairly benign economic forecast for the year might tempt you to purchase these securities and book the higher income. But there almost always are surprises. The current yields on these other bonds right now aren’t high enough to compensate you for the damage that a surprise would do to the value of the bonds.

Bond prices are forecasting low inflation and modest interest rate increases during 2005. They also aren’t forecasting much risk. Right now, the markets are encouraging speculation, and that is not a good thing. Any surprise will trigger big losses.

My advice to income investors remains the same as in recent visits. Accept the relatively lower yields of short-term corporate bonds through Vanguard Short-Term Investment Grade Bond fund (recently around 3.31%). The portfolio won’t lose much value as rates rise. You will have more capital to invest in long-term bonds after interest rates near their peak for this cycle.

Cohen & Steers Realty Shares and Dodge & Cox Balanced funds have stayed above their sell signals. If the signals are triggered in these portfolios, sell only the Managed Portfolio shares and put the proceeds into VFSTX.