Market Outlook – Part II

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In last week’s column, I discussed the impact of the Republican domination of the 2004 elections would have on the economy and bond markets for 2005.  For this week, let’s look at your best options for stock market investing for the coming year.


In last year’s market forecast, I highlighted three areas: dividend paying stocks (up 18% through 12/28/04), small cap stocks (up 19% through 12/28/04), and international stocks (up 16.5% through 12/28/04).  While two of my specific fund recommendations (Brazos Microcap and Longleaf Partners International) underperformed their benchmarks, these three groups performed remarkably well as compared to the broad U.S. stock market (S&P 500 Index +9% through 12/28/04).  These three areas will likely continue to outperform the broad market in 2005.


Dividend paying stocks.  More and more investors are realizing the benefits of investing in solid companies with a history of paying out a portion of their profits to shareholders in the form of dividends.  As you are aware, President Bush signed legislation during his first term of office making corporate dividends taxable at a maximum 15% federal tax rate.  Prior law taxed dividends at your highest marginal income tax rate (35% for 2005).  Solid companies with a history of raising their dividends will continue to be a magnet for more and more investors.  This is a consistent theme that my firm uses for our pre-retiree and retiree clients.  While we use predominantly individual stocks for this strategy, you can also use a no-load mutual fund such as Schwab Dividend Equity Fund (SWDSX) or an Exchange Traded Fund (DVY).


Small company stocks.  Small company stocks have outperformed large company stocks since 1998 and I expect them to continue to do so in 2005.  What could derail this outcome would be the collapse of the U.S. dollar verses foreign currencies.  If that happens, investors will likely abandon riskier smaller companies in favor of large companies with strong balance sheets such as the blue chip dividend stocks mentioned above.  For our clients, we are using Exchange Traded Funds such as IJR.  A low fee no-load fund alternative is Vanguard’s small cap index fund (NAESX).


International stocks.  There are a lot of smart minds, Warren Buffet included, which are betting that the U.S. dollar will continue its fall in the foreign currency market.  If this turns our to be true, it should help boost foreign stock returns.  You can invest in foreign stocks through an Exchange Traded Fund such as EFA or a no-load mutual fund.  One of my favorites is Dodge & Cox International (DODFX).  If you already own an international mutual fund, check to see if the manager hedges the portfolio against currency risks.  Assuming you expect the dollar to continue its decline, you would prefer a fund that does not use a currency hedging strategy.


Currently the biggest risks to your investments for 2005 appear to be a collapsing dollar and the ever-present risk of a terrorist attack or significant escalation of the war in Iraq.  These and other risks cannot be predicted so your best defense is a portfolio that is specifically designed around your needs and risk tolerance.  This would be an excellent time to meet with your financial advisor to review your goals, objectives, and concerns regarding your financial future.