Market Commentary:  February 2005

“In order to succeed, your desire for success should be greater than your fear of failure.”

Bill Cosby, Comedian

After a disappointing start to 2005, stocks rallied in February to trim their January losses, although some portions of the market still remained in the red for the year. Domestic equities lagged behind a strong international market. The S & P 500 Index rose 2.0% for the month, reducing its year-to-date loss to 0.4%. The Russell Mid Cap Index rallied by a strong 3.1%, carrying its year-to-date return back into positive territory at 0.5%. Small caps failed to keep pace; the Russell 2000’s return of 1.7% trimmed its cumulative loss, but the index still remains down by 2.6% for the year.

On a positive note, international stocks continue to exhibit the strength that they demonstrated in 2004. The EAFE index reversed course from January, posting a strong 4.3% gain and pushing its year-todate return to 2.4%. Despite the laudable returns of the U.S. stock market since the beginning of the current rally in March 2003, the recovery in the international markets has been even stronger.

The fixed income markets slipped fractionally again in February, with both high quality taxable and municipal bonds giving ground. The Lehman Aggregate Bond Index lost 0.6% for the month, lowering its fractionally positive year-to-date return to less than 0.1%. Municipals fell further off the pace, with losses in the 0.4% - 0.5% range for the Lehman 3-year and 5-year indices, respectively. International bonds gave ground during February, although the 0.5% loss for the Citi World Government Bond Index failed to fully erase its January gains.

Despite rising interest rates and oil prices, both of which tend to put a drag on economic growth, the pace of domestic job growth picked up in February. Shortly after the end of the month, the Labor Department reported that 262,000 new jobs were created in February, better than the consensus expectation, but not strong enough to prevent the unemployment rate from ticking up to 5.4%. Coupled with a solid upward revision in fourth quarter productivity to 2.1% and some easing in concerns about the potential for accelerating inflation, the jobs numbers were welcomed by the equity markets. The absence of any negative surprises should allow the Fed to continue on their “measured pace” of raising short-term interest rates.

While we embrace positive news, we’ve grown accustomed to “the other shoe falling.” After moderating in the fall, oil prices have begun to rise again. In early March, OPEC’s secretary general suggested that the possibility exists that prices could rise to 80 dollars per barrel over the next two years. Although he noted that any such spike would likely be short-lived, it would almost certainly dampen economic growth in the short-term.

More concerning may be the rising U.S. trade deficit that reached $58.3 billion in January, second only to the single-month deficit of $59.4 billion in November. Even with a weakening U.S. Dollar, the trade imbalance refuses to moderate, let alone go away. Because the Gross Domestic Product (GDP) calculation factors imports into the equation as a reduction in domestic economic activity, a burgeoning trade deficit could have a negative effect on the U.S. economy. Given our dependence on crude imports, rising oil prices will not help that deficit, nor will our enduring appetite for inexpensive foreign goods.

While we are not forecasting that either the U.S. economy or equity markets are about to falter, some of these considerations could provide a favorable environment for U.S. investors in foreign stocks. Growth in earnings has pushed P/E’s for both domestic and international stocks much lower in the past few years. Attractive valuations are no guarantee of positive future investment performance, but historical evidence provides strong support for value investing. As always, maintaining diversification between both domestic and foreign stocks should provide a reasonable hedge to investors navigating the undertow of conflicting economic data.