Popular Stock & Bond Indices:

Once again: good news bad news. The fourth quarter of 2004 experienced a powerful post-election rally in stock prices that sent the DJIA up over 8%. It’s hard to believe, now, that in our last letter we stated that most stock indices were slightly negative for the year, and that a 2%-4% investment return would look good. Whether this enthusiasm for stocks stems from the election results, lack of terrorism before and during the election, or just the removal of the election uncertainty, it definitely was a nice Christmas present.

DJIA 10,783.01
Prime Rate 5.25%
Three-Month Treasury Bill Yield 2.23%
Six-Month CD Yield 1.42%
Five-Year Govt Bond Yield 3.60%
Ten-Year Govt Bond Yield 4.22%

As for the bad news, interest rates remained low. We characterize this phenomenon in a negative light because so many investors need fixed income for retirement. What seems really confusing, and perhaps even more significant than the rally in stocks, is that the bond market remained strong in the face of two powerful forces: one, the strong rally in stocks; two, rising short-term interest rates. Most experts (with whom we agree) would forecast that these conditions would cause interest rates to rise rather than stay the same or fall. In any event, low rates are a problem for the portion of investors capital earmarked for fixed income. And the message from the bond market, a priori, continues to be that stock returns sooner or later will disappoint.

Tax Loss Selling:

Throughout the year we pay attention to opportunities that arise from matching realized gains and losses in taxable accounts. If an account has realized losses, for instance, we might sell something just to take a profit to match the losses. If we buy back our realized profit stock, this raises the cost basis and lowers the reported gain when we sell it for good. Although we try to be diligent in our efforts to capitalize on these opportunities when they occur, rather than waiting until the end of the year, our year-end reviews always seem to find a few losses that we need to take in order to offset earlier gains, or visa versa.

This year we found less than the usual number of opportunities to match up profits with losses, mainly because there are not many unrealized losses remaining in your taxable accounts. Also, in many instances where there was an unrealized loss and we still liked the position, we kept the position and let you pay some capital gains taxes at the low maximum rate of only 15%. After year end, we will send you our usual statement of gains and losses for your tax accountant.

Expectations (For Equity Prices):

An interesting article by Peter Bernstein appeared in the November/December, 2004 issue of Financial Analysts Journal. What we would call a wise observer of the investment scene for many years, Bernstein is the author of Against The Gods, which is a history of probability theory and its effect on modern society. (Though I read this book with less understanding than many, I still found it useful and interesting.) Readers of our past letters may recall references to Bernsteins work.

In this article, Bernstein analyzed twenty-three 20-periods beginning in 1873 and ending in 2003. In other words: 1873-1893, 1878-1898, 1883-1903, etc. For each of these periods he examined annual stock returns, economic output, inflation, bond yields and money supply. Without trying to describe each variable, we thought it might be of interest to discuss the bullish observations that can be derived from the data, as well as the bearish side of story.

Positive Observations:

First, as market historians often remark, stocks seem to provide an average annual return of around 9%. Bernsteins actual conclusion was 9.2% for all of these periods. No periods, including the periods containing the Great Depression, experienced a negative return for stocks. The last three periods, 1973-1993, 1978-1998 and 1983-2003, saw stock returns of 11.4%, 16.9% and 12.6% respectively. These returns significantly exceeded the average 9.2% for the entire 130-year period. For those expecting a reversion to the mean, however, Bernstein’s data show that above average returns can have substantial staying power. Double digit returns actually occurred five times in a row for the periods 1933-1953, 1938-1958, 1943-1963 and 1948-1968. So just because the last three 20-year periods have experienced higher than average returns, it doesn’t necessarily follow that the period from 2003-2023 will revert to the mean or be below average.

Further, a reversion to the mean from the 1983-2003 period’s 12.6% return wouldn’t be the worst thing to ever happen to investors, especially with today’s low interest rates (more on that below). What would the chances be of a reversion to significantly below the mean? The largest change of returns from one 20-year period to the next occurred in the 1933-1953 period, when equity returns rose from 4.4% from the prior period (1928-1948) to 12.8%, a move of 8.2 full percentage points. Even if the 2003-2023 period experienced a reversal equal in magnitude to this increase in returns, investors would experience a positive return of 4.6% annually. Interestingly, the lowest return for any period was the 4.4% of 1928-1948. On average, the change in equity returns from one 20-year period to the next was only 2.5 percentage points. Thus, an average negative departure from the last 20-year period would only drop stock returns from 12.6% to 10.1%.

Are stocks a good inflation hedge?

Much of academic literature purports that inflation is bad for the stock market. Intuitively, the theory is that high inflation, accompanied by high interest rates, increases the discount rate that investors require from stock returns. (For example, $1.00 of earnings discounted at the average 9.2% return would result in a stock price of $1.00 divided by .092, or $10.87; the same $1.00 of earnings discounted at 6% equals $1.00 divided by .06, or $16.67; but discounted at 12% the stock price drops to $1.00 divided by .12, or $8.33. The higher the discount rate, the lower the stock price.) Bernstein’s empirical observations, however, indicate just the opposite. On average, when interest rates rose for the period, stock prices increased an above-average 10.3%. When interest rates fell, stock prices increased a below-average 8.5%.

Negative Possibilities:

While it could be said that, based on the article’s observations, the next rolling 20-year period from 2003-2023 could easily be an average 9.2% or even match the double-digit returns of the previous three periods, the last five years of the present 20-year period could be problematic. In other words, the period 1988 -2008 has five years remaining. For the first 15 years, the return for stocks has been plus 12.2%. A reversion to the mean for the twenty-year period ending in 2008, therefore, would require a zero percent return for the next five years. And even an average deviation downward from the last twenty-year period (1983-2003) of 2.5 percentage points would reduce the outlook from 12.6% to 10.1%. This adjustment would predict very low, single-digit returns through 2008.

Of course, should the current 1988-2008 period return some rate below the average 9.2% for the entire 130-year study, then the next five years would need to be negative to offset the first 15 years of 12.2% returns. We bring up this possibility because of Bernstein’s observations on interest rates: namely, periods of declining interest rates were accompanied by lower than average stock returns. We are all aware of today’s low interest rate environment, with the 10-year Government bond yield now around 4.25%. When the current 20-year period began, however, (1988) these same rates were dramatically higher, at 8.8%. Thus, should rates remain relatively constant over the next five years, the current 20-year period will be one of declining interest rates. As stated, on average such circumstances have been accompanied by lower equity returns.

A final point in discussing Bernstein’s article is dividends. Although he did not break out the contribution to equity returns from dividends, he made it very clear that dividends contributed significantly to the stock market’s healthy returns. In fact, the 9.2% average equity return for the 130-year period encompassed by the study included average stock dividends of 5.1%. Given today’s current stock dividend yield of only 1.4%, Bernstein believes that matching long-term equity returns of the past will be difficult. “Even an allowance for cash distributions by means of buybacks will not pull dividend yields back up anywhere near to where they were when stocks were producing that 9.2 percent long-term total return.” Thus, as Bernstein says, “a powerful feature of past experience has recently disappeared from the scene.”

(All of these observations are in nominal terms, meaning they have not been adjusted for the effects of inflation. The article, however, provides data in real terms as well, which show inflation-adjusted figures. Thus, if you would like to know more about Bernstein’s conclusions, give us a call. We would be happy to discuss the article in more detail.)

Reflections (On Expectations):

As stated in our review of the popular stock indices above, the last three months of this year were enveloped in a beautiful stock market rally that lifted almost all stocks. Your returns went from plus two or three percent for the first nine months of the year to a more robust eight or nine percent, with some of you ending up in the double-digit category. (This, even though we went into the period with widespread holdings of Merck and Pfizer, two stocks that didn’t participate see Quarterly Letter to Clients, October 1, 2004.) On top of a strong 2003, therefore, the finish to this year couldn’t have been nicer. As we said, Merry Christmas.

As to the dour conclusions some might draw from the discussion above, we would encourage investors to at least consider the possibility that investment returns could be below average for the next year or two. In past letters, we have discussed the contrary indicator of Investor’s Intelligence, which measures the attitude of investment newsletter writers. These results are published weekly in Investor’s Business Daily. With 62.9% of the writers bullish, it seems that they, too, enjoyed the last three months of 2004. Unfortunately, this figure represents a multi-year high, and it is more characteristic of a market top than a bottom. Here’s an example of the opposite from today’s conditions on this front. In March of 2003, bullish newsletters represented 39.8% of the total. The DJIA was 7,992.13. In hindsight, this was a time to buy. One year and nine months later today the DJIA is 10,800.00. The complacency that is associated with today’s market sentiment makes us nervous.

It is also interesting to us that Bernstein’s article overlaps the remarks made by us in January of 2002. Our January 1, 2002 remarks on the subject bear repeating:

“Both Templeton and Bogle have suggested that the 2000-2009 decade will be difficult for investors compared to the fabulous 1990’s. Warren Buffett has made similar observations. The world of academia has stated over the years that stocks return between 9% and 10%, on average, when viewed over the past 100 years. If the twenty-year period from 1990 to 2009 has an average experience, therefore, the implications for this decade could be grim. Using each decade as one observation, it would take a 0% return in the current decade to balance out the 18.9% return of the 1990’s (18.9%+0%/2=9.45%). While this is not a prediction on our part, the idea of a 0% return in stocks over a 10-year period is not as far-fetched as it may appear.

“First of all, such a return would be the complete opposite of what we are being told by the investment community, which is encouraging investors and the financial press to invest at the bottom of this market. And doing the opposite of what some of these characters want us to do is at times very profitable.

“Second, there is precedence. Our calculations indicate the DJIA hit the 1,000 mark in 1966 and didn’t get past this level until 1983, marking a 17-year period of 0% return in stocks. Then, of course, there is the more recent, sad story of Japan.

“Third, we hate to call it to your attention because time is flying (hope we’re having fun!), but only four months after this New Year we have just entered, the decade will be a third gone. And so far, we’re not even back to even. As for the NASDAQ, which has risen nearly 43% from its bottom, it could double and still not be within 1000 points of a 0% return for the new decade.”

For the record, when these remarks were made the DJIA was 10,021.50. It was January 2002. By October of 2002, the DJIA had fallen to 7,181.47 (October 7, 2002). And even five months after that the DJIA was still in the low 7,000’s (7,397.31 on March 10, 2003). The investment community was telling us to buy the “bottom” of the market in January of 2002, but 3,000 points lower and nine months later, the same Wall Street shills had fully bought into the concept that the decade was going to be a bad one for stocks. They warned investors to LOWER exposure to equity. (We have an article from a leading financial commentator actually advising investors to put their money in the mattress.) Please indulge us with one more quote from our own writing: our “Clients of The Firm” letter dated August 7, 2002, right in the middle of the market’s free fall described above.

“Fourth, while we have learned that in the short term the market is dangerous, in the long term the outlook is getting brighter. These are not glib words.

Remember our letter of January 1, 2002. We made a long-winded case for the possibility (not a prediction) of zero return for stocks for the whole decade of 2000 through 2009. This was not popular dialogue at the time. Today, however, we see articles and hear experts telling us to expect low stock market returns for the next five years. We are advised to reduce our expectations for returns in equities. This is crazy. Where were these experts two years ago? They are the same brokerage houses and financial publications that were telling us to raise our expectations, and then we would get it. They were telling us RAISE our expectations when the market was at its peak, and they should have been telling us to LOWER our expectations! Now they are telling us to LOWER our expectations? When the NASDAQ is down over 75%? When the Dow is down 35%? When the S&P500 is down 46%? In eight months, this decade will be a third gone. If we get back to even by decade’s end, just on the Dow, the market will go up 7.8% annually. We don’t know where the market is going to bottom, or if it already has, but we think it’s highly likely that we’ve made the big adjustment these prognosticators are just beginning to forecast.”

Isn’t it interesting? Now it’s January 2005. The market (measured by the DJIA) has made a round trip. A little over 10,000 in January 2002, and the Street was telling us to buy. Down below 7,500 nine months later and five months after that, and the Street was telling us to sell. Today we’re back to DJIA 10,800 and a record number of newsletters are bullish.

Reflections (On Investment Strategy):

Our purpose in belaboring the points in this discussion is not to suggest that we here at Dreher Capital Management predicted the markets. Far from it; we were just as scared as everybody else. We certainly didn’t take all of your money out at the top and put it back in at the bottom. We’ve said repeatedly that we’re not smart enough to do that. What we would like to take credit for, however, is helping you develop an Investment Strategy that allows you to stay the course in periods of extreme volatility. If we do this, and our communications help to keep you from panic decisions going all in at the top and all out at the bottom, as advised by the pundits then we think we are adding value to your investment experience.

As for your Investment Strategy, diversification is its backbone. For example, it was just as important to keep some equity exposure at the bottom as it was to maintain some income exposure at the top. As we stated, we don’t know when or where markets will bottom. Therefore, we have some exposure on the downside in order to be there when the upside happens. A good example is October 2002. The decade of 2000-2009 was almost one third over. It was a scary time; it might have felt comfortable to have everything in the bank and nothing in equities. We identified, however, that a zero return decade that took the DJIA back to its 1999 year-end level of 11,497.12 would result in significant investment return. With approximately seven years left, and a possible 4,000 point gain (11,500 minus 7,500), even a zero return for the decade would work out to 7.6% annually on a simple basis: (4,000/7500)/7years). But look what happened. The discipline developed from this line of reasoning paid off early. We didn’t have to wait seven years. A powerful rally in 2003 and a belated follow through in late 2004 have given investors over 3,000 points back in just a little over two years. Result, 18.2% simple return: (3,000/7500)/2.2years). This is why we needed to maintain the equity exposure in your Investment Strategies. And, now that we’ve traveled the lion’s share of the 4,000 point trip back to the end of 1999 on the DJIA, isn’t it interesting that Wall Street is once again raising price targets and newsletters are 62% bullish? Especially so given Bernstein’s observations this past quarter and the remarks of Templeton and Bogle three years prior.

Reflections (On Investment Tactics):

So now that we’ve demonstrated a good reason to be cautious on equities, and bond yields remain below what a reasonable person would believe, what do we do with money? In other words, how do we implement Investment Strategies? First, be careful. In a low-volatility market it is even more difficult to make up for big losses. We want to be sure that everyone’s Investment Strategy is being followed, and in some cases we may be more conservatively postured than called for by Strategy guidelines. This means we may have some cash pile up in your accounts, and that you (and we) need to be patient. As to equity exposure, it will remain subject to the above comments, but we will put a lot of effort into diversification. If the next five years turn out contrary to our cautionary views, and stocks soar, we’ll at least get part of the action. Meanwhile, if in the second half of this decade stocks remain in their broad trading range, hopefully we’ll be clinical enough to raise equity exposure when opportunities develop.

An important adjunct to the tactical implementation of your Investment Strategies is to realize that our comments are not meant to forecast a market crash. In fact, we doubt a return to the 7,000 level on the DJIA is in the cards, and we do not plan to hold a bunch of cash in anticipation of such an event. Rather, we think the stock market, like the bond market’s low yields, will tend to be flat and offer smaller returns for the balance of this decade compared to the returns that characterized the last half of the 1990’s. Such a trading range could easily result in a zero-return decade (2000-2009). Finding good stocks with dividends and earnings growth will become a priority in such a Chinese-water-torture environment. As our friends at Tweedy Browne remarked in their Investment Adviser’s Report for September 30, 2004, “If we are correct in our analysis, prospective gains would come from investment returns, a rise in earnings plus dividends. We have little expectation that these stocks will have an increase in their price/earnings ratio.”

Reflections (On Drivel):

Advice for all: don’t get caught up in the “noise” that results from our insatiable need to explain every wiggle in the financial markets. Consider the following.

“More recently we’ve been warned that a rise in oil prices is a terrible thing and a fall in oil prices is a terrible thing; that a strong dollar is a bad omen and a weak dollar is a bad omen; that a drop in the money supply is cause for alarm and an increase in the money supply is cause for alarm. A preoccupation with money supply figures has been supplanted with intense fears over budget and trade deficits, and thousands more must have been drummed out of their stocks because of each.”

Sound familiar? It shouldn’t. It is fifteen years old! “The Drumbeat Effect” segment in Peter Lynch’s book, One Up On Wall Street, is one of the most under-rated pieces of stock market advice that was ever penned. It was copyrighted in 1989. Here’s an example of today’s drivel, written by an editor of Morningstar, obviously in a hurry to catch his train instead of realizing the inane quality of his remarks.

“With interest rates ticking up in the past few weeks, it’s likely that the long-expected rise in rates is finally under way. While we’ve had a similar false start earlier in 2004, the reality is that if rates do continue to move higher in a steady fashion, it won’t be easy sledding for bond-fund investors, especially those in or near retirement.”

Nothing could be further from the truth. Retirees with whom we are familiar would benefit tremendously from a steady rise in interest rates. A simple bond ladder, with or without the help of a bond mutual fund, would experience a rising stream of income under a rising interest rate environment. Principal fluctuation would be irrelevant, because it would come back on the schedule structured in the laddered maturities. Let’s try to focus on the fundamentals and tune out the “noise” that comes from the media. As Peter Lynch said, “These days, dumb ideas are at a deafening roar.”

New Business (SEC Registration):

As of the end of 2004, we were managing over $30 million of your money. Investment Advisers with assets under management equal to or exceeding $30 million are required to register with the Securities and Exchange Commission. Accordingly, our registration with the SEC is scheduled to become effective Monday, January 3, 2005. We have been preparing for this event for over a year, and, while we have formalized some of our procedures, we have not found it necessary to make any dramatic changes in our operations. We will be sending all of you our new registration statement on form ADV-II to update your records. Otherwise, we expect this change to be seamless as far as our clients are concerned.

Thank You:

Another milestone for H.S. Dreher Capital Management, LLC occurred in 2004, when we celebrated our 10th anniversary. As you know, being in business for ten years is an important accomplishment for a small company. We believe our investment style–which is based on diversification and has been refined over the past decade–and our clients willingness to accept the responsibility of adapting prudent Investment Strategies, are responsible for helping us achieve this growth. As we have done in the past, we will continue to investment your money based on the principles that embrace the concept of diversification. We understand that by definition, therefore, the best return in the long term is not always the highest return in the short term. With the caveat that results in the past cannot be guaranteed in the future, we have faith that this investment process over the long run will continue to provide returns that match the risk that is appropriate for your individual situations.

Thank you again for ten years in business. All of us here at Dreher Capital Management are looking forward to the next ten.

Sam Dreher & Tom Veleivs, CFP

Copyright 2005, H.S. Dreher Capital Management, LLC. All rights reserved. This letter is for the information of clients of H.S. Dreher Capital Management, LLC: 275 SE Broad St, Southern Pines, NC 28387, #910-692-4330. Information is taken from sources believed to be reliable, but is not represented to be complete; is not guaranteed for accuracy by the firm and is subject to change without notice. More information on specific companies and topics mentioned in this letter is available upon request.