So what are we thinking?

We think that Steve Leuthold, who we are fond of quoting each year, is right when he says, “Hell if I know?” We’ve always liked Steve’s candor. Barron’s reports that Steve admits that “the outlook is unusually cloudy…. There is every reason to be bullish about the economy and the stock market. On the other hand there is every reason to be bearish.”

But our clients are not paying us to equivocate. They are paying us to make investment decisions based on our best perceptions of the market.

Here is our best perception regarding the economy and its impact on stocks.

Right now the economy seems to be on track to continue growing. The question is at what pace? The UCLA Anderson forecast expects domestic GDP growth to slow to 2.8 percent by the second half of 2005. They say, “That means rising interest rates, some weakness in housing and consumer durables, but only shaving a bit of normal GDP growth.”

By 2006 “We (UCLA) are talking a recession driven by a plunge in consumer spending on homes and durables.”
We are comfortable with their forecast, but would add a cautionary note that the recession could come faster than 2006 under certain circumstances.

Therefore the market mavens may be right and the “most likely case” is that stocks U.S. should advance again next year—at least into the first and second quarters. But we are not willing to make a heavy bet on that because of our concerns over valuation and other variables that might go wrong. We will enter the year with a “model portfolio” allocation of 49 percent to the overall stock market, including all U.S. and foreign stocks.

The real question becomes which sectors of the market to buy as we allocate to equities?

Healthcare is a good long term bet for patient investors. We will be allocating money to health care stocks and funds.

Utilities are still a great place for long term investment dollars. We’ll be sticking with “da Utes” in 2005 and banking the dividends

Banking and finance stocks have really cooled off lately. They are currently out of favor again. The concern is that they don’t do well in a rising interest rate environment. We’ll be sticking with our allocation to banking and finance and collecting great dividends as we do.

Tech is no longer just “tech”. There are lots of sector bets in “tech”. Internet related services are the most overpriced, but probably still the best bet in “tech”. We will be placing selective bets on specific “tech” trends in 2005.

Despite our concerns regarding valuations, small cap stocks could easily outperform large cap again in 2005. We expressed our concern a year ago that small caps were generally overpriced relative to large caps. That may still be true, but it didn’t slow down the best small cap mutual fund managers in 2004, and it probably won’t in 2005. Small companies are just more nimble and can often avoid some of the pitfalls that may hit the general economy and large cap stocks. We will enter the New Year owning several small cap stock mutual funds that have significantly outperformed the markets in recent years.

We hold four “balanced” mutual funds in the various portfolios we manage. All four have superior performance over the past several years. They really stood out during the 2000-2002 stock market debacles, by providing positive real returns right through the cycle. They tend to be allocated about 60 percent to stocks and the rest to cash or bonds. We figure if they got through 2000-2002 in fine shape they are good to go through 2005.

Japan should be alright and continue its slow, but hopefully steady recovery from 15 years of stagnation. Japan is worth a market bet. One of our favorite hedge fund managers thinks Japan’s market may be the number one performer in 2005.

China may stumble in 2005, but if it does it should be a very temporary stumble. Investing in China today is like investing in the U.S. in 1880. There may be wild swings up and down but we want to be dollar cost averaging into their equity markets for the next 5 to 10 years.

Western Europe is an investment mess. We’ll be skipping it.

Eastern Europe and Russia could be great “wild card” bets for long term players. We don’t make too many “wild card” investment bets so we’ll be waiting for better times there.

Latin America is overpriced. We will pass.

Australia is the one place we wished we had put money in 2004 that we didn’t. Now we will have to wait for a pullback or selective opportunities. We will be getting more familiar with that market and looking for those opportunities.

There are many “overpriced” stocks and sectors in this world and we remain concerned about “valuation”. Therefore we intend to be “short” overpriced stocks at all times during 2005, even when we are “long” other equities that we believe have significant value. This is a major new policy for K&A. Heretofore we have shorted occasionally and very selectively.

Our thoughts on bonds

Last year we quoted Steve Leuthold who said that he wouldn’t be touching bonds with a 10 foot pole. This year he is saying that he wouldn’t touch them with a 15 foot pole—even though he was wrong in 2004. They went up in value in 2004!

We are really on the fence about this one. If the pundits are right, bond yields should rise and bond values should drop. Therefore we are going to start the year owning Treasury Inflation Protected Securities (TIPS) in some accounts. Any California tax free muni-bonds that we currently hold in accounts will stay there, but we won’t be adding new positions. The bonds we hold are sufficiently “laddered” and short enough in duration that any increase in interest rates, within the magnitude that is probable, should not significantly impact current portfolio values.

But if our worst fears about the economy are realized the U.S. may be in a recession by the end of 2005 or early 2006. It bothers us a lot that long term interest rates are not rising in step with the action of the Fed regarding short term interest rates. The Fed is raising the “Fed funds” rate because of their perception that the economy is growing quite nicely on its own. If it is, why aren’t long term rates rising too? Is the bond market trying to tell us that the economy isn’t as strong as everyone would like to believe? History has taught us to pay attention to the bond market, and it isn’t telling us the same story that the stock market is. It certainly appears to be signaling that the “mavens” are wrong about “moderate growth” forecasts.

Therefore, there is a significant chance that long term interest rates in the U.S. will be the same at the end of the year as they are now, or even lower.

Which takes us to foreign bonds and currencies

The dollar should continue its adjustment downward. We say that even in the face of President Bush’s announcement on December 15, 2004 that he favors a “strong U.S. dollar”. We would advise investors to ignore what Bush says in favor of watching what his administration is actually doing. Right now the administration and the Fed are cooperating to flood the world with dollars.

We concede that the dollar may consolidate and could rally in the short term. The chart at the left, provided by someone more bullish on the dollar than we are, depicts the dollar’s slippery slope. Its movement downward is extended and counter cyclical rally’s often occur within the context of any secular movement. We’d speculate that any rally may take the dollar back up to the “blue line”, or “moving average”. But we remained convinced that the longer term direction for the dollar is downward. This is a function of two major forces.

First, there are way too many dollars in circulation and the U.S. government seems to have no intention of changing that. Too much supply of anything can lead to its price declining.

Second, there are competing “reserve” currencies for the first time in many decades. People simply have other choices including the Euro, Yen, and Yuan. Competition also tends to lower prices.

Therefore we will be entering 2005 intending to increase our client’s participation in “Predictive Growth and Income, LP (PGI). This is the “market neutral” currency investment strategy that we pioneered in 2002. Frankly PGI is designed to work whether the dollar rises or falls against other currencies.

We will also be entering 2005 with unhedged foreign currency denominated bond funds in many of our investor’s portfolios. They are pure plays on a falling dollar strategy. They are also yield oriented investments, providing us with current return in uncertain market times.

Speaking of uncertainty, is there a real estate “bubble”?

The highly respected UCLA Anderson Economic Forecast calls the current state of affairs “the bulked up Housing Bubble.” On Sunday, December 12, 2004 the San Francisco Chronicle ran a major feature on California real estate which concluded there is no such thing as a bubble. How is that for definitive?

We think it is time to be incredibly selective when making real estate investments. We have already sold all the individual REITS that we had owned during the period from 2000 to early 2004. Our only remaining “pure” real estate related investment is Cohen and Steers Realty Shares. We will be sticking with a very small allocation to this fund as we enter 2005. We agree with the UCLA forecasters who think that real estate may cool off. It is difficult to tell whether the “cooling off” will mean a leveling off of prices or an actual drop in prices. That depends on various factors you will read about in the section of this report entitled “What is there to worry about?”

We still own one specialty REIT in some portfolios and that is Plum Creek Timber (PCL). They specialize in one thing, growing and selling timber. While PCL is organized and operated as a REIT, we see it as a commodity investment.

What about commodities and oil, gas and the stuff of wars?

The word “commodities’ represents an incredibly broad investment spectrum. In fact, it is too broad an investment spectrum for us to focus on. We will enter 2005 with three investments in the world of commodities. We think the price of timber will remain strong into the foreseeable future, therefore the investment in Plum Creek Timber (PCL).

We think the price of gold will continue to go up. Therefore we have made investments through two mutual funds which own the shares of gold mining companies. We will continue to hold them as we enter 2005.

As we are writing this report most industrial commodity prices are in retreat after a big run up in 2004. Industrial commodity prices may be in for a year or more of drifting sideways. Yet we think that the “opportunistic” investor will find plenty of opportunities to make money in commodities over the next several years, regardless of price direction. Therefore we will enter 2005 holding one mutual fund that trades commodities for profit using an opportunistic strategy. The fund itself “combines a position in commodities, typically through swap agreements, backed by a portfolio of inflation-indexed bonds and other fixed-income securities. The commodity position aims to capture the total return of the commodities market”. The fund targets the Dow Jones AIG Commodity Index as its benchmark. When fund management is not trading commodity related instruments they park cash in “TIPS”. We want to own “TIPS” anyway.

Gas and oil are commodities but we treat them as a separate asset class. Not only are they “commodities” they are “political commodities” which takes them out of the world governed by pure supply and demand functions. They are the stuff of wars and global tensions. Think IRAQ!

If we could predict the price of oil we could have skipped everything we have written so far and simply gone long or short oil—depending on that prediction. But we can’t. In fact we can’t think of anything more uncertain than reliable data on supplies and therefore the direction of prices. We think it is a reasonable bet that prices will remain manipulated, and high. Therefore we will enter 2005 with a portfolio allocation to oil and “energy” of three percent.

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