Stock and Bond Markets End Lackluster Year — 2006 Clouded

By Harvey A. Rowen, Keiretsu Forum East Bay Member and President, Starmont Asset Management, LLC

As I write this is mid December the DJIA is flat, the S&P 500 is up around 5%, the Russell 3000 is up 6% and the EAFE International Developed Markets Index is up 8%.  Bonds also have languished, with the Lehman Brothers Aggregate Bond Index up around 1% for the year.

2006 is not shaping up to start out much better.  The economy is expected to slow, corporate earnings are expected to slow, the Fed will continue to raise short term interest rates through the first quarter, and the budget and trade deficits will continue to be at or near record levels.  All in all, a difficult investing environment.

The rising short term interest rates have started to spill over into the mortgage market, with mortgage rates rising and home sales and price increases slowing or plateauing.

Since the tech bubble burst in March 2000, four areas have provided value in the public markets.  Those are (1) bonds; (2) real estate investment trusts; (3) international stocks; and (4) domestic small cap value stocks. None of those asset classes are likely to continue to have the returns they had during the last five years.

When the bubble burst the Fed began lowering short term interest rates, and the long term market followed.  By June 2003 interest rates had reached 45 year lows, as bond prices reached 45 year highs.  Then the Fed started raising rates. As the Fed has raised short term interest rates, bond prices have gone down to stayed steady.  The ten year Treasury bond has moved a little since the Fed started raising short term rates. If we are not to have an inverted yield curve as the Fed continues to increase on the short end, the 10 year yield must go up—which means that bond prices must go down.  Bonds continue to play a part in a diversified portfolio, but their role is much more as a shock absorber than as a generator of a significant total return during this tightening phase.

REITS are expected to start to show the effects of rising interest rates, with investors able to buy bonds for income yield instead of REITS.  If the economy slows, and office space goes begging and business people stop staying in hotels and shoppers slow their mall outings, REITS will suffer.

International stocks of both developed and developing countries appear to pose better risk/return characteristics than do domestic stocks.  But it is still the US economy that is the engine of the global economic train.  There is an old saying that if the US sneezes, the world catches cold.  If the US economy slows, the economies of other countries are likely to feel the effects.

Domestic small cap value stocks have led the domestic market for five years—an awful long time for any one asset class to lead.  The expectation is that in 2006 leadership will move to larger cap and growth stocks as small cap value reverts to the mean.

What To Do With Your Portfolio
As the public markets languish, private markets look more attractive.

Commercial real estate, through individual deals or real estate funds, can provide attractive opportunities.  The risk is that these investments are not liquid for some period of years.

The same with private equity—through individual investments or through a private equity fund.  The possibility of higher returns is coupled with the present illiquidity of the investment.

For the liquid portion of your portfolio keep bond positions short.  With the spread between 2 year Treasury notes and 10 year Treasury bonds at around 15 basis points, there is no reason to lend long term.  Cash, in the form of money market funds, is yielding around 4%, and money market funds do not have the illiquidity features of CDs.

On the equity side of the portfolio, keep diversified.  Domestic and international stocks or stock funds (or ETFs); large cap and small cap; growth and value.  No part of the market presents a more compelling opportunity than any other at the moment, so stay close to your strategic asset allocation, and wait for the opportunity to make tactical moves when those opportunities present themselves.