2004 Scorecard
All things considered, the fourth quarter of 2004 produced an exciting end to a rather unremarkable year for equities.  For most of 2004, the stock market was frustratingly range-bound as investors anguished over Iraq, the Presidential election, interest rate hikes, and rising oil prices.  A rally ensued in late October as oil prices fell from their highs and as investors sensed that the incumbent President would win the election.  With major market indexes in the red just three months ago, the S&P 500 finished the year up 9%, the Dow Jones Industrial Average up 3.2%, and the Nasdaq added nearly 9% as well.  Overseas markets also finished 2004 moderately higher, with major European indexes and Japan's Nikkei index up in the 7% to 8% range.

Expectations for rising interest rates were prevalent at the onset of 2004, with consensus predictions that 30-year mortgage rates would jump to the 7% range.  The reality was that mortgage rates actually dropped slightly to 5.81% from the 2003 year-end level of 5.85%.  Still, some rates did increase:  The Federal Reserve upped the fed funds rate five times to 2.25% from a near-record low of 1%, and banks accommodated by raising their prime rates accordingly.  In spite of these actions, interest rates are still at historically low levels, with the 10-year note yield currently at 4.3% and the 30-year bond yield at 4.9%.

The big news in 2004 was the oil price increase, with crude oil prices rising about 30% and closing the year near $42 a barrel.  Crude actually topped at $55 a barrel in October, translating into a nearly 70% price rise at its peak!  Inflation nearly doubled from 2003 to 2004, with the CPI increasing 3.5% from November to November versus 1.7% for the same period in 2003.  Inflation estimates for 2005 are currently at about 3%.

The Economy in 2005
Consensus is that the economy in 2005 is likely to see a significant slowdown.  With the prospect of continued increases in interest rates by the Fed, the lack of new tax cuts, and the lingering effect of higher energy prices, the logical conclusion is that continued growth could be in question.  On the plus side, a weak dollar should help exports, and the boom in productivity may actually result in job growth.  The other positives are that the economy, and corporate earnings in particular, are still quite strong.  The end result should be positive economic growth albeit at a decelerating rate.  St. Nicholas feels that we will revert back to a more reasonable and sustainable rate of economic growth.  Hopefully, the markets will focus on the durability of that growth rather than the deceleration of the growth rate.

Obviously, there are risks to the sustainability of our growth forecast.  As always, geopolitical risk is of major concern, and the threat of terrorist activity has not diminished.  The situation in Iraq remains grim, and oil price spikes are possible given the ever present tension in the Middle East.  Additionally, we continue to monitor China, and the effect that that country's slowing demand and growth will have on the US economy.  If, however, the dollar and oil prices behave as expected, we are more optimistic that growth can continue uninterrupted.

The Stock Markets in 2005
If you read no further, rest assured, we continue to feel that the stock market will offer selective opportunities in 2005.  We say "selective" because there are numerous cautionary factors that apply to the overall market that may have a negative impact on investor sentiment.  For instance, post-election years are often the weakest of the four year Presidential cycle, and the first year has historically resulted in negative returns, even though there have been some occasional significant upside surprises.  Also, although earnings growth should be up for the fourth consecutive year, it is not expected to be as strong as in 2004, and the two-year bull market run could possibly begin to weaken.  Accordingly, we feel this bull is still moving forward, it's just that he may be jogging rather than charging.

Many stock market investors are hoping that the year-end momentum in 2004 will carry forward into January.  St. Nicholas feels that the market will definitely establish a higher trading range in 2005, but expects continued volatility to be a very limiting factor, with the prospect for earnings growth disappointment increasing in the second half of the year.  We expect selective areas of the market to continue to do better.  Continued low interest rates and high demand should result in further growth in the housing sector.  Retail stocks should continue to do well as long as consumer demand remains strong, and there are still values to be had in technology stocks, as many companies continue to make investments in productivity with tech providers whose stocks did not fare as well in the past two years.  We would also look for our multi-cap strategy to begin to expose some larger-cap buy candidates who would benefit most from a weak dollar or present more defensive characteristics in a toppy economy.
In short, 2005 looks to be an ideal stock-picker's market - no more riding on the coattails (we already apologized for cliche' usage...) of a rising market.  We feel that growth should be visibly evident and that we mustn't pay too much for it, but, more importantly, a trading range market means we must be willing to consider exit strategies for individual stocks throughout the year.  A buy and hold strategy would certainly be acceptable for anyone with a very long term investment horizon, but for those individuals who are looking for out-performance in 2005, we suggest taking profits as individual positions (or the market as a whole) become extended on a price basis.

Bonds and Inflation in 2005
At the risk of sounding overly simplistic in the formulation of our 2005 interest rate outlook, we refer to the recently released Fed minutes which stated, "the current level of the real funds rate target remained below the level it most likely would need to reach to keep inflation stable."  Need we say more?  We're not going out on a limb by predicting that short term rates will continue to inch upwards, while long-term rates should also begin to reflect the growing concern of inflation. Our forecast is that rates will rise modestly across all maturity levels, and our strategy would be to remain short (principally 5 years and under) with increased exposure to lesser credits whose fortunes will still benefit from a growing economy.

In closing, we would like to emphasize one of the tenets of the St. Nicholas approach which is flexibility in the investment management process.  If nothing else, we enjoy the freedom to exercise judgment based upon some of the lessons we all so brutally learned in the past 4-5 years which include 1) Don't be afraid to take profits; 2) Don't be afraid to sell losers; 3) Cash is not always a bad thing; 4) Don't get cornered into one area of the market, and; 5) Be willing to adapt to changing conditions.  We feel that all of these disciplines benefited our clients in the fourth quarter of 2004, and they should continue to provide significantly greater benefit in 2005 in what is likely to be a topsy-turvy environment.