Publicly Traded Stocks Suffer

by Harvey A. Rowen, Keiretsu Forum Member hrowen@starmont.com

The first four months of the year have been challenging. The Russell 3000 index of the domestic equity market is down 5.4% through April; NASDAQ is down 11.7%. International equity markets continue to outperform the United States--the EAFE index of developed international markets is down only 3.5%. Bonds have done better than stocks, notwithstanding the Fed continuing to raise short term interest rates. The Lehman Brothers Aggregate Bond Index is up 0.9% through April.

Large cap stocks have taken over leadership from small cap stocks, which means that they have lost less in the first third of the year. Value stocks continue to outperform growth stocks by a significant amount, which again means that they have lost significantly less in the first third of the year.

What’s Going On?

There are some structural problems negatively impacting both the stock and bond markets.

The price of a barrel of oil has risen from in the $30s to the high $50s, and as I write this at the beginning of May is trading right around $50 a barrel. This has been driven by the rising world demand for oil—mostly from the United States, China and India, and the inability of world supply to keep up with world demand.

The United States is the largest user of oil in the world. While the rise in the price of oil has been positive for the energy companies, it has been negative for other companies and for consumers. Consumers have a major impact on the direction of the economy.

The United States imports a large portion of the oil we consume. As the price of oil has risen, so has the size of our trade deficit (the dollar value of what we import, less the dollar value of what we export). The flow of dollars abroad has caused the value of the dollar to decline (more supply of dollars than demand for dollars). This is good for the foreign stocks and bonds in the international portion of portfolios, as profits and interest payments are translated from the native currency to depreciated (and thus more) dollars. It has not been good if you have traveled abroad and experienced what things cost in dollars.

The dollars flowing abroad end up in the hands of foreign central banks. They can use them to buy the increasing amounts of United States Treasury bonds that the United States is issuing to fund our annual $500+ billion budget deficit. So more and more of our deficit financing is being held by foreign central banks.

Recently, some of those banks have indicated that they may own enough dollar denominated debt instruments. If they started to sell some of that debt, it would drive the price of Treasury bonds down (more supply than demand). If they simply stop buying more bonds, the United States will have to raise the interest rate it offers on the new Treasury bonds it issues as it continues to finance the ongoing Unites States budget deficits, to make those bonds attractive to potential buyers. This will drive the value of outstanding bonds down.

While this has been occurring, the Fed has indicated that it sees inflation problems looming in the distance, and that it will continue to raise short term interest rates to thwart inflation. While long term rates, as measured by the yield on the 10 year Treasury bond, have not risen as the Fed has raised short rates, it is expected that in time long term rates also will rise. Rising rates have adverse impacts on corporate profits (and thus stock prices), and on the real estate market.

It is these concerns that have had a negative impact on the stock and bond markets so far in 2005.

What Should You Be Doing in Your Portfolio?

Our experience at Starmont is that markets make adjustments eventually.

So we expect that there will be some combination of Americans driving less, and buying more fuel efficient cars, and more refining plants being built, and alternative energy sources being developed, and more oil being produced in the United States.

And we expect that budget deficits will be reduced as voters make known their unhappiness over ongoing deficit spending and increased foreign funding of those deficits.

While those market adjustments make their way through the system, here are some steps you can take.

First and foremost is to stay diversified. It is not clear which parts of the equity market will lead going forward.

Hold some portion of your portfolio in foreign stocks and bonds. This will allow you to take advantage of further declines in the dollar, and to take advantage of the fact that foreign central banks are not raising interest rates at the present time like our own Federal Reserve Board is doing.

As larger cap stocks appear to be taking over market leadership from smaller cap stocks, rebalance your portfolio, taking some of the gains made in smaller cap over the last few years, and using the proceeds of those sales to increase the allocation to larger cap.

Consider having part of your portfolio in real return strategies, seeking to obtain returns that are some percentage better than the inflation rate. This is discussed at length in a front page article in the Wall Street Journal’s Quarterly Fund Review that appeared in the April 4th edition. If you would like a copy of this article, contact Jean Samson at 925-648-4738 or jsamson@starmont.com .