"The pace has been fast-fast, slow-slow," says Saut, managing director of investment strategy at Raymond James & Associates in St. Petersburg, Fla., reversing the basic steps of the dance credited to vaudevillian Harry Fox. "We observed fast-fast economic numbers in 2003, followed by slower growth in 2004. Now we're on a 'glide path to muddle,'" as he puts it, indicating that the economy will muddle through with neither a recession nor breathtaking acceleration in 2005.
Just as the economy is expected to muddle through this year, consensus forecasts indicate parallel plodding in the financial markets, with unspectacular returns for stocks and bonds. Nevertheless, some specific investment strategies may produce more sprightly results, especially for financial planners who move in step with major trends.
"This is not your father's typical business cycle," says Saut, who compares the present situation to the 1930s and even to 1807, when Robert Fulton took the first steamboat ride up the Hudson River from New York to Albany. "There was a canal bubble back then, and it burst," Saut says. "When new technology appears, overinvestment occurs, just as it did in the late 1990s." Going forward, a period of slower growth may be inevitable as the boom-and-bust is digested.
In terms of describing this year's economy, "slow-slow" might turn out to be more apt. Chris Sheldon, director of investment strategy at Mellon Private Wealth Management in Boston, says that investors should recognize that the U.S. economy has shifted from recovery to expansion. "That means a slower, more sustainable pace of growth and a slowdown in the growth of corporate profits," he says.
High oil prices and moves by the Federal Reserve to raise short-term interest rates will crimp the economy a bit, holding real growth to a range of 2.5% to 3% in 2005, Sheldon predicts. "We're also expecting inflation to remain subdued," says Sheldon, who sees the same 2.5% to 3% increase for the Consumer Price Index this year.
A similar forecast comes from Keith Hembre, chief economist at U.S. Bancorp Asset Management in Minneapolis, who sees 3% real economic growth in 2005, along with a 2% inflation rate. He doesn't anticipate a repeat of the 2003 tax cuts, which helped to stimulate the economy, while post-election government spending restraint, high oil prices, and the Fed's move from an accommodative to a neutral stance all are likely to impede growth.
On the positive side, though, Hembre sees a cyclical downturn in unemployment, which would lead to growth in household income and an increase in consumer spending. "And business investment should continue to grow at a moderate pace," he says. "In addition, the dollar has depreciated, making U.S. products much more competitive around the world, so exports probably will pick up."
Altogether, the positives offset the negatives, according to Hembre, making a modest expansion likely. Even as the economy expands, however, inflation shouldn't be a problem. "There's still slack in the labor market, so labor costs should not increase markedly," he says. With compensation outlays under control and worldwide competition at the retail level, runaway inflation is unlikely.
Not everyone is so comfortable about the inflation picture. For Judy Lau, a financial planner in Wilmington, Del., inflation ranks as an increasing concern. "The value of the dollar is declining, especially against the euro," she says. A weak dollar, while helping exports, pushes up import prices and the overall cost of living.
"The official inflation numbers today don't truly reflect the increased cost of commodities," Lau adds. "China is sucking up commodities and raising prices, which is apparent to anyone building a house these days. Prices are soaring for concrete, lumber, and so on."
The economic outlook for 2005, then, calls for moderate growth in the U.S. economy along with inflationary pressures that could range from mild to wild. If those will be the underlying trends, what investment strategies are indicated?
Fretting about Fixed Income
Even subdued inflation is likely to boost interest rates a bit, so Sheldon is cautious on bonds, advising investors to overweight maturities between five and seven years. Mark Kiesel, executive vice president and a senior member of the investment strategy and portfolio management group at Pimco in Newport Beach, Calif., also sees slow economic growth, moderate increases in inflation, and higher long-term interest rates.
"Ten-year Treasuries now yield slightly more than 4%," Kiesel said in late 2004. "By the end of 2005, we expect that rate to be moving toward 5%."
Growth and inflation are expected to be lower in Europe than in the United States this year, so Pimco is increasing its weighting in European bonds, especially German issues. "Low inflation and a strong currency are likely to be good for bonds there," Kiesel says. Pimco also holds bonds from emerging markets like Russia, Mexico, and Brazil--countries that stand to benefit from natural resources and cheap labor.
In the United States, Pimco has overweighted Treasury inflation-protected securities (TIPS) in maturities from four to 10 years, to hedge inflation and rising interest rates. "We are underweight in corporate bonds because of tight spreads," Kiesel says, meaning that yields are low relative to Treasuries. "When spreads are low, we are reluctant to take credit risk, so we're selling BBB and moving to A- or AA- rated bonds."
Chris Wheaton, a partner at Litman/Gregory Asset Management in Orinda, Calif., says one risk facing investors relates to the current account deficit in this country. "There's a possibility that foreign sources of capital won't continue to fill the gap. Asian countries have been buying dollars, trying to keep their currency down." If those nations stop buying dollars, lower demand would bruise the buck.
"The worst-case scenario--a destabilizing decline in the dollar--is unlikely, but remains a risk," Wheaton notes. "To protect against this risk, we own a foreign bond fund. We get the same recession hedge as we do from a domestic bond fund, as well as a dollar hedge."
Encouraged About Equities
Although no one interviewed for this article foresees a repeat of the heady days of 1995-1999--or even a year as strong as 2003--there was measured optimism about the stock market in 2005. "We believe interest rates are going higher, so investors will do better in the equity market," Sheldon says. "An investor whose portfolio allocation was 60% in equities 18 months ago might go up to 65% today."
Maggi Keating, vice president in the McLean, Va., office of Bethesda, Md.-based WealthTrust FBB, offers other reasons for boosting equity allocations. "After the election, the prospects for tort reform improved. The 2003 tax cuts probably will become permanent, and the research and development tax credit was just extended in the tax bill passed in 2004. This year, estate tax cuts might be passed." All of this legislation and potential legislation, if realized, will put more money into investors' pockets and corporate coffers, increasing the demand for equities.
What's more, the accounting scandals that sank stocks in 2001 and 2002 are unlikely to resurface, at least right away. "Companies have cleaned up their acts," says Bob Olstein, manager of the Olstein Financial Alert Fund in Purchase, N.Y. "There is less obfuscation in financial statements than at any time I've seen in the 36 years I've been in the business."
Known for crunching corporations' reported numbers, Olstein says investors now can get an honest idea of companies' earnings and free cash flow. "We believe that stocks are fully valued. In fact, we're actually increasing our cash position because we're finding it hard to get fully invested. Even though finding good opportunities is difficult, at least you can believe the numbers."
The numbers may indicate that it's time to reverse recent strategies in the domestic stock market. "Growth has been out of style," says Bernie Myszkowski, executive vice president and chief equity officer of ABN Amro Asset Management United States in Chicago. "Growth stocks have underperformed value stocks in the last five years." Long term, the picture is different, however, and it may soon change once more, some industry observers believe.
"Growth has outperformed value over the last 10 and 15 years," Myszkowski says. "That's because of the results during the 1990s. Now, the relative price/equity ratios of growth stocks, compared with value stocks, are lower than the last time growth stocks took off."
Myszkowski is lead manager of ABN Amro Growth Fund, so it's natural he'd have such leanings. However, several planners agree with his assessment.
"Small-company stocks have been outperforming for so long that they're bound to cool off," says Mark Balasa, co-president of Balasa Dinverno & Foltz, a wealth management firm in Itasca, Ill. "Similarly, there has been an over-reliance on value stocks for quite a while now." Thus, it may be time to start looking at large-cap growth, perhaps bringing portfolios back to a neutral weighting.
Cheryl Holland, president of Abacus Planning Group in Columbia, S.C., also expresses increased interest in large-cap U.S. stocks, especially dividend-paying companies that have demonstrated stable growth in the past. At Mellon, Sheldon believes equity leadership will shift to large-cap, high-quality companies with solid earnings and the potential to increase their dividends.
Support of large-caps isn't unanimous, however. "Large-cap companies need worldwide growth," says Mary Lisanti of AH Lisanti Capital Growth in New York, which manages the Adams Harkness Small Cap Growth Fund. "With overall growth slow, investors can find more earnings growth in small companies. Small firms still tend to be more innovative, more domestic, and more focused on product or market niches."
What's more, the quality of small companies may be higher than it was a while ago. "After the past few years, small companies that weren't tough enough are out of business," Lisanti says. "Mid-caps have become small-caps. The survivors are those lean, mean, high-quality companies with good balance sheets." Similar conditions led to a great small-cap run from 1975 to 1983 after the 1973-74 market collapse, Lisanti points out, and this asset class could post outstanding results for years after the 2000-2002 bear market.
Not all small-caps stocks are likely to prosper, however, just as there will be losers as well as winners among blue chips. Myszkowski says his fund screens for companies with above-average revenue growth, earnings growth, returns on equity, and stability of earnings, along with lower debt levels. "We don't have a dividend screen, but as it turns out, most of the companies in our fund are paying dividends." At present, he says, his fund includes no oil, utility, or telecom companies but is overweighted in technology and basic materials.
At WealthTrust FBB, Keating and her business partner Kathleen Hastings are more upbeat on energy stocks. "Anything to do with oil looks appealing," says Hastings, noting that worldwide economic and political conditions favor exploration for oil and gas. A second Bush Administration may be good for healthcare stocks as well; Keating and Hastings are especially enthusiastic about generic drug companies, which are not under the microscope of public scrutiny to the same degree as the large pharmaceutical companies.
"Our clients like thematic underpinnings for their investments," says Bibi Conrad, senior vice president at Fiduciary Trust in New York. "One theme is demographic; aging baby boomers are approaching retirement. This may be good news for companies in healthcare and leisure as well as those selling long-term-care insurance."
Security after 9/11 is another theme mentioned by Conrad, who thinks defense consultants and military contractors may have good prospects. "Investors also should consider the exciting growth of emerging markets," Conrad says. "You can buy local companies through funds but also keep in mind how companies in the developed world might benefit, for example, when the women in Afghanistan start buying cosmetics."
A fourth trend cited by Conrad is an increased interest in current yield. She, too, likes high-dividend-paying stocks, along with TIPS, global bond funds, and selected real estate investment funds (REITs).
Going Global
If such a lineup (dividend-paying stocks, bonds, REITs) sounds fairly tame, that's not surprising. "Clients are much more gun-shy now, less willing to take risks than they were in the 1990s," Holland says. "They're more willing to delay gratification."
On the other hand, Holland reports, clients are "less fragile than they were after 9/11." Therefore, they're willing to invest in a number of unfamiliar asset classes if the resulting diversification can reduce volatility. "If two portfolios have equal average returns, the one with less volatility will grow faster over time by not having to dig out of holes," Holland says.
For greater diversification, many planners are putting clients into investments that go beyond domestic stocks and bonds. Foreign securities were frequently cited; as mentioned, international bond funds have gained popularity because they offer exposure to low-inflation economies and potentially stronger currencies. International stocks and stock funds have their supporters, too.
"We've increased exposure to international equities in the developed markets out of concern for a weaker dollar, and we've established a position in emerging markets, partly because clients are interested in places such as China and India," explains Christopher Shea, portfolio manager at U.S. Financial Advisors in Braintree, Mass. "A portfolio that was 10% invested in foreign equities a year ago might be 20% in those asset classes now and may go even higher."
Balasa agrees that international stocks deserve attention if the dollar weakens, "especially small international companies." U.S. Bancorp is overweighted in international stocks relative to domestic equities, Hembre reports, mainly because of valuation. That is, foreign stocks tend to be cheaper than American issues by traditional measures.
Again, not everyone agrees. Aside from American Depositary Receipts, which comply with U.S. accounting principles, Olstein avoids foreign stocks. "I have enough trouble understanding American companies' accounting, let alone financial reports from other countries," he notes. "Besides, you can invest in many U.S. companies that have foreign operations."
Accepting Alternatives
In addition to international investing, Shea's firm also has moved into REITs, primarily to satisfy yield-hungry clients. "Some of that exposure is in non-traded REITs, for clients who can stand the illiquidity," he says. Such REITs pay distributions now to investors and hold out the hope for future profits, if the REITs become publicly traded. For 2005, Shea's firm is looking into a precious metals play but has not yet decided on a way to invest directly in metals rather than in mining companies.
Lau also is looking beyond traditional asset classes, but cautiously. "We're putting some money into TIPS, some into foreign bond funds that are not linked to the dollar, and some into Pimco's commodity fund," she says. "We've been investing in oil and gas and real estate for years, but prices are so high now that good deals are getting hard to find. Therefore, we're increasingly holding cash, waiting patiently for the right opportunities to come along."
Other planners continue to make their way through alternatives alley. "We have been investing in oil and gas royalty funds for several years and continue to do so," says Holland, who also suggests commodities funds and timber to selected clients. "In addition, we're investing some client money now into mutual funds that follow absolute-return strategies, such as merger arbitrage, convertible-bond arbitrage, and market-neutral plans. Private equity has fewer overhangs now, which creates some good opportunities. We are putting some clients into a private equity fund of funds, pooling money with other financial planners."
Active or Passive?
Broad diversification among asset classes, then, has increasing appeal for planners. Within each asset class, though, planners must choose between active and passive investment management. "We prefer active management now," Sheldon says. "If you index today, you're buying more of the lower-quality companies that led in 2003 and less of the high-quality companies we expect to outperform in 2005."
In fact, some financial professionals believe in very active management. "Market volatility has increased," says Mark Caner, national sales manager of select markets for Nationwide Financial in Indianapolis. "In the first four years of this decade, there were more shifts of 2% in a single day than in the previous 10 years." Those sizable moves have been on the upside and the downside, changing the market's direction.
"Buy-and-hold investors are finding it more difficult to make money in stocks," Caner says. "Therefore, some financial planners are using tactical asset allocation for a portion of their clients' portfolios. Programs are coming onto the market to help advisers work with managers who have different approaches for moving in and out of various market sectors." Some investment vehicles, such as those offered by Rydex funds, are suitable for such strategies.
If some trends seem to be taking planners toward more active investment management, other factors are tilting the other way. Lower expected returns put more of a premium on controlling expenses, which can lead to a focus on passive investment strategies.
Harold Evensky, chairman of Evensky & Katz, a wealth management firm in Coral Gables, Fla., says the biggest issue on his radar screen is the relatively modest level of investment returns he anticipates. "They'll be modestly lower than historic returns," he predicts, suggesting that domestic equities might return 8%-9% per year over the next decade, while fixed-income returns may be a few points lower than those from equities.
"In such an environment, expenses and taxes can become a huge drag on net returns," Evensky says. "Planners need to focus on reducing those costs."
Evensky's response has been to adopt a core-and-satellite investment strategy for clients, relying heavily on exchange-traded funds for core holdings. "We are big believers in ETFs because they're transparent, cost-efficient, and tax-efficient," he explains. "In 2005, we may well see more of these funds come onto the market, including additional fixed-income ETFs and actively managed equity ETFs." Actively managed ETFs will be a "different animal" from the closed-end stock funds that are now available, Evensky says, because greater transparency is likely to eliminate trading discounts and premiums.
Balasa, too, reports using more ETFs, explaining that they can help combat the "style drift" that may thwart asset allocation. He also believes that future investment returns may lag those of the past. "The world is hovering in neutral now, with no 'fat pitches' for big investment scores," he says.
That makes 2005 a year to focus on investment basics, but also a time to deal with clients' expectations. "After the results of the last several years, we've been telling clients they probably won't be able to retire as early as planned," Balasa says. "Most have said, 'I knew that,' but it has been an unpleasant revelation to some clients, especially widows and divorcees.
Rising Regulation
Even when overall stock market returns are uninspiring, some investors can excel. "Stocks stayed in a trading range from 1966 to 1982, yet there were tremendous opportunities to make money during that time," Saut says. "That's likely to be true again, and the best opportunities this time might be through small, nimble mutual funds."
The problem, though, is that "small, nimble mutual funds" may be an endangered species. "Most mutual funds are small, in terms of assets under management," says Ron Roge, a planner in Bohemia, N.Y. "Now, because of increased regulatory scrutiny, they're having to hire more trustees, the trustees hire attorneys to advise them, and so on. It becomes a full employment act."
That's good news for the legal profession, perhaps, but not necessarily for funds and their shareholders. "We tend to overshoot in these matters," Roge notes. "Because of a few bad apples, we will hurt smaller investors." Either the bigger fees will be passed on to shareholders, or some good managers will leave the business.
For example, Roge's son Steven, a research analyst at his firm, has pointed out that the Atlanta/Sosnoff Fund will be liquidating and returning cash to investors. This mutual fund, described as a "hidden gem" run by "outstanding money managers," reportedly decided running a mutual fund in the current regulatory environment would become too burdensome and costly.
Stricter scrutiny of financial services is likely to continue in the year ahead, says Mark Phelan, senior vice president of the individual investments group at Nationwide Financial in Columbus, Ohio, who calls it a "good thing for the industry as well as for consumers." With more transparency and self-regulation, financial products should be easier for everyone to understand.
"We are already seeing it," Phelan says. "Firms are creating simpler platforms that have more transparent products. Buyers will know what they cost."
Products affected will include insurance and annuities as well as mutual funds. Among variable annuities, simpler products will stress protecting the downside while allowing growth on the upside, Phelan says.
"We expect to see products that will have a fundamental income guarantee along with increased flexibility for consumers, who will be able to pick a time period for accumulation." Such products, he says, may give investors multiple options for withdrawing some or all of their money from the account.
Life-Long Concerns
Beyond increased regulation, other trends may impact the world of annuities, suggests Roger Ibbotson, chairman of Ibbotson Associates in Chicago. He points to demographics as an issue that is likely to emerge this year. "Before World War II, births were down. As a result, relatively few people have been retiring," he says.
That will begin to change in 2005, however, as the oldest baby boomers (who were born in 1946) approach age 60 and begin to think seriously about their retirement. "There will definitely be growing interest in annuity products, especially immediate or 'payout' annuities," Ibbotson notes. "Our firm, in fact, has done quite a bit of research indicating that adding such annuities to their investment portfolios can help retirees keep from running short of money as life expectancies increase."
Immediate annuities now are less popular than deferred annuities. But Ibbotson says sales will begin to gradually grow this year as interest in retirement income products increases.
For many years now, investment strategies have emphasized increased accumulation. In 2005, as more clients do more thinking about retirement, planners may have to develop new tactics for tapping portfolios without getting tapped out.
