2005 Report to Clients*

 

INSIDE THE MARKETS                        Summary

 In a perfect world, we would practice financial analysis to select stocks and bonds for your investment portfolios. And in our “Ivory-Tower” setting we come pretty close to doing so, spending most of our time looking for good investments with little regard for the size of a company’s market capitalization or the metrics that determine whether its shares are in the growth camp or value camp. We like to invest in what we think will deliver the best return for the least amount of risk, regardless of the investment community’s classifications. 

At times, however, it is prudent to make a distinction between the trees and the forest. History shows us that markets, sooner or later, revert to the mean. Being over weighted in one category, while not necessarily a bad idea, should be a matter of choice. And without paying attention to investment categories, it is not possible to exercise this choice. (You have to know where you are before you can decide where you want to go: investors need to know when they are over weighted—or under—in various investment categories.) In this regard, we find it interesting to study past investment returns in the market categories we follow.

Specifically in the bond markets, we note that with the 10-year Government trading around 4.38% yield to maturity, it wouldn’t take much of a fluctuation in principal to override the coupon as far as total return is concerned. Thus, we are defensive in our maturity selections for your bond ladders. And specifically in the equity markets, we note that small-capitalization stocks, as well as REIT’s, have over performed for all of this decade-to-date. A reversion to the mean could happen in any number of ways, but to the extent we have exposure to small-capitalization stocks, we want to be sure it represents our choice. (1)

As for the second conclusion stemming from a brief overview of these market segments, we would suggest it is their nature to vacillate from year to year. Looking at five-year return histories instead of just one year reveals years of negative returns in contrast to 2005, when all returns were positive. Hence, the need for diversification among the categories. And the third conclusion: not only was 2005 a positive year for all of these components, the returns have been positive for three years in a row. In other words, all of the markets have been pretty friendly since the 2000-2002 crash in stocks. Sooner or later, the investment seas won’t be so smooth, and investors will do well to be prepared with diversification.

(1) Relative exposure to different market categories can take many forms. For example, with regard to small-capitalization stocks, one form of limiting exposure might be to make direct investments (as opposed to index funds) in the stocks of small-capitalization companies we believe have above-average return possibilities. Many times, it seems to us at least, when a market category is hot, professional investors find it difficult to out perform the category with their individual stock selections. In this case, it can be advantageous to own an index fund that represents the category. When a market category is cold, however, individual selections often out perform. Of course, this rule, or perception, is not always on target, as the 2001-2002 debacle in utility stocks so painfully demonstrated. (This is why we pay attention to diversification.)

*Complete reports available to clients and subscribers in Client Area.