There certainly is a lot to think about as we head down the home stretch toward the end of the year. With one month to go the Election Cycle Theory will hold true if the market can maintain its current level through the end of December. Since 1952, the average annualized returns for pre-election years was 17.6%, significantly higher than the two preceding years, which produced returns around 4%. Historically, the election year itself tends to produce decent returns as well, averaging 10.5% over the same time frame.
So, what does all this mean for 2004?... Unfortunately, I’m not sure it means a whole heck of a lot. With all due respect to our political process there are three critical issues that may have greater impact on the markets in 2004. First, the credibility of the mutual fund industry is under attack on multiple fronts. The well-publicized trading scandal involves the timing of mutual fund trades where market timers achieve short-term gains at the expense of long-term investors. According to an article in the November 4th edition of The Wall Street Journal, SEC Enforcement Division Director Stephen Cutler stated that half of the nation’s largest 88 mutual find firms had questionable trading practices related to market timing. The dark cloud of suspicion related to this may hang over the markets for some time.
Meanwhile, the investment community is finally beginning to understand the excessive total costs often associated with mutual funds. Annual charges can be as high as 1.5% to over 3%, and includes sales commissions, fund expenses, management fees, front end and back end loads. In contrast, the total cost to the client for separate account management, where client portfolios hold individual stocks, can be 50% less than the total cost for mutual fund portfolios. To put this in perspective, the savings to a client who invests $1 million in a separate account portfolio with an annual fee of 1% vs. a mutual fund portfolio with a total cost of 2% will be close to $500,000 over a 20-year time frame. (This assumes that the returns for each portfolio are the same.)
Will there be an investor backlash?... Going forward, will investors continue to bail out of mutual funds, as they have out of firms like Putnam, which has suffered billions of dollars in outflows? To put this in perspective, there is approximately $7 trillion invested in mutual funds. My totally biased opinion is that investors will increasingly look for alternatives to mutual funds over the next several years. As a portfolio manager who offers separate account management, I couldn’t be happier. Still, massive outflows from even a few large mutual fund firms can depress stock prices, as fund managers may be forced to sell shares in their equity holdings to meet redemption requirements. The sheer size and money flows of the mutual fund industry make it an important driver of the overall equity market. In this regard, it will be important to monitor investor’s response to these ongoing controversies.
Before I run out of space let’s turn to the second important issue for 2004.
As many of you may remember, I have often talked about the importance of leadership or a dominant theme that must exist in order to drive a sustained bull market. For instance, the glory days of the late 90’s were driven by technology stocks involved in the build out of the Internet. In 2003, technology has once again been the best performing sector, up 41% vs. the 19% gain in the S&P 500 through November 14th. In my view, most of this impressive relative performance in 2003 was a recovery from the dismal performance of the tech sector during the three-year bear market. Not surprisingly, few market strategists predict a repeat of this out performance by tech stocks in 2004.
Which leaves a lot of uncertainty for 2004… The political and economic landscape is far from certain as we approach the New Year. Trade protectionism, federal deficits, health care reform, election-year rhetoric, and the quagmire in Iraq will continue to dominate the headlines over the next several months. Unfortunately, it is nearly impossible to quantify these factors in order to incorporate them into an overall forecast for the market, or to determine which sectors might offer the best performance.
One thing is for certain… Eventually, the next meaningful growth driver will emerge, most likely driven by technological innovation. In fact, Intel recently announced a promising new development in computer chip design that may provide the launching pad for the next generation of microprocessors. Another exciting growth innovation is nanotechnology, which involves manufacturing design of objects smaller than 100 nanometers. (A nanometer is one billionth of a meter. The thickness of a cell membrane is ten nanometers.) I’ll have more to say on this in future editions of Willingdon Views.
From the smallest to the biggest we turn to China, the third issue for 2004… The developments in China related to international trade policies and its own internal economic growth will likely have a profound impact on the global economy over the next decade. The low-cost manufacturing potential of China is certainly staggering, while at the same time, China is the fastest growing market for U.S. exports. In essence, China represents a vast potential market of consumers as millions of farmers are moving to the cities each year. Unfortunately, high cost producers in the U.S. or elsewhere, will find it increasingly difficult to prevent continued loss of market share. In a nutshell, prudent fundamental analysis of most industries will have to include an assessment of both the risks and opportunities related to China.
Willingdon Wealth Management in 2004… We remain on plan to be in operation around year-end, and will certainly keep you posted of our progress going forward. The opportunity to leverage the benefits of separate account management is enormous. Our investment strategy will be to continue to focus on the highest quality companies, as we continually test their sustainable competitive advantages in the context of future growth trends and geopolitical developments.
