Brian Mcmorris - New Year Financial Outlook - 2003

Hi to All and Happy New Year. I have put together my 2nd annual investment plan for 2003. I would like to share with you, if I can be so presumptuous, to give you additional ideas to help with your own investment plan. To recap last year’s plan (emailed on Dec. 31, 2001) and how it fared: My overview of the market to you at the end of 2001: “I have decided there still is some risk of the economy getting sicker (sp: more sickly?) (or not a lot better, which is almost the same thing). The stock markets seem to think we are going to have an excellent recovery and have priced that in. I think we may drift sideways for a while, and if some really bad political news happens, or if the economy is not getting a lot better by June, we may see new 52 week lows (below 8000).” We did. My recommendations for 2002 were: + Stay conservative + Protect against the possibility of inflation (it didn’t happen) by going to short term bonds and TIPS + Use REITs to provide downside protection and some upside plus current income (they have done fairly well in a tough market, with Vanguard REIT (a good index type fund) up +5.2% as compared with S&P500 down –16.55%) + Stocks: buy small caps (they have done all right compared with the S&P500 index; two examples: Neuberger Genesis (growth) is –0.9% in 2002 and the Fidelity Low Price (value) is –2.4%. Here are my recommendations and my Outlook for 2003 and my thoughts on investing in the New Year: + Stay conservative + Protect against the possibility of inflation (this time it more likely will happen) by going to short term bonds and TIPS + Use REITs to provide downside protection and some upside plus current income up +5.2% as compared with S&P500 down –16.55%) + Stocks: buy small cap index; two examples: Neuberger Genesis (growth) is –0.9% in 2002 and the Fidelity Low Price (value) is –2.4%. + Stick your neck out just a little and begin SLOWLY accumulating High Volatility Techs and Biotechs (see following for a good method) + Not too many changes for 2003!

OVERVIEW of 2003: 2003 will be good for stocks, especially small cap, and not so good for long-term bonds. But the rally may fade at around 10,000 on the Dow and we could retest the October 2002 low of 7200 during the new year. I believe we are in a multi-year trading range between those extremes. If this is true, then dividends will come back into style (especially if legislation in the Congress eliminates double taxation on dividends) and stock picking will be more important to achieve short-term gains. Capital appreciation will not be a good investment goal if we are stuck in a range. (Note: Historically, stock dividends exceeded corporate bond returns, to compensate for the perceived additional risk of common stocks. Bonds have priority to common stocks during bankruptcy, as we have been reminded this year. Maybe dividends are returning to their historically important role in investing). What determines this range? Historic P/E ratios. 10,000 DJI is roughly 1100 on the S&P500 index. For the historic P/E to get back to average at 1100 (it is 890 now) would require aggregate earnings of $78.57 (1100 divided by 14). The problem we face today is that the best-case scenario for S&P earnings in 2003 is only $50 (from a 2001 low of approx. $27. And if earnings are reduced by accounting changes in coming years, even lower). It may take ten years to get S&P earnings to $79.00 (allowing compounding at approximately 4% per year). Why be optimistic in 2003 for the USA stock market? We have just finished the first three year period of successive negative returns for the Dow Jones Industrial Index since the years 1939-41. This puts the past three year investing period in the same category as the Great Depression. Another comparison is that the NASDAQ has declined almost 80% from top (at 5132) to bottom, (at 1109). This is near the 93% decline in the DJ Industrial average in the early 1930s. The NASDAQ today is the growth stock index that the DJI was in the 30s. (Then the oldline index was the Transportation index, railroads mostly). So, could we have a 4th successive negative return year in 2003? It is possible, but unlikely. Still, the market is relatively expensive compared to very long term comparisons. If you believe that fundamental market valuation is based on human emotions and notions of value that really never change, then long term historical comparisons are relevant, regardless of the changes in the global economy over time. The long-term (since 1930) average for the P/E ratio of the USA stock market is around 14. It has been as low as 7.5 (in the mid 70s) and never higher than the 30 recorded in mid 2000. The S&P500 is currently around 20 based on this years earnings (the validity of current earnings is another matter. It is possible that accounting changes for stock options, pensions and recognition of revenue and “nonrecurring” expenses (pro-forma earnings) may reduce earnings as they are currently reported, by 30-40% over the next five years). So, even with a decent economic recovery (GNP growth of 4-5%), the market will still be over-priced as compared to the historic averages for several years. On the other hand, the market sentiment is pretty negative right now (using several gauges like volatility, negative stock fund flows and investor surveys). So a contrarian will say that this is a decent time to invest for the shorter term. Another factor to consider is the low interest rate situation that makes stocks attractive as compared to the yield of short-term bonds. The trend for interest rates should be slowly up. Inflation is nowhere in sight in consumer products. But commodity prices have been inflating for two years. This cost increase is in the face of a global recession. This tells us there is too little supply of basic commodities (since demand is off during the recession). It takes a while to bring commodity sources, like oil wells, mines and farms, on line. So commodities pricing pressure will eventually make its way into the CPI and cause some inflation. Our poor (deficit) balance of trade is also inflationary. Inflation may begin to increase in 2003 as the economy improves around the world, putting further demand on limited supplies of basic commodities.

The global political situation is a big negative, but is always an unknown and is probably factored into the market already. The domestic political situation is very bullish for the economy with Republicans controlling all the branches of government with a public mandate to get the economy rolling (perhaps eliminating double taxation on dividends?). Also, investment strategist Ken Fisher points out that the 3rd and 4th years of a president’s tenure are almost always good stock market years. The only two 3rd years of presidential terms that were down in the past 70 years were 1931 (the second leg of the depression highlighted by bank failures) and 1939 (World War 2 started in 1938). So what could go wrong in 2003? Unpredictable events like a huge currency devaluation in China that would deflate world economies (read Deflation vs. Inflation for our economy); Iraq or North Korea going badly; a nuclear attack somewhere in the world. Namely, circumstances we can’t predict. Speaking of China, having visited Shanghai in 2001, I am very impressed with the capitalization of their economy. If they continue on the current course, China will be the economic force in the world in twenty years, surpassing the U.S. Asian economies already understand this and Japan is remaking its economy into a service economy, exporting to China its manufacturing. This is hard to believe given the amount of historical animosity between the two nations (and it still exists if you talk to anyone from one nation about the other). My approach for 2003 Given the above situation analysis, this brings us to my investment strategy for 2003: A 10-15% increase in the DJI average this year and maybe a little more in the NASDAQ average. (I will guess at a close of 9500 (+12.7%) for DJI and 1800 (+24%) for NASDAQ Comp., but it is strictly for fun). As mentioned, I also believe the market will be in a trading range for several years as the market consolidates all the damage of the past three years and to allow earning to grow so that the market P/E gets back into line with historic averages. (this is also Warren Buffet’s opinion, for reference). Even if you believe this scenario, it is hard to know where in that range the year will end. I always try to keep a balance in my portfolio so that I won’t be hurt too much if my personal predictions don’t work out. Asset Allocation is the number one determinant of investing success. Stock picking is not very important, according to long term studies. You can use tools like Quicken to analyze your portfolio and provide long term returns based on a particular mix of investment types. The idea is to get the maximum return within the limits of your personal risk tolerance (which probably decreases with age). It may not surprise you that I am not very risk tolerant. Any of my friends who have gone to the casino with me will tell you that. I hate losing money and only take chances with a small part of my portfolio. (I don’t even like gambling, much). Here is my relatively conservative asset mix: 60% stock, 20% bonds, 10% real estate (excluding our home), 10% cash. I have held this mix pretty constant the past five years. It kept me underexposed during the 1999-2000 years of stock outperformance (and I was kicking myself at the time). In 2001 and 2002 the same approach has protected me. The bottom line is that this allocation has kept me even with other allocation models suitable for my age, like the Fidelity Freedom 2020 (+3.96% annual for the past five years), which is my personal portfolio benchmark. (Fidelity offers these portfolio models with risk designed for retirement in the stated year, in my case 2020. It makes a good portfolio benchmark). Stock: Stocks rotate by cap size along with the economic cycle. Historically, the rotation begins with Small Caps at economic recovery (more nimble) and moves to Large Caps (better global exposure and able to acquire small caps as the business cycle generates cash flow). There is also a rotation in terms of risk, from Growth at the beginning of an expansion, to Value at the beginning of a contraction. Stocks can be lumped by industry or sector into these groups of value vs. growth and small vs. large cap, to assist with the selection process.

If we are at the bottom of the economic cycle and improvement is underway, the best place to be would be small cap growth. If we are in a time of economic stagnation, we may want to stay a little defensive, which would bring us to value stocks (both large and small). However, large cap stocks are still expensive, on average, when compared with small caps. A long-standing relationship between large and small cap stocks as compared by the P/E ration is that small caps command a small premium to large (due to the faster growth rate possible with smaller cap size). Right now, small caps are still discounted from 10-20% as compared with large caps. This means, the small caps can appreciate 30% more than the large caps and maintain their historical relationships (not be over priced). Small cap is the place to be. Since small caps are hard to pick, unless you know something about a company based on personal experience, it is good to use mutual funds for small caps. As mentioned, two good ones (according to Morningstar) that I own are Neuberger Genesis (SG) and Fidelity Low Price (SV). There are several others that can be researched by using Morningstar. Look for low volatility (beta) and high relative return. To hedge the small cap bet a bit, a little large cap value may be called for at this point in the cycle, though the LVs are the first to come back during a recession and may already have run their course, especially the deep cyclicals like steel or chemicals, which are really like a commodity (inflation) play, anyway. Individual stocks can be purchased here, if you like picking stocks, or an index can be used. Stock picking is less important for large caps and indexes will probably do as good or better than individual pickers. Vanguard Value, Dodge and Cox, American Funds Washington Mutual, and Oakmark are good picks. Another way to participate in stocks is to guess at the sectors that will outperform in the future. Over the mid term (3-5 years) the best performing sectors are likely to come from the worst performing the past three years. This is where contrarianism really can pay off. Where are the worst sectors of the past three years? Techs, of course. And the worst of the Techs are telecoms, networking and internet. Biotech has also been hurt the past two years. Unless these sectors become obsolete like “buggy whips”, they will be back, but maybe with different names in the leadership. Because it is hard to know who will survive in a damaged industry sector, the best way to buy into the future performance of the sector is with sector funds. The only funds with which to do this once were only at Fidelity. But now, a new low-cost way to participate in sectors is available by buying “Exchange Traded Funds” (ETFs). These are baskets of stocks that trade daily on a stock exchange, mostly the AMEX. You can buy any sector and any foreign country index this way. The maintenance costs are also very low compared with mutual funds (0.20% vs. 1.2% for example), so you keep more of the returns. All the above sectors can be purchased through either the HOLDRs series or the Ishare series. Another stock category for the long term is Biotech. If you look at investing themes that will do well over time, the first thing to consider is the sectors that are driven by basic human needs. Health care is probably perceived by people as number three among necessities. One and two are food and shelter. But these are both commodities and not necessarily great investments over the long term (but can be so over the short term as both categories tend to be good defensive sectors going into a recession as was demonstrated by these sectors the past two years). Biotechs though can be hazardous to the investor’s health. They are extremely volatile and subject to investor emotion. Maybe only one of ten biotech companies will actually produce a viable medicine. No one, not even the founders of the biotechs, know what the successful compounds will be. Again, a good biotech ETF, that owns many companies and is capitalization weighted (and includes profitable Amgen, Genentech and Biogen) is the way to go. Try Ishares’ IBB or HOLDRS BBH. The best way to buy into damaged or volatile sectors? I have found that an account with Sharebuilder.com is a good option. Sharebuilder allows you to deposit on account through wire transfer from a savings account and make periodic investments of a given amount in a wide range of stocks. This includes the aforementioned ETFs. In this way, you can invest gradually and “dollar cost average” into a

sectors with the ETF. You can choose the flat rate plan and buy as many stocks as you want, in any increment, for $12 per month. Not a bad deal. You can open both IRAs and taxable accounts here. Bonds: Short term and inflation protected bonds are called for with rates about as low as they can go. Vanguard is the best source of bond funds, based on its low expenses. There are short term treasury and TIPS options. Other possibilities, based on recovering world economies: one is an Emerging Markets (read third world) bond fund. This type of fund does better in a recovery and worse in a decline than the USA equivalent fund. It also should be somewhat de-linked from the USA bond funds. Another alternative fund is a high yield corporate bond fund. The spread between high yield (junk) bond funds is historically high. This is another indicator of a market recovery. Now is the time to buy junk bond funds, if you ever will. Vanguard has a good offering here, too. Another way to buy into bond and debt assets at very low cost is ETFs. There are new versions by both Ishares and HOLDRs that track all types of debt instruments. You can use Sharebuilder for this as well, to gradually build your bond portfolio. Real Estate: I believe real estate was good ballast in a portfolio. It has low correlation to the stock market (as measured by Beta, a common way to measure volatility and stock market correlation or lack thereof. Available by company on Moneycentral.msn.com/company report, the lower the better). Real estate moves with the economy and with inflation. It is one of the best inflation hedges available (along with commodities and precious metals). It moves, for the most part, independent of the stock market. The great thing about real estate as compared with other hard assets used to hedge inflation risk is that it generates income. So, even if the market goes against real estate, as it usually does during a recession like the one we are in, real estate continues to provide a dividend. This will often offset the reduction in the price of the stock, as it has this year. REITs, as I elaborated (endlessly?) last year, are the best way for the average passive investor to have real estate exposure, along with your own home. I have friends, you know who you are, that have been pounding the table for directly purchased investment property. I know this can also be a real winner. I have seen acquaintances do very well with personally owned real estate. But the management takes a lot of work. My business schedule does not allow me to participate in this type of investment. Also, there is the problem of lack of diversity. Most direct real estate owners will end up buying one class of property (houses, condos, small apartments) in a single geographic area. It is always better to be diversified in investing. So I have chosen to give up some financial return for the peace of mind I get with REITs. (Note: I would like to offer that a good REIT will return almost exactly the same as a direct real estate investment when all is considered. In a REIT you are a limited partner. The general partner gets paid for actively managing the properties. In direct investment time (yours) and materials will offset any gains. As for the capital appreciation, if REITs were leveraged to the degree of the average direct real estate investment, they would return as much. Most REITs are a very conservative 50-50 or 60-40 debt to equity mix today. I would guess most personal real estate investments are 70-30 or 80-20. But with leverage (return) comes risk. If one really wanted to leverage up a REIT to get the better capital appreciation, one could buy on margin, and probably pay for the margin interest with the dividends of the REIT). A good REIT is Equity Office, run by Sam Zell, the best real estate investor in America. Another way is to buy a broad fund like Fidelity or Vanguard. Or, if you like shopping mall investments, my friend Louis Bucksbaum’s General Growth is a good choice. Cash:

The interest rates on Money Markets are as low as they have ever been. But I always have some “dry powder in the keg” as they say. This is especially true with maximum uncertainty, like right now. Hope some of this will help you invest well in 2003.

Brian