4th Quarter 2005 Review

From the Desk of Ron Rowland

2005: A Below Average Year

Domestic equity funds and benchmarks were below their historical averages in 2005, as were bonds and money market funds. Most traditional asset allocation practitioners view these three asset classes as the backbone of portfolio construction, leading many of their followers to believe there could never be a year when all three are simultaneously "below average." The year 2005 proved to be another chink in the armor of traditional asset allocation.

So where were above-average gains found in 2005? The short answer is commodities and international equities, two asset classes that delivered double-digit returns last year and were ahead of their historical averages. However, these are also two asset classes that many investors shun, or even refuse to consider, when building a portfolio.

Providing international exposure in a portfolio is now extremely easy thanks to the proliferation of international mutual funds and ETFs. The primary obstacle that remains is investor fear of investing in areas of the globe that are outside our borders. Investors who can overcome this fear will find a world of new opportunities waiting.

Investing in commodities is a little trickier, although it is getting easier. In years past, the most popular method of investing in commodities was through the use of commodity futures contracts. Used properly, futures are an excellent trading tool for commodities. However, there are many risks involved that can be quite hazardous to a novice investor.

Two recent changes have made commodity investing easier and less risky. The first is the introduction of traditional open-end mutual funds, such as Rydex Commodities (RYMBX), that are designed to track the performance of various commodity indexes. The other is the availability of ETFs, such as StreetTracks Gold Trust (GLD), that represent ownership in gold bullion. Crude oil and other commodity-linked ETFs are also under development.

Commodities exposure can also be gained indirectly by investing in sector mutual funds and ETFs that own commodities-related stocks. Energy, basic materials, and precious metals funds can give us exposure to crude oil, copper, aluminum, and gold in a less risky, yet efficient manner. In addition, we now have available a new breed of commodity related funds and ETFs that invest in various commodities without exposing our clients to the risks associated with futures.

Successful investors use all the tools that are available, while prudently controlling their risk. As our toolbox grows, we are able to find opportunities in new places. We will continue to take advantage of all the suitable alternatives we can find.

The Quarter in Review

The third quarter of 2005 was dominated by Hurricane Katrina and its effects on the economy and especially the energy sector. After sharp gains in September, energy prices reversed in October. Meanwhile, it is now clear that the stock market formed a bottom in late October. Major benchmarks climbed higher in November, drifted sideways for most of December, and took off to the upside again as the new year began. Mid-cap growth stocks were by far the strongest style category for the quarter.

With energy prices easing somewhat, transportation stocks gained ground. Technology was up, but the gains were highly specific to a few companies resulting in a great deal of variation in fund performance based on their particular holdings. Financial services stocks, especially brokerage and asset management companies, were higher. Gold and gold stocks resumed their uptrend after a sideways period in the fall. On the losing side for the quarter were automobile and auto parts manufacturers, utilities, real estate, and housing stocks.

Internationally, Japanese stocks built on a rally that began in August, while European markets drifted slightly upward. The U.S. economy acquired a new driver with the confirmation of Benjamin Bernanke to replace Alan Greenspan as Fed chairman.

From an annual perspective, 2005 will go down as a generally sideways year for broad-market funds and indexes. Yet this disguises significant movements within the year. The markets spent a good part of 2005 climbing back from losses incurred in the first quarter.

If not for strong gains in energy and utilities to offset losses elsewhere, 2005 might have been a disastrous year for many investors. Some analysts began to wonder if the bull market that began in late 2002 has now run its course. As of this writing in early January, it seems not. The new year brought renewed buying interest and a broad rally across almost all sectors. In fact, within a few days of the year's opening bell most of the indexes had already surpassed their 2005 annual gains. If current trends continue, 2006 could be a much different year.