Brian Mcmorris - New Year Financial Outlook - 2006

To All My Investor Friends: Happy New Year 2006 It is hard to believe another year has gone by so quickly. Where does the time go? It was a challenging year for investors. The markets went down, they went up, and ended up not far from where they started. One had to be in the right place at the right time to make any advance in 2005. I was fortunate to do just that with a market beating portfolio again this year, for the 7th year in a row (since my dismal relative performance in 1998). This year saw the launching of my financial services website: www.wealthed.com. It also saw my enrollment in UCLA and their online Financial Planning certificate program. I received “A’s” in both classes I took (I am sure you are impressed), and had great enjoyment in the curriculum and my return as a university student for the first time since 1982. But as the year progressed, I found the time is not right to make Financial Planning a full time, or even part time endeavor. Instead, I am assisting my son, Jared, with his own business and website: www.xactsensing.com. I will get back to the financial services business once XACT is up and running profitably. Still, I will continue to post this annual letter, plus the occasional financial or life insight on “Wealth-Ed” (The Money Academy). As always, I start by recounting last year’s plan (quotes in italics as emailed on Dec. 31, 2005) and how it fared: My overview of the market to you at the beginning of 2005: “The story line for investing in 2005 has one important theme: Protect against a declining dollar.” Okay, this goes to show that one can’t count on being right all the time. I was dead wrong on the direction of the dollar vis-à-vis other currencies. However, I was not wrong about the underlying weakness of the USA currency due to current account and budget deficits and the direction of gold and oil against the dollar. But what I didn’t count on was the commitment of other central banks to match the dollar move for move. Basically, we are in another period of “Beggar thy neighbor”. This is an economic concept whereby each country tries to devalue its currency against others to improve its domestic economic agenda, i.e. to put its people to work. The last time the world saw a prolonged period of this phenomena was the 1930s. Need I say more? I have been concerned about the rate of appreciation in real estate since at least 2002. 10% plus appreciation is not sustainable for any length of time since real estate historically appreciates at the rate of inflation plus 1% (probably attributable to quality-of-life improvements like average square feet, plumbing, water and electricity) and no more. Here was my comment last year on that subject: “We are currently at a flux-point after the bursting of one bubble, the stock or equity bubble, but just prior to the bursting of a real estate bubble. We can argue about the degree of the real estate bubble, but not about its existence. The long term, 100 year average of real estate appreciation is approximately the same as real GNP (inflation adjusted). So, in this period of low inflation, there should also be low real estate appreciation on par with GNP, about 3-4% annually. Yet, real estate has been appreciating from

10-20% annually in various markets the past 10 years. This is a bubble and it must burst or revert to historical norms at some point.” First, Dr. Robert Shiller (Yale University) precisely defined growth at 1% over inflation, the number I now reference, in his book from March 2005, “Irrational Exuberance 2”. This number was arrived at by extensive historical research conducted by a squad of graduate students. So, long term, 100 year growth rates in real estate are less than I had estimated last year (3-4% over inflation). Second, I believe government and industry data from the last couple months (nearly 20 year high in housing inventory on the market, “days on market” at over 60 days, another 20 year high), shows that the real estate bubble is in the process of being popped, thanks in large part to the commitment of the Fed to raise interest rates and discourage excess lending. We will know more next year at this time how severely the real estate markets turn down, which geographic markets are most affected and whether all of this precipitates a recession. On my list last year of 10 things to consider for financial security, number 9 was: “The very best commodity to hold in 2005 will be gold. Why? Gold is the likely exchange currency of choice should the $USD fall out of favor because of the devaluation underway. Also, gold is a commodity that has many industrial uses and is therefore consumed every year. It is relatively difficult to increase supply, so a suddenly increased demand is likely to exceed the ability to increase supplies to match.” Again, I was right on the money here, and my position in gold stocks benefited because of this call. I believe this trend will continue for some time. It has only just started. The gold cycle is similar to the oil cycle. They benefit from both being valued as “hard assets” with intrinsic historic value, even though the values are different to homo sapiens. As our trade and budget deficits continue to weaken the dollar, it becomes less attractive as the world’s “reserve currency” and gold becomes more attractive. This change in thinking will take years to play out as gold continues its march to $2000 per ounce. Here is my advice from 2005 and my commentary on any changes needed for 2006: + Stay conservative (Still True and will be until equities are again cheap…below 10x current earnings); I still think this is not a time for the market to rally. The market price to earnings ratio is not anywhere near a typical low in respect to valuation, at the current 17 or 18 times (even higher once employee stock option expenses are deducted from earnings, which will be required by July 1, 2006). But a 10x earnings factor would require a significant inflationary environment. I am not as convinced of runaway inflation as last year, especially with Ben Bernanke as Fed Chairman. So I am changing the definition of a “cheap stock market” to 13 times in a 5% inflation environment. + Protect against the possibility of inflation… inflation is very likely in 2005, more so than 2004 for reasons that will be outlined. While inflation, as measured by CPI, stayed relatively quiet in 2004 at less than 3%, it reversed 20 years of downward direction; given the large increases in commodity prices, most notably oil from $25 to $50 per barrel, inflation will continue to accelerate into 2005. How do you like that prediction of $50 oil? Seemed crazy a year ago when at $35, didn’t it? This is why I think

that 5% inflation is baked into the cake, even though government stats don’t yet report it. Commodities of all kinds have increased 2-5 times over what they were in 2000 (when oil was $10 for a time). Much of this is offset by imports of cheaper manufactured goods from Asia. But going forward, imports will not get any cheaper (higher commodity input prices and increasingly higher labor costs are also a reality in China) and the higher costs of commodities will work their way through the world economy. + Sell REITs and any commercial real estate holdings; we are at the peak of a 20+ year real estate cycle; REITs are now selling at prices that yield less than 5% on average, on par with risk free 10 year Treasuries; REITs will be hurt by higher interest rates and an eventual economic downturn in 2006. Cash out now; Hey, another good call! I haven’t changed my views on real estate, and won’t until we get those REIT dividend yields back to 8% like they were in 1999 and 2000. All that is required is for real estate to decline relative to other asset classes and rents / revenues to increase. This will not happen for another 5 or more years. REIT yields are now less than super-safe 6 month T-Bills. + Stocks: the Large Cap Value sector is the last stop during a business cycle. This was a good strategy in 2004 with a total (price + dividend) return on the Russell LC Value 1000 (ETF ticker: IWD) of 14.2%. High dividend, high ROE and free cash flow, large cap, and slow growth stocks will do well again in 2005; medical, insurance, energy, consumer staples (household) products, defense, are the place to be at the cycle peak and going into a business downturn (in 2005); expect another 10-20% return in 2005 on this sector; Okay, this one wasn’t perfect, but not bad either. Classic recession proof / defensive sectors like consumer stales and defense did not do well because the economy held up well against all odds. But defensive energy and healthcare proved to be very good sectors for 2005, placing first and third out of the ten S&P sectors (utilities, another defensive sector was No. 2). I wouldn’t make any changes to this prediction, since I think we will finally see the economy weaken in 2006, though I have lowered my energy exposure since it has become fully valued at this time. Utilities, which I never bought, are also fully valued. + Commodities: given the direction of the dollar, a very good hedge is to own commodities which will appreciate in $USD terms, as the dollar declines. The best way to own commodities is mutual funds or ETFs that hold companies producing those commodities. Additionally, many have significant dividends. See the following for recommendations. This was perhaps my boldest and best call. Gold mining stocks increased over 40% in 2005 after years of doing nothing. All the commodities did well in 2005, especially the first half. We are in a bit of a pullback in most commodities as they have become overowned, but I think this is a significant long term trend and will add to my positions on price weakness. + U.S. Bonds: because inflation is accelerating, stay very short term in bonds: less than 3 year duration on average and preferably Inflationprotected; Hi-yield or junk bonds are at cyclical high prices and will only go down, especially with increasing defaults at the next economic downturn; wait for the next recession to rebuild junk bond positions; This was the proper recommendation for 2005, though the long bonds did not get hammered as expected. So anyone who did not shorten duration or improve quality got a break. Given the economic environment and the flatness of the yield curve as of this date (January 2, 2006), in 12 months, either long bonds will be at 5% and maybe much more, or we will be in a recession, at which point, short term

rates will be on their way down. bonds. Stay short.

Neither scenario is good for high risk

+ International: Continue to invest in overseas funds and stocks that are not hedged for the U.S. currency. Because of trade imbalances, the dollar decline will continue. A simple way to protect against a declining dollar is the purchase of unhedged international funds; this is another good strategy that has paid off big time for me. I have particularly liked Asian stock markets that are benefited by the Chinese economic juggernaut. The dollar situation did not work, as earlier noted, so there was not a boost from exchange rate changes. But even with a strengthening dollar, the Asian markets had a very good year. My ETFs in Korea (EWY, 53.89%) and Japan (EWJ, 24.34%) were especially rewarding. This is a good time to sell half of my Asian stocks to take profits and protect against a sell-off, but keep half for continued exposure to the world’s best growth market for the next 20 years. And I still believe the dollar will eventually devalue against other currencies, so that stock price boost is yet to come. PORTFOLIO PERFORMANCE AGAINST BENCHMARKS: This year I am adding a historical summary of my personal portfolio performance against two benchmarks, the Fidelity Freedom Fund 2020 (FFFDX, an asset allocation fund designed for people like me, who will retire around the year 2020) and the Fidelity Spartan S&P 500 index fund (FSMKX). Really a balanced portfolio, with its lower risk bonds and cash should logically under-perform an equity-only portfolio like the S&P500, but I still aim to beat the stock market with my lower risk asset-diversified portfolio, by making correct asset allocation decisions. Here are the past eight year results. Note the disaster in 1998. The lesson learned there is not to have most of one’s financial assets in one stock, my employer STI in this case (folks at Enron and MCI learned the same lesson in 2002): 1998 McMorris FFFDX FSMKX

27.2 21.7 28.5

1999 31.9 25.3 20.7

2000 0.5 3.0 9.1

2001 1.6 9.1 12.1

2002 4.1 13.7 22.2

2003 26.9 24.9 28.5

2004 14.1 9.6 10.7

2005 14.7 6.3 4.8

OVERVIEW of 2006: To summarize the theme for 2006: “it is all about Bernanke”. The big change this year will be what the new Fed Chairman decides to do with the Federal Funds overnight rate. Alan Greenspan, who has presided over the Federal Reserve Bank and Open Market Committee as Chairman since 1987, has shown himself to be adept at blowing bubbles, namely financial asset bubbles. He has been a politician’s favorite kind of central banker: always riding in to save the economy at the last minute, thereby saving the politician’s job. This happened several times the past 18 years, the first time being October 1987, but then again in 1991, 1995, 1997, 1999, 2001 and 2003 (see the pattern?!). Each time, on the brink of a crisis (S&L collapse, Asian flu, New Millenium, 9/11, Iraq war), Greenspan would infuse the economy with liquidity (cheap money) to inspire the spending behavior of the consumer and businessman, who otherwise might pull in their financial horns and go stuff a mattress.

What Greenspan has accomplished with his style of central bank management is to train global investors that the USA Fed central bank will always rescue the world’s financial markets. He has done this by pumping liquidity into global markets at each crisis during his tenure, through the mechanisms of lower interest (Fed Fund) rates, increased money supplies (through selling of Treasury instruments/printing of money), and more lenient banking policies. But what happens when market risk is removed from the investment equation? Required returns decrease for a given level or risk. This has the consequent effect of compressing returns, including interest rates, because lower risk equals lower reward/return and always has. Ironically, at his Jackson Hole, WY “going away party” in fall 2005, Alan Greenspan wrote: ”(from this point forward), any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums (as is the case right now)”. Thus, Greenspan acknowledges that by reducing the sense of risk in the investment world through his timely additions of liquidity to the economy, he has planted the seeds of economic destruction. When investors are most complacent, sensing very little risk in their investments because the central bank will protect them, that is when the risk of low or negative returns is highest. This is the essence of contrarianism and why it is very important to run opposite the crowd. Ben Bernanke is a student of the Great Depression. He has even authored books on the subject, which are on my 2006 reading list: “Essays on the Great Depression” and “Inflation Targeting: Lessons from the International Experience” and has co-authored several other books with Robert H. Frank. These texts provide insights into the person who will likely be the single most influential to investors for the next 10-20 years. The early read on Bernanke, based on his previous stint as a Fed District Vice President and Open Market Committee member, and his short time on President Bush’s Council of Economic Advisors, is that he is an inflation hawk, but also a deflation hawk. This is to say, he is on the record as planning to “Target Inflation” (the title of one of his books). This is quite a different approach as compared to Greenspan who had a policy to target a real interest rate of around 2% (real interest rate is nominal or current rate less inflation). The danger with Greenspan’s approach always was that if inflation turned to deflation, targeting interest rates would do nothing to stop it. They would just follow inflation on down to 0%. This is exactly what nearly happened in early 2004, and what did happen in Japan in the 1990s until today. Targeting inflation implies that Bernanke will let interest rates go where they may. It is also to say, that some degree of inflation will be accepted and embraced. Bernanke definitely fears deflation more than inflation, based on the infamous statement that he would have dollar bills thrown out of helicopters to thwart deflation and his writings on the subject. This fear is based on his extensive study of the Great Depression, and its consequent global deflation. We know, then, that Bernanke will avoid deflation and accept some degree of inflation. The big question is “how much”? Some have speculated 2% will be the target. Personally, I think that is too close to 0% or deflation for his comfort. I will plan on 3%, with a stated range of 2-4%. This will be

another big change with Bernanke; he has said he will be very concise and clear about his policy direction and will publicly state his targets. What will be the effect of changing the central bank focus from interest rates to inflation? The first conclusion that can be made with near certainty is interest rates will gradually drift higher, so long as the economy is strong and supply is tight for global commodities. Bernanke will be very interested in balancing supply and demand through interest rates to achieve the inflation target. If the labor market tightens because of the strong economy, if the GNP exceeds 3.5% growth (the widely accepted equilibrium rate) and if pricing power increases because aggregate demand exceeds supply, Bernanke will not hesitate to increase Fed Funds rates. I believe that Bernanke disagrees with Greenspan’s bubble blowing policies. He will take the current opportunity of increasing interest rates to continue taking air out of the real estate market. He will not stop until a shallow recession is achieved. Indications are that Bernanke will not be as concerned about appeasing Washington as was Greenspan and will not hesitate to apply the brakes on economic expansion. Because the past growth cycle has been fueled by consumers using housing equity to finance purchases, to the point of achieving a negative savings rate in this country the past three years, he will seek to shut down this debt produced expansion. Once the shallow recession has been achieved and consumer debt expansion is halted by higher interest rates along with a weaker economy, Bernanke will reduce Fed Funds rates to a level that encourages business spending on capital goods, without reigniting the housing bubble. How bad is the consumer debt fueled expansion in a historic context. Here is a chart of government data on the average savings rate for Americans showing the rate going negative in 2005 for the very first time:

Personal Savings Rate vs. 10 Yr. Treasury (data from St. Louis Federal Reserve)

13.00 11.00 9.00

Personal Savings Rate 10 Yr. Treasury Rate

7.00 5.00 3.00

Jan-04

Jan-01

Jan-98

Jan-95

Jan-92

Jan-89

Jan-86

Jan-83

Jan-80

Jan-77

Jan-74

Jan-71

Jan-68

Jan-65

Jan-62

Jan-59

1.00 -1.00

Chart by "Money Academy"

This is then the 2006 scenario: an economy that gradually weakens through the first half of the year while short term rates continue to rise to the 5%-6% range, resulting in a shallow recession beginning in the 3rd quarter. By the

4th quarter, the recession will be fully recognized and it is likely that rate increases will be halted, and depending on the severity of the recession, even lowered. If this scenario is accurate, the correct investment posture is to hold a high percentage of cash and short term bonds, at least 50% of the portfolio, and maintain defensive equity positions in consumer staples, energy, utilities, and other deep value sectors. Once the recession is acknowledged in the media, and perhaps by the Fed, that will be the time to get aggressive with equity and move to a much higher percentage. I believe that the next economic cycle will be a capital goods-led cycle. It has been six years since the last capital goods cycle. Those goods are now fully depreciated and in the case of technology equipment, obsolete. Because the end of the recession will coincide with the Presidential cycle, it is likely there will be tax incentives passed by Congress to stimulate business spending at the end of the next recession. If the market retreats to SP500 (900) and/or DJI (8500), it will signal a great buying opportunity and perhaps the bottoming of the current trading range we have experienced since 2000. This could set up an end to the Bear cycle and the beginning of a new secular Bull cycle, though I would not be surprised to see sideways financial markets for another 7-8 years based on historic patterns. Technology often leads the way out of secular bear markets (as in 1982) and it may do so again the next time. See the following chart that I update every year for an indication of the possible shape of the market over the next several years. History repeats in investing as well as other human endeavors. So history is prologue to what will happen in the stock market. This chart presents three significant periods in the USA stock markets. The 1920s and 30s, punctuated by the Great Depression, the late 1960s to the early 1980s with the Oil Crisis in 73/74 and the high inflation of the late 70s and early 80s, overlaying the current market and the blowoff of the Tech bubble in 2000-02. The major elements of each period are almost identical in amplitude and duration. As with any physical upset, there is first wild gyration followed by a significant period of stabilization, followed by another gradual upward period (starting slowly, and then accelerating into another frothy period 20 years out). The chart shows we are ending the stabilization period and heading towards a possible long-term upward period starting between 2007 and 2010.

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2006 brings secondary correction follow ed by new Bull?

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Secondary Market Decline (post election) 37-38, 76-77

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Dow Ind 1925-1940 Dow / NASDAQ 1967-1982 NASDAQ COMP 1995-2010

Primary Market Decline (post election) 73-74, 30-32

10 Jul 1924 Jan 1967 Jan 1995

Jul 1929 Jan 1972 Jan 2000

Jul 1934 Jan 1977 Jan 2005

Chart by "Money Academy"

What happened to the USA stock market in 2005 and where does it go from here? Another chart I use to show historical trends is focused on the idea of “Channels”. Market trends tend to move within a channel on either side of a trend line representing a price average over a period of time. The trend line and its associated channel only change slope at significant events during time, such as the Great Depression or the Oil Crisis. This market analysis shows we are in a flat trend coming off the Tech bubble blowoff. We are bound in a channel that is roughly 7,500 on the downside and 11,000 on the upside of the Dow Industrial (DJI) index. For the market to advance out of this channel, i.e. change the trend slope back to an upward trend, it will require a “retest” of the bottom of the range. Technical analysis suggests we must retest 7500 DJI, if this indeed is the lower limit of the channel, reached last in early 2003. It would be very bold to predict such a precise target, so I am suggesting that anything approaching 8500 DJI will constitute a retest and will allow the market to move on up out of the trend channel. If my Bernanke thesis is correct, he will precipitate a recession that will allow the market to decline to this range. Note the Pink arrows show the long term trends from previous market periods. We can expect the market to progress off the bottom following this trend line and eventually break out of the 11,000 top boundaries by 2010.

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Dow Ind 30 Real GNP - Red channels sho w lo ng term trends. - B lue arro ws sho w average slo pe o f majo r bull market and acceleratio n to the late 1990s bubble. - P ink arro ws sho w lo ng term slo pe o f GNP gro wth and sustainable market slo pe. - USA Sto ck M arket in 2004 is trending sideways. If it breaks the lo wer side o f M ajo r B ull channel in 2005, it is likely to test the lo wer limit o f a multi-year ho rizo ntal channel at Do w 7500

Jan-12

Jan-07

Jan-02

Jan-97

Jan-92

Jan-87

Jan-82

Jan-77

Jan-72

100

Jan-67

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Another chart used here in the past is the “Presidential Cycle” chart. It is very instructive primarily because of the power that presidential politics has in the economy. The President, through Congress, is able to have very positive or negative effects on the economy through taxation and spending policy. Compare the “History Repeats” chart with the chart of the Dow 30 average for the past (18) Pre-Election periods. It shows the benefit that is derived from positive efforts by the incumbent government to stimulate the economy. This average picture of the market is also identical to both the pattern and size of the past actual 18 months in terms of appreciation of the Dow 30 averages:

Dow 30 Performance Average of past (18) Pre-Presidential Elections 20.00% 15.00% 10.00% 5.00% 0.00% 1

3

5

7

9

11

Months

13

15

17

Chart by McMorris F.P.

We are currently at a flux-point after the bursting of one bubble, the stock or equity bubble, but just starting to burst the housing real estate bubble. We can argue about the degree of the real estate bubble, but not about its existence. The long term, 100 year average of real estate appreciation is approximately the same as real GNP (inflation adjusted). So, in this period of low inflation, there should also be low real estate appreciation on par with inflation plus 1% annually, or around 3-4%. Yet, real estate has been appreciating from 10-20% annually in various markets the past 10 years. This is the definition of a bubble and it must burst or revert to historical norms at some point. Note the yellow circles on the “History Repeats” chart. The circles are the one year periods after a Presidential election (1933, 1977 and 2005). Typically the year after an election has flat returns. My analysis of 18 past post election periods and the 18 months following the election shows the average annual Dow Industrial return to be +0.72% during that period. The actual total return in 2005 of the Dow Jones Industrial average was +2.47% with almost all of this return was in dividends. Price return was almost exactly the historical average for 12 months after the election. We are now at Month 13 after the last election (using January inauguration as the reference). Month 13 to 18 are between 1 and 2 percent growth on average. But given the continuing recovery off the 2000 tech bust, the market is currently weaker than average, so a decline is likely.

Dow 30 Average (18) Post Presidential Elections 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% -1.00%

1

3

5

7

9

11

Months

13

15

17

Chart by McMorris FP

Another negative in the market is that we are now past the average age of a cyclical bull market (30 months according to InvesTech research) as of April 2005, we are living on borrowed time before the next cyclical bear. My approach for 2006 Based on the above historical and current events analysis here is my game plan for 2006: A range of 8500 to 11,500 for the DOW (just about the same as 2005 and the third year in a row for this forecast range), 900 to 1500 for the S&P500, 1800 to 2500 for the NASDAQ Composite. I think that the weakness this year will come in the first half of the year with a bottom during the summer coinciding with acknowledgement of the mild recession brought on by short term rates between 5% and 6%. After that, the pre-election fiscal stimulus, and the end of interest rate increases coming into sight, will cause a market rally during the fall and early winter, culminating in a significant “Santa Claus” rally which went missing this past year (2005). Asset Allocation: Asset allocation / diversification, along with identifying the best sectors and skewing the portfolio to those sectors are the key to financial success. I learned this lesson in 1997 and 1998 as my relative performance showed. I badly under-performed the late 90s market by having my eggs in too few baskets (too much STI company stock) and also being overweight the wrong sectors (commodities, value and REITs before their time). Here is my relatively conservative “base” asset mix: 60% stock, 20% bonds, 10% real estate (excluding our home), 10% cash. In 2005, I changed this mix for the first time in seven years by decreasing bonds to 0%, reducing the overpriced real estate segment to near 0%, increasing cash or stable value money market funds to 40%, and maintaining most of the 60% equity weighting in energy, international and small cap value. Towards the end of the year, I reduced the energy overweight from 30% of my overall portfolio (half of equity) to around 15% and increased technology, which will lead the market after the next correction. All year I have maintained a relatively heavy 15% of my overall portfolio (30% of equity) in international stocks, especially Pacific-Asia and Japan.

At the top of an interest rate cycle, I would normally adjust the allocation to overweight bonds, REITs and other interest sensitive investments, and underweight commodities and hard assets that are inflation plays. But I believe we are in an inflationary environment for the next several years, cheap manufactured imports and job outsourcing notwithstanding. As I have reduced real estate and bonds to near 0%, I have been replacing the difference with hard assets and commodities which can benefit from inflation. My stock mix has changed to be overweight energy and gold, plus other commodities. The “hard asset segment which had been as high as 30% of my total portfolio in mid-2005, is now at around 16% as I took profits on energy stocks in October and November. I will increase the weighting again if oil pulls back to $45 or gold pulls back to $450 / ounce. Equities / Stocks: 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. When the economy does turn to a Bernanke engineered recession in mid 2006, large cap value (Defensive) is called for at that point. Individual stocks can be purchased, if you like picking stocks, or an index can be used. A Large Cap Value screen using a minimum 2% annual dividend, minimum $20B cap size, High ROE, Low Cash Flow multiple and Low Relative Strength (to capture out-of-favor stocks) reveals some of the following stocks: Diageo (DEO), Annheuser-Busch (AB, note Warren Buffet is accumulating this company), Exxon (XOM), Johnson & Johnson (JNJ), Coca-Cola (KO), Merck (MRK), Altria (MO), Wyeth, Conoco-Philips (COP), Pfizer (PFE), Dow Chemical (DOW), Dupont (DD), and Verizon (VZ). This list looks a lot like my list from the last two years, as large caps have remained out of favor since 2000 and now sport lower P/E ratios than small caps, a rare event. There are several established and highly regarded mutual funds covering these same stocks: several good and diverse funds are: Vanguard Value (VIVAX, 6.31%), Dodge and Cox (DODGX, 9.37%), Clipper (CFIMX, -0.3%), American Funds’ Washington Mutual (WSHFX, 3.50%), and Oakmark (OAKMX, -1.7%). We can now use Exchange Trade Funds (ETFs) to select sectors. A good ETF for large cap value, based on its low annual expenses and large cross-section is: Russell Value 1000 (IWD, 6.64%). We should continue to keep a cross section of small caps as my experience in 2004 and 2005 showed. 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 or ETFs for small caps. As mentioned, two good ones (according to Morningstar) that I own are Neuberger Genesis (NBGEX, 15.77%) and Fidelity Low Price (FLPSX, 6.72%). There are several others that can be researched by using Morningstar. Look for low volatility (beta) and high relative return. Again, we now have an index ETF to help us in this category. I suggest: Russell Small Cap 2000 (IWM, 5.20%). There are also Value and Growth only versions of this Russell indexed ETF series.

Emerging Markets: This is a stock (and bond) theme that should play a large role in any portfolio (5-10% of total). Emerging markets are the source of future long term growth in the world economy. They provide a good hedge against dollar weakness, and will increasingly provide a hedge against the domestic economy (as Asia, for example, becomes a net consumer of products). The best way to play the Emerging Markets is with managed funds. There are several closed ends and ETFs in this segment. Templeton Dragon (TDF, 20.9%), invests in China/Hong Kong, and is a fund I have owned since 1996 but traded in for the broader market EMF in late 2005. “Emerging Markets Fund” (EMF, 31.65%) has a broader EM scope and provides exposure to East Europe and Russia. We also now have the option of (EEM, 32.62%) which would have been a very good choice. It is the “Ishares” ETF for emerging markets. (TEI, 4.76%) is a closed end bond version of the Emerging Market funds, but did poorly in 2005 due to the strengthening USD. Pimco also offers a good emerging markets bond mutual fund (PAEMX, 7.97%). There is also a Fidelity bond fund for foreign emerging stock markets, with a (FNMIX, 10.65%) ticker. “High Beta” / high return stocks: 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. People probably perceive health care as number three among necessities. One and two are food and shelter. But these are both commodities and could be great investments over the near term, in an inflationary environment. Both categories tend to be good defensive sectors going into a period of inflation or a recession as was demonstrated by these sectors the past the 70s and 2000-02. “Water” is another good, defensive, basic needs theme. There is now a “Water ETF” with ticker (PHO). As dynamic as they are at the end of a recession, Biotechs and small tech stocks can be hazardous to the investor’s health at the end of a cycle. 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 biotech, knows what the successful compounds will be. The Biotechs were flat in 2004 and have had small to very good gains in 2005, and have fared much better than large cap pharmas, which have had price declines due to patent expiration and litigation. This may be a good entry point, though biotechs are not really cheap as in 2002 for example. A good biotech ETF that owns many companies and is capitalization weighted (and includes profitable Amgen, Genentech and Biogen) is either Ishares’ (IBB, 2.44%) or HOLDRS (BBH, 31.29%). The difference in the 2005 return between these two similarly structured ETFs shows the degree to which active stock picking matters in high beta funds. At some point in time, after the market has gone through the multi-year Bear phase, small cap, high beta technology stocks will again be interesting, as they were in the mid to late 1990s (peaking on March 10, 2000). Until then, I will stay away. The “Hedge”: Better portfolio return is achieved by diversifying as measured by a low (less than 1.0) or negative beta: when some stocks go down, others go up. A negative beta will occur when a stock moves in the opposite direction of the benchmark, usually the S&P500. This is also called “covariance” by statisticians. A low beta stock, less than 1.0, is also useful to mute the ups and downs of a portfolio. (The approach, by the way, is called “Modern Portfolio Theory” or MPT, though I don’t know how modern as it first was documented in the 1950s by Harry Markowitz). As statistical research and years of experience have shown, a small dose of hedging, say 10%

of a portfolio’s total value, can reduce risk (volatility) without significantly reducing return. In 2005 I used David Tice’s (BEARX, 2.02%) fund to provide a little covariance. This fund is supposedly a mirror image of the S&P500. I have not found that to be the case. He hedged his hedge fund in gold, and poorly at that, and BEARX showed a greater loss than the gain of the S&P. His gold hedge should have improved that performance, as gold has done well this year. So, I sold my BEARX in mid-February and decided to use options and shorts to achieve my hedge, along with ownership in the Vanguard Gold and Precious Metals (VGPMX, 43.79%) fund (more on gold stocks later). I added stock options to my portfolio starting in the mid-year of 2004. I continue using both option contracts and shorts to provide “insurance” for my portfolio. In 2005, I used a combination of “Way-out-of-the-money” (WOOTM) put contracts on the NASDAQ 100 (QQQQ) with January 2006 expiry, to provide portfolio insurance. I bought these contracts in February and sold (closed them out) in April at the bottom of a market decline, for a nice profit of 50%. Because these put contracts were intended for insurance, not for profit, I bought more after a small market rise a few weeks later. Fortunately for my portfolio, but unfortunate for the contracts, they proceeded on their march towards zero. But during this period, expecting more of the market bounce, I also bought some DVY (Dow Value ETF) December call contracts, and sold them three weeks later for another 50% profit. So, with the two profitable option transactions, I had paid for a good portion of my annual portfolio insurance premium. At the end of this year, I had realized significant capital gains on my profitable trades on stocks in my taxable accounts (I try very hard not to trade my taxable accounts to minimize taxes), but could offset that by my losses on my options contracts. This meant my net capital gain for tax purposes was reduced by 50%. And, if you have more capital losses than gains from your insurance program, and keep your total investing losses less than $3000 per year, you can deduct all of them from your income taxes. Trading expenses (which are amazingly low now on options) can also be deducted. The US government will help pay for your portfolio insurance. Bonds: Short term and inflation-protected bonds (Treasury Inflation Protected Securities called TIPS) are called for with rates continuing to head up in 2006. Note: I said the same thing in 2004 and 2005 regarding rates and was wrong on long term, but right on short term rates (like everyone else, including Bill Gross). With real interest rates (interest return minus inflation) reduced to negative levels in 2004, the rebound in short term interest rates were offset by increases in inflation. Since TIPS are “real rate” instruments, with a guarantee of a nominal market return over CPI inflation, the TIPS did not do well in 2005, even compared to a simple money market account. Vanguard provides the low cost TIPS fund, (VIPSX, 2.59%). Longer term bonds (over 3 years) should be avoided for the immediate future, though, if 10 year Treasury bonds make a move to 5.5%, it would be a good bet to buy those, as the next move in interest rates would likely be down. But my bet is that inflation due to commodities and the eventual devaluation of the USD is structural and baked-in. Inflation always is poison for long bonds (10 or more years). Because the economy is likely to weaken, high yield or junk bonds should also be avoided. They are still at historical low spreads over safe Treasuries, less than 2.5%, as has been the case for over 18 months. A good time to own junk bonds is when the spread is over 8%,

typically during a recession. Other than short term Treasury and TIPS options there are other interesting bond possibilities. Emerging market bonds will take advantage of a weakening USA dollar and provide currency plus market returns. Real Estate: Real estate has been good ballast in a portfolio. It has low correlation to the stock market, but a high inverse correlation to the direction of interest rates. Real Estate Investment Trusts (REITs) are the best way for the average investor to participate in the real estate asset class. It is also possible to own individual properties, but management of those properties requires time and effort. Also, it is hard to gain adequate diversity by owning individual real estate. A minimum of 15-20 properties in several geographic locations and different property classes (e.g. apartments, shops, offices) would be required to become truly diverse. Because of the so-called “real estate bubble” in the housing market and the coincident runup in the price of the average REIT, it is not a good time to own REITs. REITs were yielding over 8% in the late 1990s, when the asset class was out of favor. Subsequent price increases in REIT stocks (and their underlying real estate) has reduced the return to below 3.5%, less than many dividend paying industrial equities that often pay out less than 35% of their cash flow. REITs, on the other hand, must pay out 95% of cash flow according to the tax code. If the air comes out of the housing market, as I suspect will be the case, REIT prices will decline in sympathy. That combined with higher interest rates which discourage home ownership by raising mortgage payments, will allow leases and rents to increase. That will set the stage for higher REIT yields over the next 2-3 years and a chance to re-aquire REITs at a better price. Fidelity (FRESX, 14.9% in ‘05) and Vanguard (VGSIX, 11.89%) both have good REIT funds, as does Cohen-Steers Realty (CSRSX, 14.88%). The Cohen Steers REIT fund has a sister ETF fund that can be traded intra-day (ICF, 14.57%). REITs have returned well above average for the fourth year in a row. This will not continue. A price decline of 30% would return REIT prices to their long term total return trend line (12% annual) and increase yields to back over 5%. Fidelity has just introduced an international REIT called (FIREX, 14.94% in 2005). This might be a good place to pick up strong real estate returns the next few years while hiding from a declining dollar. Hard Assets / Commodities: I have been promoting Oil as an investment now since 2002 (actually, I made my first oil investment in 1997 with Freeport-McMoran with its 14% dividend, but was early on that one. I sold for a small loss when the dividend was cut to 4% during the oil price decline of 1998). In last year’s letter, I pushed the oil theme harder than ever. If you went along with the recommendation, you are today very happy. It turned out to be a solid bet, with average appreciation over 40%, depending on whether it was drilling equipment, producers, natural gas or integrated oil stocks that were purchased. This will continue to be a good market sector, all though there may be a short term pull back if the market sees recession. That will imply lower demand, and hence a lower price for oil. However, the long term trend favors much higher prices, so a pullback will create another buying opportunity.

Matt Simmons is an industry expert who wrote a book last year called “Twilight in the Desert”. He recently stated in a Barron’s interview (January 2 edition): “I've placed a $5,000 bet (with a NY Times reporter) that oil prices will average $200 a barrel in 2010. I don't have any idea where oil prices are headed (next week) but they could easily be above $200 a barrel. At $65 a barrel, or 10 cents a cup, we are still grossly underpricing oil, which is why it (high prices) doesn't have any impact on demand. As the markets get tighter, sooner or later we are going to have shortages. And the two times we have ever had shortages in North America within 90 days, the price of oil went up threefold”. T. Boone Pickens is also public with similar theses regarding the short term (down) and long term (up) price of oil, as is industry consultant Tom Petrie and consultant Robert Wulff of McDep Associates (www.mcdep.com). Energy should be a large portion of any portfolio for the next 10 years or more, during the time Chinese and Asian economic expansion puts supply pressure on marginal production. Also last year, I began suggesting gold for the first time. This also turned into a good bet and the gold thesis continues to look good. Gold bottomed at $250/ounce in 2001. Since then, it has doubled to over $500. As reported last year, gold has been the “Anti-dollar” since 1971, when the USA (and by extension, any central bank with currency linked to the dollar or otherwise using “fiat” currency, e.g. the Euro) went off the gold standard and onto a paper based standard (the USD). Paper-based standards are backed only by the government of the issuing country and its economic prospects. If those prospects decline, so will the currency. When financial assets and the dollar are strong, gold is weak. When financial assets backing an economy and its associated currency decline, as during a period of debt-induced inflation, gold will strengthen. The dollar became the world’s “reserve currency” after 1971 at the end of the gold standard from this point on, gold and the dollar have moved in opposite directions. From 1982 onward, as the Fed Funds interest rates decreased from near 20% to just a little over 1%, the dollar strengthened. The dollar was strengthened by investors’ conviction that the dollar was safe. The relatively high interest rates in the USA from the 1980s provided a further attraction. The more money flowed into “zero risk” USA Treasury bonds and bills, the stronger became the dollar, since other currencies were in effect traded for dollar denominated Treasuries. As the USA interest rates declined over a 20 year period, buying long term US bonds and bills became a very wise investment. Bonds appreciate in value as interest rates decline. This created a “virtuous cycle”, lower rates attracted more foreign currency, and more foreign currency flowing to America drove down interest rates. But the bottom is now in at 1.25% Fed Funds rate in 2004. It has now increased by 3% and sits at 4.25%. As the interest rate cycle is long, we can expect gradual increases in inflation and interest rates for another 10-15 years. Last year I wrote: “Even if the worst case does not come about (a dollar collapse), it is likely that the Chinese must de-link currencies in the next 2-3 years. Our problems are becoming their problems. Our devaluing currency is expanding their money supply at a time when the Chinese government would like to throttle back to avoid hyper-inflation, over-investment and ultimately an economic crash. When China de-links, it will cause their exports to cost more in USD terms, and we will undergo accelerating

inflation. The end result of these concerns is the need to own either commodities (in the form of mining, energy or other natural resource companies), and rare metals (gold, silver, platinum, etc) in certificate or in fact.” About this paragraph, I will not change a thing. In fact, the Chinese did de-link in 2005 for the first time. They have elected to link to a “currency basket” that they will not define. It is likely they intend to gradually change the mix of currencies away from the USA dollar. They will gradually decrease their dependence on American assets. Because there are no other really good “fiat currency” alternatives, I am betting they will be adding more and more precious metals to that reserve basket. What does this mean for us as investors? Vanguard Gold and Precious Metals (VGPMX, 43.79%) was recommended last year in this space as a low cost way to get the needed exposure to the precious metals that China will seek as part of its “currency basket”. VGPMX has a current 3.5% yield. It returned 43.79% in 2005, well ahead of actual gold. There is operational leverage in the mining stocks that comprise VGPMX. The fund manager is also free to move between countries for exchange rate advantage and types of precious metals depending on what is most undervalued. Individual mining stocks like AU (37.9%), or Newmont Mining (NEM, 21.4%), or the gold ETF (GLD, 17.76%) are also available to provide a hedge against inflation. As for Energy stocks, again, I wouldn’t change anything, other than to recommend more natural gas and producer stocks, but not until we have seen a price pullback under $50 / barrel. The large cap integrateds have not done well. Will they in 2006? At some point, the market will recognize their value. The integrated energy companies are disadvantaged in that much of their oil reserves are in countries where the government receives a large portion of the profits resulting from increasing prices over the production cost. The best integrated companies own large domestic natural gas reserves and refining capacity where margins are high. Most trade at less than 10x earnings. Large cap integrated energy companies like Exxon (XOM), Chevron (CVX) and British Petro (BP) may be the most exposed to the negatives of this segment while Conoco (COP) which just bought natural gas producer Burlington Resources is a good bet. There are several diversified ETFs in this sector. (IYE, 34.67%) is a good domestic and diverse choice with a 35.5% return in 2004, and more to come. (IXC, 29.47%), up over 35% in 2004, provides more international exposure, and possible benefit from the resulting currency trade. (OIH, 62%) and up over 56% in 2004 is focused on only the energy equipment manufacturers. This provides a higher beta in this group, which means higher return as long as energy does well. There are also many energy mutual funds including the Fidelity Natural Resources, (FNARX up 40.94%) that also provides some mining exposure and Vanguard Energy (VGENX up 40.05%). In early 2005, I added to my positions in oil and gas producers that trade as trusts. The best trusts are the Canadian Royalty trusts that are given special tax treatment to help provide income to retirees. I currently own Petrofund (PTF) and Provident (PVX) which have done very well in 2005 while providing a terrific dividend payout over 12%. The high dividends pay out makes them best for tax advantaged accounts like IRA or 401K. They will continue to perform well as their reserves gain in value.

Cash:

Cash is good. The good thing about the 13 consecutive increases in the Fed Funds rate is that it has brought a decent rate of return back to money market funds and other short term bond funds like stable value. Now, you can get 4.5% sitting on your cash until the next buying opportunity in the stock market. Have a lot on hand for investing opportunities later in 2006. Have a Prosperous and Secure 2006.

Brian McMorris 651-334-0673