Noyes Capital Management, Llc

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

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

Taking Away the Punch Bowl

In today’s “fair and balanced” news culture, the media likes to have a Bull and Bear commentator debate the market outlook. The Bulls talk about how healthy the US economy was, the resilience of the US consumer and how corporate profits were higher and of better quality than in 2000. Therefore the stock market must be a bargain and historically cheap. The Bears message is that the US is running a massive current account deficit, consumers are living well beyond their means by cannibalizing their home equity, politicians refuse to raise taxes where necessary and are sacrificing the dollar to maintain market share. They conclude that the US stock market must be expensive and a bear market should ensue. Both of these cases have some merit, so what is an investor to do?

First Quarter Facts and Observations :

• Quarterly market performance -1Q 2005:
DJIA -2.59%
NASDAQ 100 -8.50%
Russell 3000 -2.20%
Lehman Aggregate Bond Market -0.48%

• The Federal Reserve continues to remove interest rate stimulus from the economy. The Federal Funds rate target has increased from 2.25% on December 31, 2004 to 2.75% on March 31, 2005 and is likely to be 3.25% on June 30th and 3.75% on September 31st. Raising the Federal Funds rate typically results in higher mortgage and consumer rates, a slowing of the economy and weakness in high yielding stocks.

• Energy prices should trade at a high plateau ($50 to $60) based upon strong global demand and a shortage of refining capacity even though the Saudi’s are pumping adequate supply. The energy sector and oil-drillers were exceptionally strong in the 1st quarter. For example, Exxon increased 17% in Q1, rising from roughly $51 to $60.

• Warren Buffet, our generation’s most famous value investor, comments in his 2004 annual report that there appears to be little value in today’s asset markets. His cash holdings are now greater than his holdings of stocks, as a percentage of book value. He also believes that a decline in the value of the dollar is inevitable.

• Charles Royce, one of the better small-cap managers, commented in his annual report that he believes small cap stocks will under-perform large cap stocks in 2005. This is a disturbing comment since small cap stocks have led and outperformed the market for the past three years.

• In a recent article, Bridgewater Associates showed that earnings made from manufacturing is “a pittance in comparison to the amount of money made from shuffling other people’s money around: 44% of all corporate profits in the US come from the financial sector compared with only 10% from the manufacturing sector.” This implies that a substantial portion of corporate earnings may be adversely affected by higher short-term interest rates.

• Our view to underweight financials was well rewarded recently, as the financial sector was hammered due to both scandal and higher funding costs. In particular, AIG, Fannie Mae, MBNA, Countrywide Finance and Citibank are all down over 10% since year-end.

• Retail stocks received a beating on the expectation of a weaker consumer, precipitated by higher energy costs. For example, Wal-Mart declined from $57 in November, 2004 to $49 in March 2005.

• Every time the dollar rallied, primarily due to higher rates, both the stock and commodity markets stumbled. Emerging markets were similarly affected and remain vulnerable to an environment of tighter money and a rising US dollar.

• The US stock market has historically averaged 8% to 9% growth. Since the economy is growing at 3% to 4% and inflation is under control, the market deserves the benefit of the doubt.

Our Outlook

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 by the end of the summer. Due to the long lag between interest rate moves and their impact on the real economy, it is likely that in 2005 the real economy will only decelerate modestly from a 4% to 3% growth path.

Higher interest rates will hurt Wall Street more than Main Street. P/E ratios should contract throughout the summer. Financial markets should struggle with funding costs and too much accumulated speculation since 2003. 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.

The weighted value of the US Dollar is likely to stabilize over the summer due to increased short-term interest rates and slower relative growth in Europe and Japan. Higher interest rates can halt the decline in the dollar over the intermediate term but it will require a recommitment to fiscal discipline from our representatives in Washington to meaningfully reverse the dollars decline.

Interest rates should move higher throughout the summer and then plateau for the rest of the year. Five-year US Treasuries currently yield 4.15% and could reach 4.75% by the end of the summer. A reduction in financial leverage should also create wider credit spreads. Overall, I expect the bond market to continue to under perform throughout the summer. Cash is king.

The US equity market appears to have more downside than upside for the next quarter or two, though a dramatic move away from current valuations isn’t presently expected, and choppiness in Q2 and Q3 may set up a fourth quarter rally. Stock sectors with strong growth prospects for 2005 include Healthcare, Industrials, Security, Natural Resources and Materials. 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 may suffer over the summer but remain an essential component 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, India, Russia and Germany. 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 remains that 2005 will be a moderately successful year for investors, with global and domestic diversification continuing to offer balanced returns consistent with sound judgment.