In my December 2003 Letter, "2004: An Encore Presentation?," I summarized our outlook for 2004 by saying we liked all the same themes we had profited from in 2003, just less so. And I cautioned that we would be watching for some of these themes to reverse. It turns out, that caution wasn’t needed.

On the equity side, those themes were: small-cap stocks should do better than large-caps (the Russell 2000 index surged 18.3% compared to 11.4% for the Russell 1000); foreign stocks should outperform U.S. stocks (the EAFE index rose 20.2% compared to 10.9% for the S&P 500); and emerging market stocks should be the hot spot within international equities (the MSCI Emerging Markets index gained 25.6%).

In the case of small-caps and foreign stocks, while their absolute performance was lower in 2004, their relative outperformance was actually even greater than in 2003. (In fact, we were too early last year in reducing our overweight in small-caps.)

In the fixed-income markets, the story was much the same with 2003’s winners, high-yield bonds, TIPS, foreign bonds and emerging market bonds all repeating their outperformance in 2004. Although in this case, all except TIPS saw their relative advantage (over the general bond market as represented by the Lehman Aggregate Index) shrink as we had expected.

What’s our outlook for this year? Well, the view of the majority of Wall Street strategists is a continuation of these same themes for a third consecutive year. However, if last year we liked 2003’s themes - just less so, this year we like them even less still. And if last year we were cautious in watching for some of these themes to reverse, this year we expect some will, in fact, reverse. As a result, moving into the new year, our portfolios are closer to neutral weightings across all assets classes than they have been in several years.

Surprises For 2005
Last January, I wrote about four surprises for 2004 and I noted that examining the consequences of potential surprises to the consensus view serves as a good way to "check" our portfolios against what could go wrong. (In fact, three of last year’s four surprises actually came true, which, by the way, is a higher batting average than you or I should expect from these forecasts - they are supposed to be surprises after all!)

There are several potential surprises we see for 2005 and while by definition they would be a "surprise," they all have a reasonable chance of occurring. The investment consequences of these surprises is one of the reasons that we are more cautious heading into 2005 than we were last year. They may not come true, but it doesn’t pay to ignore them. We would rather leave a little money on the table, then subject your portfolio to unnecessary risk.

The Dollar Gets Stronger?
The overwhelming conventional view is that the dollar must get weaker. We have also been proponents of that position in recent years, but moving forward, we don't quite have the same level of conviction. While we still suspect that by the end of the year the dollar will be lower, the fact that a weaker dollar is practically a "given" is alone a good reason to be wary. Another good reason we might get a firmer dollar is that the Federal Reserve has been steadily raising short-term interest rates. Investable money tends to flow to where it gets the best return and one of the causes of the dollar’s decline in recent years was that our short-term rates were among the lowest in the world. Thanks to the Fed, today, our rates are now above most other countries. If a foreigner wants to invest in U.S. debt, they have to buy dollars.

The trade and federal budget deficits remain our biggest concerns for the dollar, but it's reasonable that both could improve. It takes a while for the effect of a lower currency (which makes exports more attractive) to be felt in a country’s balance of trade. This year we could see the effects of the dollar’s decline over the past two years start to reduce the trade deficit. The budget deficit could improve also, now that the election is over and the economy has recovered reducing the need, political or otherwise, for federal deficit spending.

We still believe that foreign stocks offer better growth prospects at cheaper valuations than our own, but those advantages have diminished from prior years. Moreover, if the dollar does strengthen, rather than boosting returns as in the past two years, it would reduce them. On balance we are essentially neutral on the foreign/domestic asset mix.

Domestic Stocks Are Disappointing?
Last year the consensus was that stock returns would be a modest 3-5% — we thought there was a reasonable chance they would be nicely higher. Now after stock returns in 2004 were, indeed, much better than that, overall bullish sentiment and complacency is running quite high and many pundits are calling for returns in 2005 to be similar to 2004. We think there is a more than 50/50 chance they will be lower. With valuations above long-term averages, economic growth slowing, short-term interest rates on the rise, and liquidity not as supportive, it is very reasonable that returns could be rather soggy in 2005.

Large-Cap Stocks Outperform Small-Caps?
While this isn't really an unconventional view like most of the statements above, it is a view that many investors have not acted upon yet. Large caps now represent one of the few areas that appears undervalued relative to the general market. If the economic growth continues to slow as we expect, large caps should have an advantage as small caps tend to be more levered to the economic cycle. Also larger companies tend to be more dependent on exports and, as noted earlier, the dollar’s decline over the past two years should begin to show up in the form of higher exports this year.

Once Again, Long-Rates Don’t Advance?
Last year, everyone thought that inflation would heat up and long-term bond rates would rise substantially (and bond prices decline substantially) - it didn’t happen. So now everyone expects that to happen this year. How many times have you heard that only a fool would buy a bond these days?

With the Fed continuing to increase short-term rates, economic growth, and thus inflationary pressures should be dampened. And low inflationary expectations support firm long-term bond prices. Also, if the dollar does get stronger, this too, could dampen economic growth and inflationary pressures.

If short-rates continue to rise, while long rates hold steady (or rise more slowly), the yield curve will flatten (more on this later). In such an environment where you don’t get paid a lot of extra yield to go out too far on the maturity spectrum, bonds in the intermediate range offer the best bet. And while we have preferred both high-grade corporates and high-yield corporates over Treasuries, we are now neutral on that trade-off, as well. In fact, under these conditions, cash is not trash. If stocks and bonds both have below-average returns, then the risk-free, low volatility, money market fund - with yields beginning to approach intermediate-term Treasuries -- looks pretty good.

A 2005 Recession?
The U.S. consumer is in a jam. Many refinanced their homes over the past several years, switching to adjustable rate mortgages that offered lower (and declining) rates. In the process, they often took out a bigger mortgage and spent the excess. Consumer debt levels are at record highs. Now all those adjustable-rate mortgages will be adjusting upwards as short-term interest rates continue to rise, putting the squeeze on consumer’s budgets. And with rates rising, the opportunities to refinance again are gone. It's reasonable to expect a slowing of U.S. consumption.

Yield Curve

With global and domestic economic growth already slowing, if the U.S. consumer retrenches significantly, the stage could be set for a potential recession in late 2005 or early 2006.

One of the leading indicators of a looming recession is a flat or inverted yield curve. Normally, the yield curve is upward sloping in that short-rates are lower than long-rates. But as can be seen in the graph at right, the curve has flattened considerably in 2004 as the Fed raised short-term rates, but long rates held steady or declined. We expect this flattening to continue in 2005.

Conclusion
While we believe in active management for the long-term, and while active managers are getting a lot more love from the financial press and investors of late, it could be a tough year for active management. This will be particularly true if volatility remains subdued and a there is a rotation from small-caps back to large-caps. However, no matter what challenges active managers may face, we remain confident in our thorough research process to uncover the best ones for your portfolios.

Again, thank you again for your confidence in us. If you have any questions, please feel free to contact us.

Sincerely,

P.S.As we begin 2005, we are currently accepting new clients. If you know anyone you think might benefit from our professional management, just let your Account Manager know. We would be happy to review their portfolio at no charge as a way to introduce our services.