2004 turned out to be a rather strange year for the stock market. The U.S. stock market was stuck in a sideways pattern with a slightly negative bias due to a number of factors including the uncertainty of the outcome of the presidential elections. Senator Kerry and President Bush offered very different strategies for our economy with potentially dramatically different outcomes for the stock market. In an election that was ‘too close to call’, investors decided to hold onto their money and wait and see which way the wind would finally blow. Once President Bush won reelection, investors moved money into the market with renewed confidence, moving the markets from negative territory to mid to high single-digit returns by year-end.
President Bush not only won a solid re-election but Republicans also extended their majority in both the House and Senate. How will a Republican controlled Administration and Congress affect you in the coming year? First, the Bush Administration will attempt to solidify tax reform legislation passed during Bush’s first tour of duty. Many of the new laws have ‘sunset’ provisions, which means the laws are automatically repealed if not extended by Congress. It’s likely there will be Congressional attempts to make prior tax reform permanent including the lower tax rates and tax brackets as well as lower tax rates on corporate dividends. I also expect the Bush Administration to resolve the current estate tax dilemma. Currently, the amount of estate taxes you owe depends on the year in which you die. Bush appears serious about privatization of Social Security, which, if passed, would likely flood the stock market with fresh cash, igniting a strong rally. Income tax reform will likely be postponed until 2006. Deficits have increased under the first Bush Administration and they are likely to continue during his final administration. This, along with the cascading dollar is likely to result in both rising inflation and the acceleration of rising interest rates. If interest rates and inflation move up in a controlled way, the stock market should continue to rise. Should they begin to rise rapidly, the stock market and economy in general will suffer. I believe that oil prices will play a smaller role in 2005 than they did in 2004.
With these events as the backdrop, what should investors do with their money in 2005? Let’s begin with a discussion of your fixed income investments. It appears certain that the Federal Reserve, lead by Alan Greenspan, will continue to raise interest rates in 2005. Under this scenario, your best bet is to remain relatively short with your bond maturities until it becomes apparent that rates have peaked (listen to what Greenspan says for clues). Some of my favorite no-load bond fund choices are Schwab Yield-plus (SWYSX) whose current 12-month yield is 2.6% with an average maturity of .55 months; Dodge & Cox Income (DODIX) yielding 4.5% with an average maturity of 3.4 years; and Vanguard Short Term Bond (VFSTX) yielding 3.4%. If you prefer not to monitor interest rates, consider setting up a bond ladder. With this strategy, you simply divide your allocation to fixed income securities into equal amounts and buy bonds that mature in successive years. For example, say you want to invest $200,000 in bonds but don’t want to worry about which way interest rates move. Take $20,000 and buy a bond that matures each of ten successive years. At the end of year one, when your first bond matures, reinvest it in a bond that matures in ten years. This way, if interest rates begin to rise, it won’t be long before you have a bond maturing that you can reinvest at the new higher interest rate.
Next week, I’ll discuss your best options for your stock market investments.