January 1, 2004
8:00 AM, Perdido Key, Florida

Year End Letter

To Our Valued Clients and Friends:

It is new year’s day and Beth and I are congratulating ourselves on being able to stay up last night to celebrate the new year. I guess we cheated a bit as we watched Dick Clark’s ball fall at Times Square in New York, we pretended it was our new year even though it was on east coast time. The girls, Haley and Brooklyn, stayed up and celebrated the “real” new year on central time.

This morning I asked the girls if they noticed much of a difference between 2003 and the new year. They admitted that there was little difference and of course this was an unfair comparison, comparing one new year to the next, with only a few hours difference. Nevertheless, I am struck this morning as to how different the first day of January 2004 is compared to January 1st of 2003.

It was only a year ago that both the country and investors were struggling. Investors had shouldered the third consecutive year of a down market and the country was wondering what would be the outcome of the Iraq crisis. Nine-eleven was an open wound and we all wondered what effect a second terrorist attack might have on the country.

A lot of territory has been covered in 365 days. Most of the uncertainty of Iraq has been resolved, although continued operations in that country are deadly and costly, their effect on the economy is much clearer now. Investors have enjoyed a nine month market rally that has brought both the Dow and S&P up by approximately 25% and the NASDAQ has rallied 50% from it’s bottom. The pain of nine eleven will never be forgotten, but the insulation provided by another year has helped. The country has become calloused to the various terrorist threats and while another terrorist attack might be costly I believe the country would shoulder the effects much better than it did several years ago.

This is one of many letters that I have written to you from our modest place on Perdido Key. Beth and I purchased this property with partners back in 1987 when it was far more affordable. It allows us just enough distance to get away from the office and try to gain some perspective. I enjoy coming down here at the first of each year, burying myself in the financial journals in hopes of gaining some insight into what the next year holds.

After several days of reading I believe that I have the answer! According to Richard Bernstein of Merrill Lynch and Bill Gross of Pimco the market will suffer a 20% decline as the economy will crash because of disappointing earnings. On the other end of the barbell are Edward Yardeni of Prudential and Abbey Joseph-Cohen of Goldman Sachs who say the market will rally between 12-20%.

This is wonderful guidance and should be considered along with Barron’s calling the year 2003 a “suckers rally” in a bear market, while the New Yorks Times declares that 2003 represents the opening of a new bull market.

I, of course, after gaining all this wonderful insight, am ready to give you a prediction, but I would like to give you some historical perspective first.

Bull Markets:

Going back to the early 1920’s the stock market has enjoyed or shouldered both bull and bear markets. Historically, the first and second year of a bull market have a combined average rate of return of 44% from their bottom. The first year historically averages approximately 38.9% and the second year 6.4% There are few, if any exceptions, to the relationship between the substantial run up in the market in the first year of a bull market and the modest return of the second year. As a result one might conclude that even at the beginning of a bull market the second year’s returns, in most cases, will disappoint.

Historical Perspective:

If I ask you the question of what is the average annual rate of return on equities since the early 1920’s most of you would get pretty close to the answer of 10.2% a year. But if I ask you what the worst decade was for the stock market, 1920, 1930, etc. . far fewer would know the answer. The answer by the way is the 1930’s.

Here is the kicker! What damage was done to the market during the 1930’s? Did the market lose 10%, 20% or 30%. The answer, the market for the decade of the 1930’s gained 1/2 of 1 percent. (While the 1930’s were the worst decade the 1950’s were the best with a 19.35% annual return. )

This is an eighty year perspective and the bottom line is that the stock market has never lost money if you consider a full decade time period. As a result, let’s take a look at the decade of 2000. By December 31st, 2002 the market had fallen a full 27.45%. For the market to rebound in a manner that would allow it to match the worst decade’s performance the market would have to rally at a rate of 4.5% a year between 2003 and 2010. If the market were to rally to a point where it matched the average decade rate of return from January the first of 2003 to December of 2010 the market would have to increase by 15% per year, which may be a bit optimistic.

So here is my prediction for 2004. For the market to match the combined first and second year return of the average bull market the market will have to rally 19%. For the market to continue it’s rebuilding process so that the decade of 2000-2010 does not divert too far from the averages, the market will have to rally about 15%%. As a result, I believe that the market could rise in 2004 between 8-14%. Even if the market does not perform in such a manner in 2004 I believe that by the year 2010 the eight year average rate of return for the market will result in positive return for the market of between 6-9%.

Volatility:

We all know that the Dow Jones Industrial Average peeked in early 2000 at approximately 11,800 and the NASDAQ peeked at 5,080 during that same period. Although the Dow Jones Industrial Average dropped a full 27% in the first two years of the decade its 25% return in 2003 now requires the market to increase by only 11.9% to retrace it’s peek of March of 2000.

In sharp contrast, even with the 50% return that was generated by the NASDAQ in 2003 that index will have to increase by another 148% before it will once again achieve the level of 5,080 as was reached in March of 2000.

“So, what is your point?”

The point that I am trying to make here is that the long term track record of the Dow Jones Industrial Average reveals, that there has never been a ten year period when the market did not achieve a positive return. In sharp contrast, speculators whether they invested in tulips, or in dot.coms, must wait far longer for the damage caused by volatility to be repaired. As a result, because we have now experienced perhaps one of the worst speculative bubbles in history we must make disciplined decisions as to whether we will be investors or speculators

If you are an investor, some portion of your portfolio must be exposed to the more mature equity markets. If you have not already done so you must mentally convince yourself that it is time to get back into the market with the portion of your assets that will be drawn upon in five to ten years down the road. For those of you that insist on making some speculative investments make sure you can determine the difference between your serious money, funds which are held for retirement, educating the kids, etc. . . and the amount that you can afford to direct to speculation. I believe this is the lesson forgotten four years ago. Whether it’s tulips or dot.coms speculators will not see the next investor bubble until it bursts.

“Boring stuff”:

In 2003 we used two balanced mutual funds to lead us back into the market. These funds were the Dodge and Cox balanced fund and the Oakmark equity and income fund. These funds made up the core of our Thoroughbred program and gave us an indication as to when to increase our equity exposure. These funds, which have both beaten the S&P index by over 2% a year over the last ten years, with only 50% of the standard deviation or risk, ended the year up 24% and 23% respectively. These funds virtually matched a 100% equity exposure while ending the year 65% invested in equities, and 35% in cash and bonds. Sound boring? Sure, it may be, but it delights the heck out of me.

As the year unfolded we increased our equity exposure and we will continue to reduce our core bond exposure in January, but our movement away from bond funds will not be directly into the market, but into the previously mentioned balanced funds.

With interest rates at historically low levels we do not recommend any investment commitment to longer term bonds, and feel the economy has improved enough to justify an increase in balanced exposure.

General Observations:

Interest Rates:
With the government generating such huge deficits and the economy improving I do not see how interest rates cannot rise in 2004. Nevertheless, I believe that the combination of the administration and the Fed will keep interested rates artificially low through the 2004 election.

Suggestion:
I recommend that you lock in longer term rates, clearing any variable rate mortgage exposure that you have. I also recommend that you wait before taking longer term bond positions until after the election.

The Dollar:
The dollar has fallen dramatically against the euro, yen and gold. Demand for gold has not driven gold prices to $420 an ounce, it’s the falling dollar that has made gold more expensive. I believe the current administration will continue maintaining a weakened dollar position until after the election in hopes of improving the export market. Interest rates will remain low and the dollar weak until after November.

The Economy: (excluding jobs)
The economy will continue to improve in 2004 while companies enjoy low borrowing cost and excellent export opportunities because of the weakened dollar. This should continue to lift stocks, but at the same time begin to deteriorate long term bonds. Bonds will produce little more than a coupon rate, so a portion of your bond exposure should make it’s way to a balanced portfolio as mentioned earlier.

Jobs:
It would be nice to say that jobs will automatically return with the improved economy as they have in the past, but I do not think this will happen this time. Increased productivity and a willingness to push jobs offshore will contribute to a slow recovery of the loss of jobs. This is painful for those seeking work in those sectors that are being effected, but an economic reality that must be dealt with from this point forward.

THE MARKET:

I do not believe that anyone can make a case for the markets being undervalued at this point. Earnings will have to continue to improve to justify the levels that the market has already achieved. U.S. Equities are overvalued when compared to international securities so I believe that international managers will shun U.S. investment, finding better values overseas in 2004. (The S&P is already trading at 32 times trailing earnings which is at the higher end of it’s historical P.E. ratios)

With interest rates held low because of the election and a continuance of improved corporate profits I believe the market will move higher, but not at the pace of 2003. (Please notice earlier prediction)

INTERNATIONAL MARKETS AND FOREIGN CURRENCIES:

Not only are foreign equities being viewed as better values than those of the U.S. , but two major investment managers, Warren Buffet and Jim Rogers, advocate simply investing in foreign currencies this year. This is an indication that the attractive returns of foreign securities may continue, partly because of value and partly because of a continued weakening of the dollar. (Many international funds were up sharply in 2003, with almost half of the gains being attributable to the “currency play. ” Look for additional international exposure in your portfolios. )

Thoughts that I would like to leave you with today:

1) Historically the Dow has never had a losing decade. For those of you who have been badly burned by the market since March of 2000, and are adamant about not returning to the market, consider investing a portion of your funds, those that will be drawn upon in five to ten years, back into balanced accounts.

2) Know and understand the investment goals that you have established for educating your children and establishing a retirement program. If you are unclear as to how much needs to be invested to achieve these goals - call me today and we will confirm your financial plan.

3) Determine, and be truthful, about how much you can afford to lose in the market before you begin to lose sleep. So many of us did not understand our true risk tolerance leading up to 2000. The 1994-2000 bull market made many forget that markets fluctuate in both directions. Now that we have all been hit in the head by a 2X4 let us not have that lesson brought to us again. Understand your risk tolerance and convey it to me if you have not done so already.

4) Measure your progress to that of your goals, not the investment index de jour. If you goals and risk tolerance suggest that you can reach your goals, sleep well, and enjoy life with rates of 8-10% then build your serious investment portfolio accordingly.

5) Understand the difference between core, or the backbone of your portfolio, and the funds in which you can take greater risks. Do not commit the core of your portfolio to speculation, no matter how attractive a new investment may appear to be.

I look forward to bringing you up to date at the end of the first quarter.

With warmest regards,
M. Brooks Clark
MBC/alm