Advisors proceed cautiously as interest rates rise and the dollar falls.
In many ways, last year's fears have become this year's realities. As 2004 began investors wondered whether the long-awaited bear market breakout could possibly continue after a year in which the S&P 500 Index had risen 26.4%, and the Nasdaq vaulted 50%. Energy prices were creeping up and the dollar was sliding, but the continuation of those trends was far from certain. And while whisperings of inflation filled the air, interest rates seemed to be comfortably mired at historically low levels.
As this year begins, higher energy prices and a falling dollar have matured from worrisome anomalies to what some believe could be potentially long-lasting trends. Despite some post-election euphoria, stock market returns that were generally listless for most of 2004 have paved the way for modest expectations this year. And interest rates, particularly at the shorter end of the yield curve, are moving up again.
Against this backdrop, financial advisors positioning client portfolios for 2005 are tweaking their strategies to adjust to the economic and market environment, and to their own expectations about where markets are headed. To the advisors interviewed for this article, the threat of inflation and a meandering stock market portend lethargic or possibly negative returns in the coming year.
"The year after a President is elected for a second term has historically not been a good one for stocks," says Ronald W. Roge of R.W. Roge & Company in Bohemia, N.Y. "I'm assuming single-digit returns for the equity and fixed-income markets."
High on his list of concerns is the budget deficit, which he fears could nudge inflation higher. "The country can either tax its way out of a deficit or inflate its way out," he says. "I think there is a higher probability of inflation than a tax increase."
Although Louis Stanasolovich of Legend Financial Advisors in Pittsburgh expects low single-digit returns from the stock market over the long term, he feels that 2005 is shaping up to be a year of retrenchment. "As the Fed raises interest rates, stocks could be viewed as relatively expensive. We could see returns at the negative teens level," he says.
Not all advisors share that view. Michael Weber, principal of Weber Financial Services in Green Bay, Wis., believes that now that the Presidential election is over, the stock market will have "fewer distractions and will be able to get down to business. But there won't be a return to the 1990s bull market. I'm looking for stock market returns in the 5% to 7% range over the next decade."
Although Weber expects modest returns from stocks this year, he still thinks they will outperform bonds, and he plans to increase his exposure to U.S. equities slightly in the coming months. "If we have a portfolio with 40% U.S. equities, we might go to 45% or 50%," he says.
Other advisors expect to make more noticeable shifts. Roge says his portfolios this year will have more of an international flavor than they did in 2004, a reflection of the dollar's continued weakness against the euro and other foreign currencies. The widely held expectation for a further fall in the dollar was reinforced late in the year, when the greenback dropped to an all-time low against the European currency. (A record number of investors are also scouting opportunities overseas. According to AMG Data Services, international stock funds received nearly $43 billion in inflows through the end of October, eclipsing the previous record of $34 billion for all of 1994.)
Over the next six months, Roge plans to step up his firm's equity allocation to international funds to a maximum of 50%, up from 25% at the beginning of November. His portfolios are overweighted in funds that invest in small and mid-sized international companies because they do business in their local economies and are more immune to the ravages of a weaker dollar than larger companies, which derive much of their revenue from sales in the United States. Funds on his list of favorites include Julius Baer International Equity and Artisan International Small Cap.
For some advisors, the added assurance that the maximum tax rate on qualified dividends will remain at 15% after the President's re-election, as well as expectations for modest stock market returns, are putting high-dividend stocks on the front burner for 2005. Weber, whose client base consists largely of retirees, plans to use iShares Dow Jones Select Dividend Index Fund (DVY) to beef up dividend yield. A little over a year old, the exchange-traded fund tracks the Dow Jones Select Dividend Index, an index of 50 of the highest-yielding stocks (excluding REITs) in the Dow Jones U.S. Total Market Index. Its current yield is around 2%.
Charles Sausman, president of Boca Raton, Fla.-based Wharton Advisors, says that while he will continue to favor high-dividend stocks this year, he prefers individual issues such as DuPont, General Motors, General Electric and Altria to mutual funds or exchange-traded funds. He also uses equity-index annuities, which have returns linked to equity indexes and guarantee a minimum return when stocks fall. "Because I'm dealing mainly with seniors, my No. 1 priority is safety, whether it's in the stock or bond market," he says.
With uncertainty in the air, Litman/Gregory Asset Management in Orinda, Calif., is taking a wait-and-see approach by sticking with a neutral position in its asset allocation models. The firm's newsletter, the No Load Fund Analyst, recently noted that "equity-type asset classes are generally in a fair-value range, neither overvalued nor undervalued," with foreign stocks appearing only "somewhat undervalued."
Larger-cap U.S. stock funds account for 65% of the firm's equity portfolio allocation, with another 15% in smaller-cap U.S. stock funds and 20% in core international funds-a position that has seen little change since the beginning of 2004. "While it's frustrating to stand in at the plate with the bat on our shoulder, the one thing we can say with certainty is that opportunities will come," the newsletter notes hopefully. "The world will always be a volatile place, and at some point something will cause investors to act irrationally."
On the fixed-income side, protecting principal while squeezing out a decent yield remains a priority. Roge is laddering maturities to minimize interest rate risk, keeping a maximum maturity of ten years and an average portfolio duration of four years. He's using individual municipal bonds for taxable accounts, since these continue to offer better after-tax returns for most of his clients. In Roge's home state of New York, a married couple with $200,000 in taxable income would need to earn 7.25% on a fully taxable bond-over two percentage points more than the recent yield on 30-year Treasury bonds-to equal the 4.5% yield available from a high-quality municipal security.
Weber is complementing a laddering strategy with the use of immediate annuities to beef up income for retirees, and is generally sticking with bonds that have stated maturities rather than bond funds. "If we get caught up because of an increase in interest rates, at least it won't become a permanent problem," he says.
Stanasolovich argues that conventional approaches to controlling risk lose some of their effectiveness in a period where U.S. stocks and bonds are expected to provide low real returns. In his newsletter Risk-Controlled Investing (published jointly by Wealth Advisor Publishing and Charter Financial Publishing Network, the parent company of Financial Advisor magazine), he notes that even "safe" intermediate-term bonds can generate negative returns, or returns lower than inflation. The newsletter notes that between 1937 and 1981, intermediate-term government bonds with five-year maturities returned 3.6% annually, while inflation ran at 4.3%.
According to Stanasolovich, substituting or complementing traditional stock and bond funds with funds that have a low correlation to those markets and low correlation to each other will lower portfolio risk by providing equity-like returns with volatility that more closely resembles bonds. His low-volatility portfolios include ample use of funds that exploit non-traditional investment techniques, including selling short significant parts of the portfolio, hedging, tactical asset allocation and merger arbitrage.
Instead of traditional bonds or bond funds, he suggests alternative fixed-income investments for higher total returns in a period of rising interest rates. One such investment, bank loan funds, hold short- to medium- term loans made by banks to noninvestment grade borrowers. Because the rate is reset at intervals of 60 to 90 days, there is little interest rate risk to the lender. Current yields are in the 5.5% range.
Another fixed-income alternative investment, adjustable-rate mortgage funds, also offer protection against rising rates, but have provided lower returns than bank loan funds in recent years because of interest rate caps on mortgages and other factors. He also prefers funds that are actively managed to hedge interest rate exposure or seek out overlooked opportunities to investing in traditional fixed-income instruments. As for the latter type of investment, he plans to "stay away from anything except ultra-short maturities of no more than one year."
Marla Brill is a freelance writer and founder of brill.com, a leading independent Web site on mutual funds.