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...the second year of the Presidential cycle is historically the worst for stocks.


As the year winds to a close, I thought it would be helpful to go over our current positioning, review the year and try to get a glimpse of what 2006 will bring. From a performance perspective, in stocks, we find ourselves squarely ahead of the Dow Jones Industrial Average and slightly behind the S & P 500 (including dividends, gross of fees). In bonds, from a tax-equivalent basis, as a firm (although performance varies by account and particular goals) we are slightly ahead of most major bond indices. You may notice I have used the word "slightly" already. This is due to the pure lack of volatility in stocks (I have read that 2005 had the least volatility in stocks from high to low this century). So, taking advantage of large moves in the market generally was quite difficult to accomplish, although one could have taken advantage of large moves in precious metals, semiconductors and energy. In fixed income, due to the Fed's continued tightening of monetary policy and a nearly flat yield curve, mostly all major bond indices returns year-to-date reside between 0.50% and 1.5% in terms of total return. Not trying to make excuses here, but it was just one of those years where it was tough to make a great deal of money, very typical of a year with the Fed tightening and in a first year of a Presidential cycle.

As for our current positioning, we have continued to be defensive, particularly in stocks. In ETFs (or exchange traded funds), we have focused on defensive sectors such as health care and consumer staples. Traditionally, these sectors perform the best at the end and just after a fed tightening cycle. While that strategy worked until the end of October, the rally that began at the October lows has left these sectors squarely in the dust. Hedge funds and others with year-end "performance anxiety" have been chasing high beta (highly volatile sectors) and sold off the defensive sectors in an effort, in our view, to force performance and to get a decent paycheck at year-end. You can be assured that no one is more frustrated than I when it comes to owning underperforming sectors. So we find ourselves at those awful crossroads that a portfolio manager faces at times. You must ask yourself, "Am I wrong and should I just cut my losses short or do I stick to my guns because I feel this is the correct intermediate to long-term position despite near-term underperformance?" It is a decision between stubbornness and discipline and is what really separates the men from the boys in portfolio management. It particularly relates to our holding in a large pharmaceutical stock ETF (ML Pharma Holder12/40 (PPH)) which is dragging along the lows of the year. For the moment, we are sticking to our guns that it is the cheapest and most defensive (along with a nice dividend yield) sector in the marketplace. We also feel that it is likely that mergers and acquisitions activity could heat up there soon as valuations are getting a bit silly. This could be the catalyst to drive the group up 25-30% in short order. However, after 26 years, I have learned to not be stubborn and to cut my losses as short as possible, so while sticking with this area for now, consider it on a "tight leash." One last comment about stocks is that we continue to focus on value in general, while trying to maximize dividends.

As for bonds, our viewpoint has not changed. The Fed is likely close to done as housing is already slowing and those poor folks with adjustable rate mortgages are about to start getting some nasty surprises in the mail in the form of higher payments. We continue our large allocation to those securities as they are typically stable and we are the beneficiary of the higher coupons as the ARMs adjust upwards. We also favor short-term Treasury bonds and have been increasing our exposure to long-term, high quality municipal bonds in a big way. For the first time in my career, high quality municipal bond yields are 105% of long-term Treasury securities. As a point of reference, the average since 1960 has been approximately 85% of Treasury yields. I am a little perplexed by the value here, but suspect it is due to the general lethargy of the time of year and the fact that stocks have been ramping up of late. But one thing is for sure, these inefficiencies don't usually last too long, so I expect a rally very soon in this sector. The value relative to Treasurys is so far out of whack that the move could be quite large.

2006 Outlook

Turning to 2006, it is time for the second year of the Presidential cycle, historically the worst for stocks of the 4 years in each cycle. In fact, according to a Pepperdine University study, if a person had held stocks from the first day of the term since 1955 and sold them on October 1st of the second year, they would have lost a cumulative 35% of their money. If, on the other hand, a person had bought in October of the second year and sold at the end of the term they would have made over 70 times their money. The study is rather interesting and can be found here. In addition, optimism about stocks is in "extreme optimism" zones in virtually every measure that I use. What is equally interesting is that there is unprecedented bearishness about the bond market (people expect higher long-term rates and lower prices) according to the recently released Conference Board monthly survey. Every other time bearishness has gotten that thick, bonds have rallied significantly. And housing, as we have stated here multiple times was in a bubble that we believe is now unwinding. Our new Fed Chairman will be faced with quite a challenge next year as nearly half of the new jobs of the past 5 years have been housing or construction related according to Northern Trust and if housing slows (let alone declines) job creation could come to a halt. Our feeling after reading an interesting article in the Wall Street Journal this morning (on the front page if you want to read it) explains that Mr. Bernanke is an expert on the Great Depression. It also states that he would likely drop rates quickly and dramatically if an economic slowdown did indeed appear. After all, a debt based society with a negative savings rate (Canada has a negative savings rate too) cannot stand falling asset prices. The burden will fall on an overleveraged consumer and could quickly lead to slower economic growth or even recession. It was Bernanke in 2002 that said he would "drop money from helicopters and take rates to zero" if need be to stop deflation. So in a nutshell, we expect a more volatile year in 2006 with a downward bias. In fact, we think the cyclical bull market has mostly run its course; fear will once again rear its ugly head and then we will be delighted to take more risk in stocks. I can assure you that there is no one more frustrated with this year's boring nature and lack of great returns than I, but one thing you can never do is force performance. As Ned Davis likes to say, "The big money is made in the big moves." We are looking for a low in mid-late 2006 where we will look to take advantage of one of those moves.

I hope that you and your family have a happy, healthy and prosperous Holiday Season and New Year.

I can be reached via e-mail at

Past commentaries can be viewed at

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Positions in PPH, XLV, XLP

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