Noyes Capital Management, Llc

NOYES CAPITAL MANAGEMENT, LLC
Investment Management, Financial Planning, 401(k) Consulting
PO Box 271 New Vernon, NJ 07976
(973) 267-8120

By: Scott P. Noyes, CFA® CFP® AIF®
January 10, 2005

What Is Iceberg?

The year 2004 was somewhat unique in that all asset classes rose in value, including equities, bonds, commodities, real estate and the art market. The common reason for this strong performance was the large quantity of US liquidity placed in the system by the Federal Reserve through low short-term interest rates during the previous two years. The Fed’s stated goal was to eliminate any perception of deflation in the US and to stimulate an economy in recession. The stimulus created by low interest rates allowed for a large amount of investment leverage at a very low cost to borrowers. However, the impact on financial products prices (stock, bond and commodity prices) was far greater than on real economic growth factors (jobs, growth and inflation) throughout 2003 and 2004. This monetary stimulus created financial markets “inflation” and moderate economic growth. The Fed had accomplished its goals for the year.

Starting in mid-2004, the Federal Reserve signaled that they would remove this excessive stimulus by raising short-term interest rates. Debate abounds as to the number and degree of coming rate hikes. The economists at PIMCO believe they will pause at 2.5% while many other believe they will raise rates to 3.5%. Most market talking heads hate higher rates as they raise the cost of borrowing for their employers, squeezing profits. But from a bond investors’ point of view, higher rates allows one to receive a better rent for ones money and is considered a good thing. In all likelihood the Fed will raise rates until they start to slow the real economy. With core inflation running at 2.4%, interest rates should start to bite at 3%. But due to the long lag between interest rate moves and their impact on the real economy, it is likely that the real economy will decelerate slightly from 4% to a 3 % growth path during 2005.

Higher interest rates will hurt Wall Street more than Main. Financial markets should struggle with funding costs, complacency and too much accumulated speculation in 2005. The higher cost of short-term funds reduces the amount of leverage that the financial markets can deploy. Investments must offer a higher rate of return to attract capital. As short-term rates increase the impact should be felt most heavily by low return, low growth and capital-intensive businesses. In addition, stock dividend payouts will have to rise or stock prices fall to compete on an income basis against higher interest rates. Less leverage will likely result in greater volatility and choppy equity market for the year 2005.

The decline in the dollar is likely to halt in 2005 due to higher short-term interest rates and a higher relative rate of growth in the US. Purchasing Power Parity between countries still works over the long run. This summer we should see a large influx of tourists and corporate acquisitions by foreign investors as they attempt to spend their cheap dollars on goods and services. Higher interest rates can halt the decline in the dollar over the intermediate term but it will require a recommitment to fiscal disciple from our representatives in Washington to meaningfully reverse the dollars decline.

Interest rates should move higher in 1H 2005 but should then plateau for the rest of the year. Five year US Treasuries currently yield 3.65% and should reach 4.50% by the summer. This is based upon the Federal Reserve raising the Fed Funds rate from its’ current level of 2.25% to 3.00% by June. A reduction in financial leverage should create wider credit spreads during the year. Overall, I expect the bond market to deliver a 3% to 4% total return for the year.

The US equity market should be much more volatile and favor stock pickers in 2005. Higher interest rates will result in more volatility as brokers and hedge funds hold less inventory of equities. The increasing pressure on hedge funds and momentum traders to perform will result in greater sector volatility. I believe that stock sectors with strong growth prospects for 2005 include Biotechnology, Healthcare, Aging, Fashion, Homeland Security, Natural Resources and Life Essential. Sectors to avoid are banking, utilities, REIT’s, general retail and consumer cyclicals. Overall, I expect the equity market to take a long and winding road to modest growth for the year.

International equities remain essential components of your portfolio for diversification and earnings prospects. The global economy is expected to continue to grow at 3% to 5% during 2005. I remain biased in favor of Asian equities. My current favorites are Japan, Canada, Malaysia and Singapore. I would be a buyer of China, India and Russia on a meaningful dip in their equity prices. European equities have performed well in 2003 and 2004 due to the strong Euro but are unlikely to perform well in 2005 if the dollar stabilizes. Overall, I believe that one should follow growth stories in international and emerging markets to achieve investment success.

Commodity prices are likely to remain strong in 2005 due to continued global economic growth. With continued rapid economic growth in the developing world, the demand for resources is outpacing new capacity. The world will continue to invest in developing new capacity for 2005. Companies that produce mining equipment, drilling equipment, harvesting equipment, etc. should perform well in 2005. Countries that are resource producers should remain strong (Canada, South Africa, Russia).

My overall expectation is that 2005 will be a moderately successful year with returns earned through good timing, strong financial analysis and intuitive judgment. It is not a year to put the throttle on Full Speed and take a nap. Watch out for the Icebergs!