To All My Investor Friends: Happy New Year 2006

It is hard to believe another year has gone by so quickly. Where does the
time go? It was a challenging year for investors. The markets went down,
they went up, and ended up not far from where they started. One had to be in
the right place at the right time to make any advance in 2005. I was
fortunate to do just that with a market beating portfolio again this year,
for the 7th year in a row (since my dismal relative performance in 1998).

This year saw the launching of my financial services website: www.wealth-

ed.com. It also saw my enrollment in UCLA and their online Financial
Planning certificate program. I received “A’s” in both classes I took (I am
sure you are impressed), and had great enjoyment in the curriculum and my
return as a university student for the first time since 1982. But as the
year progressed, I found the time is not right to make Financial Planning a
full time, or even part time endeavor. Instead, I am assisting my son,
Jared, with his own business and website: www.xactsensing.com. I will get
back to the financial services business once XACT is up and running
profitably. Still, I will continue to post this annual letter, plus the
occasional financial or life insight on “Wealth-Ed” (The Money Academy).

As always, I start by recounting last year’s plan (quotes in italics as

emailed on Dec. 31, 2005) and how it fared:

My overview of the market to you at the beginning of 2005:

“The story line for investing in 2005 has one important theme: Protect
against a declining dollar.”

Okay, this goes to show that one can’t count on being right all the time. I
was dead wrong on the direction of the dollar vis-à-vis other currencies.
However, I was not wrong about the underlying weakness of the USA currency
due to current account and budget deficits and the direction of gold and oil
against the dollar. But what I didn’t count on was the commitment of other
central banks to match the dollar move for move. Basically, we are in
another period of “Beggar thy neighbor”. This is an economic concept whereby
each country tries to devalue its currency against others to improve its
domestic economic agenda, i.e. to put its people to work. The last time the
world saw a prolonged period of this phenomena was the 1930s. Need I say
more?

I have been concerned about the rate of appreciation in real estate since at
least 2002. 10% plus appreciation is not sustainable for any length of time
since real estate historically appreciates at the rate of inflation plus 1%
(probably attributable to quality-of-life improvements like average square
feet, plumbing, water and electricity) and no more. Here was my comment last
year on that subject:

“We are currently at a flux-point after the bursting of one bubble, the stock
or equity bubble, but just prior to the bursting of a real estate bubble. We
can argue about the degree of the real estate bubble, but not about its
existence. The long term, 100 year average of real estate appreciation is
approximately the same as real GNP (inflation adjusted). So, in this period
of low inflation, there should also be low real estate appreciation on par
with GNP, about 3-4% annually. Yet, real estate has been appreciating from
10-20% annually in various markets the past 10 years. This is a bubble and
it must burst or revert to historical norms at some point.”

First, Dr. Robert Shiller (Yale University) precisely defined growth at 1%

over inflation, the number I now reference, in his book from March 2005,
“Irrational Exuberance 2”. This number was arrived at by extensive
historical research conducted by a squad of graduate students. So, long
term, 100 year growth rates in real estate are less than I had estimated last
year (3-4% over inflation). Second, I believe government and industry data
from the last couple months (nearly 20 year high in housing inventory on the
market, “days on market” at over 60 days, another 20 year high), shows that
the real estate bubble is in the process of being popped, thanks in large
part to the commitment of the Fed to raise interest rates and discourage
excess lending. We will know more next year at this time how severely the
real estate markets turn down, which geographic markets are most affected and
whether all of this precipitates a recession.

On my list last year of 10 things to consider for financial security, number

9 was:

“The very best commodity to hold in 2005 will be gold. Why? Gold is the
likely exchange currency of choice should the $USD fall out of favor because
of the devaluation underway. Also, gold is a commodity that has many
industrial uses and is therefore consumed every year. It is relatively
difficult to increase supply, so a suddenly increased demand is likely to
exceed the ability to increase supplies to match.”

Again, I was right on the money here, and my position in gold stocks
benefited because of this call. I believe this trend will continue for some
time. It has only just started. The gold cycle is similar to the oil cycle.
They benefit from both being valued as “hard assets” with intrinsic historic
value, even though the values are different to homo sapiens. As our trade
and budget deficits continue to weaken the dollar, it becomes less attractive
as the world’s “reserve currency” and gold becomes more attractive. This
change in thinking will take years to play out as gold continues its march to
$2000 per ounce.

Here is my advice from 2005 and my commentary on any changes needed for 2006:

+ Stay conservative (Still True and will be until equities are again
cheap…below 10x current earnings); I still think this is not a time for the
market to rally. The market price to earnings ratio is not anywhere near a
typical low in respect to valuation, at the current 17 or 18 times (even
higher once employee stock option expenses are deducted from earnings, which
will be required by July 1, 2006). But a 10x earnings factor would require a
significant inflationary environment. I am not as convinced of runaway
inflation as last year, especially with Ben Bernanke as Fed Chairman. So I
am changing the definition of a “cheap stock market” to 13 times in a 5%
inflation environment.

+ Protect against the possibility of inflation… inflation is very likely in

2005, more so than 2004 for reasons that will be outlined. While inflation,
as measured by CPI, stayed relatively quiet in 2004 at less than 3%, it
reversed 20 years of downward direction; given the large increases in
commodity prices, most notably oil from $25 to $50 per barrel, inflation will
continue to accelerate into 2005. How do you like that prediction of $50
oil? Seemed crazy a year ago when at $35, didn’t it? This is why I think
that 5% inflation is baked into the cake, even though government stats don’t
yet report it. Commodities of all kinds have increased 2-5 times over what
they were in 2000 (when oil was $10 for a time). Much of this is offset by
imports of cheaper manufactured goods from Asia. But going forward, imports
will not get any cheaper (higher commodity input prices and increasingly
higher labor costs are also a reality in China) and the higher costs of
commodities will work their way through the world economy.

+ Sell REITs and any commercial real estate holdings; we are at the peak of
a 20+ year real estate cycle; REITs are now selling at prices that yield less
than 5% on average, on par with risk free 10 year Treasuries; REITs will be
hurt by higher interest rates and an eventual economic downturn in 2006.
Cash out now; Hey, another good call! I haven’t changed my views on real
estate, and won’t until we get those REIT dividend yields back to 8% like
they were in 1999 and 2000. All that is required is for real estate to
decline relative to other asset classes and rents / revenues to increase.
This will not happen for another 5 or more years. REIT yields are now less
than super-safe 6 month T-Bills.

+ Stocks: the Large Cap Value sector is the last stop during a business
cycle. This was a good strategy in 2004 with a total (price + dividend)
return on the Russell LC Value 1000 (ETF ticker: IWD) of 14.2%. High
dividend, high ROE and free cash flow, large cap, and slow growth stocks will
do well again in 2005; medical, insurance, energy, consumer staples
(household) products, defense, are the place to be at the cycle peak and
going into a business downturn (in 2005); expect another 10-20% return in
2005 on this sector; Okay, this one wasn’t perfect, but not bad either.
Classic recession proof / defensive sectors like consumer stales and defense
did not do well because the economy held up well against all odds. But
defensive energy and healthcare proved to be very good sectors for 2005,
placing first and third out of the ten S&P sectors (utilities, another
defensive sector was No. 2). I wouldn’t make any changes to this prediction,
since I think we will finally see the economy weaken in 2006, though I have
lowered my energy exposure since it has become fully valued at this time.
Utilities, which I never bought, are also fully valued.

+ Commodities: given the direction of the dollar, a very good hedge is to own
commodities which will appreciate in $USD terms, as the dollar declines. The
best way to own commodities is mutual funds or ETFs that hold companies
producing those commodities. Additionally, many have significant dividends.
See the following for recommendations. This was perhaps my boldest and best
call. Gold mining stocks increased over 40% in 2005 after years of doing
nothing. All the commodities did well in 2005, especially the first half.
We are in a bit of a pullback in most commodities as they have become over-
owned, but I think this is a significant long term trend and will add to my
positions on price weakness.

+ U.S. Bonds: because inflation is accelerating, stay very short term in

bonds: less than 3 year duration on average and preferably Inflation-
protected; Hi-yield or junk bonds are at cyclical high prices and will only
go down, especially with increasing defaults at the next economic downturn;
wait for the next recession to rebuild junk bond positions; This was the
proper recommendation for 2005, though the long bonds did not get hammered as
expected. So anyone who did not shorten duration or improve quality got a
break. Given the economic environment and the flatness of the yield curve as
of this date (January 2, 2006), in 12 months, either long bonds will be at 5%
and maybe much more, or we will be in a recession, at which point, short term
rates will be on their way down. Neither scenario is good for high risk
bonds. Stay short.

+ International: Continue to invest in overseas funds and stocks that are not
hedged for the U.S. currency. Because of trade imbalances, the dollar
decline will continue. A simple way to protect against a declining dollar is
the purchase of unhedged international funds; this is another good strategy
that has paid off big time for me. I have particularly liked Asian stock
markets that are benefited by the Chinese economic juggernaut. The dollar
situation did not work, as earlier noted, so there was not a boost from
exchange rate changes. But even with a strengthening dollar, the Asian
markets had a very good year. My ETFs in Korea (EWY, 53.89%) and Japan (EWJ,
24.34%) were especially rewarding. This is a good time to sell half of my
Asian stocks to take profits and protect against a sell-off, but keep half
for continued exposure to the world’s best growth market for the next 20
years. And I still believe the dollar will eventually devalue against other
currencies, so that stock price boost is yet to come.

PORTFOLIO PERFORMANCE AGAINST BENCHMARKS:

This year I am adding a historical summary of my personal portfolio

performance against two benchmarks, the Fidelity Freedom Fund 2020 (FFFDX, an
asset allocation fund designed for people like me, who will retire around the
year 2020) and the Fidelity Spartan S&P 500 index fund (FSMKX). Really a
balanced portfolio, with its lower risk bonds and cash should logically
under-perform an equity-only portfolio like the S&P500, but I still aim to
beat the stock market with my lower risk asset-diversified portfolio, by
making correct asset allocation decisions. Here are the past eight year
results. Note the disaster in 1998. The lesson learned there is not to have
most of one’s financial assets in one stock, my employer STI in this case
(folks at Enron and MCI learned the same lesson in 2002):

1998 1999 2000 2001 2002 2003 2004 2005

McMorris 27.2 31.9 0.5 1.6 4.1 26.9 14.1 14.7
FFFDX 21.7 25.3 3.0 9.1 13.7 24.9 9.6 6.3
FSMKX 28.5 20.7 9.1 12.1 22.2 28.5 10.7 4.8

OVERVIEW of 2006:

To summarize the theme for 2006: “it is all about Bernanke”. The big change
this year will be what the new Fed Chairman decides to do with the Federal
Funds overnight rate. Alan Greenspan, who has presided over the Federal
Reserve Bank and Open Market Committee as Chairman since 1987, has shown
himself to be adept at blowing bubbles, namely financial asset bubbles. He
has been a politician’s favorite kind of central banker: always riding in to
save the economy at the last minute, thereby saving the politician’s job.
This happened several times the past 18 years, the first time being October
1987, but then again in 1991, 1995, 1997, 1999, 2001 and 2003 (see the
pattern?!). Each time, on the brink of a crisis (S&L collapse, Asian flu,
New Millenium, 9/11, Iraq war), Greenspan would infuse the economy with
liquidity (cheap money) to inspire the spending behavior of the consumer and
businessman, who otherwise might pull in their financial horns and go stuff a
mattress.
What Greenspan has accomplished with his style of central bank management is
to train global investors that the USA Fed central bank will always rescue
the world’s financial markets. He has done this by pumping liquidity into
global markets at each crisis during his tenure, through the mechanisms of
lower interest (Fed Fund) rates, increased money supplies (through selling of
Treasury instruments/printing of money), and more lenient banking policies.
But what happens when market risk is removed from the investment equation?
Required returns decrease for a given level or risk. This has the consequent
effect of compressing returns, including interest rates, because lower risk
equals lower reward/return and always has.

Ironically, at his Jackson Hole, WY “going away party” in fall 2005, Alan
Greenspan wrote: ”(from this point forward), any onset of increased investor
caution elevates risk premiums and, as a consequence, lowers asset values and
promotes the liquidation of the debt that supported higher prices. This is
the reason that history has not dealt kindly with the aftermath of protracted
periods of low risk premiums (as is the case right now)”. Thus, Greenspan
acknowledges that by reducing the sense of risk in the investment world
through his timely additions of liquidity to the economy, he has planted the
seeds of economic destruction. When investors are most complacent, sensing
very little risk in their investments because the central bank will protect
them, that is when the risk of low or negative returns is highest. This is
the essence of contrarianism and why it is very important to run opposite the
crowd.

Ben Bernanke is a student of the Great Depression. He has even authored

books on the subject, which are on my 2006 reading list: “Essays on the Great
Depression” and “Inflation Targeting: Lessons from the International
Experience” and has co-authored several other books with Robert H. Frank.
These texts provide insights into the person who will likely be the single
most influential to investors for the next 10-20 years. The early read on
Bernanke, based on his previous stint as a Fed District Vice President and
Open Market Committee member, and his short time on President Bush’s Council
of Economic Advisors, is that he is an inflation hawk, but also a deflation
hawk. This is to say, he is on the record as planning to “Target Inflation”
(the title of one of his books).

This is quite a different approach as compared to Greenspan who had a policy

to target a real interest rate of around 2% (real interest rate is nominal or
current rate less inflation). The danger with Greenspan’s approach always
was that if inflation turned to deflation, targeting interest rates would do
nothing to stop it. They would just follow inflation on down to 0%. This is
exactly what nearly happened in early 2004, and what did happen in Japan in
the 1990s until today. Targeting inflation implies that Bernanke will let
interest rates go where they may. It is also to say, that some degree of
inflation will be accepted and embraced. Bernanke definitely fears deflation
more than inflation, based on the infamous statement that he would have
dollar bills thrown out of helicopters to thwart deflation and his writings
on the subject. This fear is based on his extensive study of the Great
Depression, and its consequent global deflation.

We know, then, that Bernanke will avoid deflation and accept some degree of
inflation. The big question is “how much”? Some have speculated 2% will be
the target. Personally, I think that is too close to 0% or deflation for his
comfort. I will plan on 3%, with a stated range of 2-4%. This will be
another big change with Bernanke; he has said he will be very concise and
clear about his policy direction and will publicly state his targets.

What will be the effect of changing the central bank focus from interest
rates to inflation? The first conclusion that can be made with near
certainty is interest rates will gradually drift higher, so long as the
economy is strong and supply is tight for global commodities. Bernanke will
be very interested in balancing supply and demand through interest rates to
achieve the inflation target. If the labor market tightens because of the
strong economy, if the GNP exceeds 3.5% growth (the widely accepted
equilibrium rate) and if pricing power increases because aggregate demand
exceeds supply, Bernanke will not hesitate to increase Fed Funds rates.

I believe that Bernanke disagrees with Greenspan’s bubble blowing policies.

He will take the current opportunity of increasing interest rates to continue
taking air out of the real estate market. He will not stop until a shallow
recession is achieved. Indications are that Bernanke will not be as
concerned about appeasing Washington as was Greenspan and will not hesitate
to apply the brakes on economic expansion. Because the past growth cycle has
been fueled by consumers using housing equity to finance purchases, to the
point of achieving a negative savings rate in this country the past three
years, he will seek to shut down this debt produced expansion. Once the
shallow recession has been achieved and consumer debt expansion is halted by
higher interest rates along with a weaker economy, Bernanke will reduce Fed
Funds rates to a level that encourages business spending on capital goods,
without reigniting the housing bubble.

How bad is the consumer debt fueled expansion in a historic context. Here is
a chart of government data on the average savings rate for Americans showing
the rate going negative in 2005 for the very first time:

Personal Savings Rate vs. 10 Yr. Treasury

(data from St. Louis Federal Reserve)
13.00 Personal Savings Rate
11.00
10 Yr. Treasury Rate
9.00
7.00
5.00
3.00
1.00
-1.00
Jan-59

Jan-62

Jan-65

Jan-68

Jan-71

Jan-74

Jan-77

Jan-80

Jan-83

Jan-86

Jan-89

Jan-92

Jan-95

Jan-98

Jan-01

Jan-04

Chart by "Money Academy"

This is then the 2006 scenario: an economy that gradually weakens through the
first half of the year while short term rates continue to rise to the 5%-6%
range, resulting in a shallow recession beginning in the 3rd quarter. By the
4th quarter, the recession will be fully recognized and it is likely that rate
increases will be halted, and depending on the severity of the recession,
even lowered.

If this scenario is accurate, the correct investment posture is to hold a

high percentage of cash and short term bonds, at least 50% of the portfolio,
and maintain defensive equity positions in consumer staples, energy,
utilities, and other deep value sectors. Once the recession is acknowledged
in the media, and perhaps by the Fed, that will be the time to get aggressive
with equity and move to a much higher percentage.

I believe that the next economic cycle will be a capital goods-led cycle. It
has been six years since the last capital goods cycle. Those goods are now
fully depreciated and in the case of technology equipment, obsolete. Because
the end of the recession will coincide with the Presidential cycle, it is
likely there will be tax incentives passed by Congress to stimulate business
spending at the end of the next recession.

If the market retreats to SP500 (900) and/or DJI (8500), it will signal a
great buying opportunity and perhaps the bottoming of the current trading
range we have experienced since 2000. This could set up an end to the Bear
cycle and the beginning of a new secular Bull cycle, though I would not be
surprised to see sideways financial markets for another 7-8 years based on
historic patterns. Technology often leads the way out of secular bear
markets (as in 1982) and it may do so again the next time.

See the following chart that I update every year for an indication of the
possible shape of the market over the next several years. History repeats in
investing as well as other human endeavors. So history is prologue to what
will happen in the stock market. This chart presents three significant
periods in the USA stock markets. The 1920s and 30s, punctuated by the Great
Depression, the late 1960s to the early 1980s with the Oil Crisis in 73/74
and the high inflation of the late 70s and early 80s, overlaying the current
market and the blowoff of the Tech bubble in 2000-02. The major elements of
each period are almost identical in amplitude and duration. As with any
physical upset, there is first wild gyration followed by a significant period
of stabilization, followed by another gradual upward period (starting slowly,
and then accelerating into another frothy period 20 years out). The chart
shows we are ending the stabilization period and heading towards a possible
long-term upward period starting between 2007 and 2010.
10000

2006 brings
secondary correction
follow ed by new Bull?
1000

Secondary Market Dow Ind 1925-1940

Decline (post election)
37-38, 76-77 Dow / NASDAQ 1967-1982
NASDAQ COMP 1995-2010
100

Primary Market Decline

(post election) 73-74,
30-32

10
Jul 1924 Jul 1929 Jul 1934
Jan 1967 Jan 1972 Jan 1977
Jan 1995 Jan 2000 Jan 2005
Chart by "Money Academy"

What happened to the USA stock market in 2005 and where does it go from here?

Another chart I use to show historical trends is focused on the idea of

“Channels”. Market trends tend to move within a channel on either side of a
trend line representing a price average over a period of time. The trend
line and its associated channel only change slope at significant events
during time, such as the Great Depression or the Oil Crisis. This market
analysis shows we are in a flat trend coming off the Tech bubble blowoff. We
are bound in a channel that is roughly 7,500 on the downside and 11,000 on
the upside of the Dow Industrial (DJI) index.

For the market to advance out of this channel, i.e. change the trend slope
back to an upward trend, it will require a “retest” of the bottom of the
range. Technical analysis suggests we must retest 7500 DJI, if this indeed
is the lower limit of the channel, reached last in early 2003. It would be
very bold to predict such a precise target, so I am suggesting that anything
approaching 8500 DJI will constitute a retest and will allow the market to
move on up out of the trend channel. If my Bernanke thesis is correct, he
will precipitate a recession that will allow the market to decline to this
range. Note the Pink arrows show the long term trends from previous market
periods. We can expect the market to progress off the bottom following this
trend line and eventually break out of the 11,000 top boundaries by 2010.
 100000

10000

Dow Ind 30
Real GNP
- Red channels sho w
lo ng term trends.
- B lue arro ws sho w
average slo pe o f
majo r bull market and
acceleratio n to the
late 1990s bubble.
1000 - P ink arro ws sho w
lo ng term slo pe o f
GNP gro wth and
sustainable market
slo pe.
- USA Sto ck M arket
in 2004 is trending
sideways. If it breaks
the lo wer side o f
M ajo r B ull channel in
2005, it is likely to test
the lo wer limit o f a
multi-year ho rizo ntal
channel at Do w 7500

100
Jan-67

Jan-72

Jan-77

Jan-82

Jan-87

Jan-92

Jan-97

Jan-02

Jan-07

Jan-12

Another chart used here in the past is the “Presidential Cycle” chart. It is
very instructive primarily because of the power that presidential politics
has in the economy. The President, through Congress, is able to have very
positive or negative effects on the economy through taxation and spending
policy.

Compare the “History Repeats” chart with the chart of the Dow 30 average for
the past (18) Pre-Election periods. It shows the benefit that is derived
from positive efforts by the incumbent government to stimulate the economy.
This average picture of the market is also identical to both the pattern and
size of the past actual 18 months in terms of appreciation of the Dow 30
averages:
 Dow 30 Performance -
Average of past (18) Pre-Presidential Elections
20.00%

15.00%

10.00%

5.00%

0.00%
1 3 5 7 9 11 13 15 17
Months Chart by McMorris F.P.

We are currently at a flux-point after the bursting of one bubble, the stock
or equity bubble, but just starting to burst the housing real estate bubble.
We can argue about the degree of the real estate bubble, but not about its
existence. The long term, 100 year average of real estate appreciation is
approximately the same as real GNP (inflation adjusted). So, in this period
of low inflation, there should also be low real estate appreciation on par
with inflation plus 1% annually, or around 3-4%. Yet, real estate has been
appreciating from 10-20% annually in various markets the past 10 years. This
is the definition of a bubble and it must burst or revert to historical norms
at some point.

Note the yellow circles on the “History Repeats” chart. The circles are the
one year periods after a Presidential election (1933, 1977 and 2005).
Typically the year after an election has flat returns. My analysis of 18
past post election periods and the 18 months following the election shows the
average annual Dow Industrial return to be +0.72% during that period. The
actual total return in 2005 of the Dow Jones Industrial average was +2.47%
with almost all of this return was in dividends. Price return was almost
exactly the historical average for 12 months after the election. We are now
at Month 13 after the last election (using January inauguration as the
reference). Month 13 to 18 are between 1 and 2 percent growth on average.
But given the continuing recovery off the 2000 tech bust, the market is
currently weaker than average, so a decline is likely.
 Dow 30 Average -
(18) Post Presidential Elections
5.00%

4.00%

3.00%

2.00%
1.00%

0.00%

-1.00% 1 3 5 7 9 11 13 15 17

Months Chart by McMorris FP

Another negative in the market is that we are now past the average age of a
cyclical bull market (30 months according to InvesTech research) as of April
2005, we are living on borrowed time before the next cyclical bear.

My approach for 2006

Based on the above historical and current events analysis here is my game
plan for 2006: A range of 8500 to 11,500 for the DOW (just about the same as
2005 and the third year in a row for this forecast range), 900 to 1500 for
the S&P500, 1800 to 2500 for the NASDAQ Composite. I think that the weakness
this year will come in the first half of the year with a bottom during the
summer coinciding with acknowledgement of the mild recession brought on by
short term rates between 5% and 6%. After that, the pre-election fiscal
stimulus, and the end of interest rate increases coming into sight, will
cause a market rally during the fall and early winter, culminating in a
significant “Santa Claus” rally which went missing this past year (2005).

Asset Allocation:

Asset allocation / diversification, along with identifying the best sectors

and skewing the portfolio to those sectors are the key to financial success.
I learned this lesson in 1997 and 1998 as my relative performance showed. I
badly under-performed the late 90s market by having my eggs in too few
baskets (too much STI company stock) and also being overweight the wrong
sectors (commodities, value and REITs before their time).

Here is my relatively conservative “base” asset mix: 60% stock, 20% bonds,
10% real estate (excluding our home), 10% cash. In 2005, I changed this mix
for the first time in seven years by decreasing bonds to 0%, reducing the
overpriced real estate segment to near 0%, increasing cash or stable value
money market funds to 40%, and maintaining most of the 60% equity weighting
in energy, international and small cap value.

Towards the end of the year, I reduced the energy overweight from 30% of my
overall portfolio (half of equity) to around 15% and increased technology,
which will lead the market after the next correction. All year I have
maintained a relatively heavy 15% of my overall portfolio (30% of equity) in
international stocks, especially Pacific-Asia and Japan.
At the top of an interest rate cycle, I would normally adjust the allocation
to overweight bonds, REITs and other interest sensitive investments, and
underweight commodities and hard assets that are inflation plays. But I
believe we are in an inflationary environment for the next several years,
cheap manufactured imports and job outsourcing notwithstanding. As I have
reduced real estate and bonds to near 0%, I have been replacing the
difference with hard assets and commodities which can benefit from inflation.
My stock mix has changed to be overweight energy and gold, plus other
commodities. The “hard asset segment which had been as high as 30% of my
total portfolio in mid-2005, is now at around 16% as I took profits on energy
stocks in October and November. I will increase the weighting again if oil
pulls back to $45 or gold pulls back to $450 / ounce.

Equities / Stocks:

Stocks rotate by cap size along with the economic cycle. Historically, the
rotation begins with Small Caps at economic recovery (more nimble) and moves
to Large Caps (better global exposure and able to acquire small caps as the
business cycle generates cash flow). There is also a rotation in terms of
risk, from Growth at the beginning of an expansion, to Value at the beginning
of a contraction. Stocks can be lumped by industry or sector into these
groups of value vs. growth and small vs. large cap, to assist with the
selection process.

When the economy does turn to a Bernanke engineered recession in mid 2006,
large cap value (Defensive) is called for at that point. Individual stocks
can be purchased, if you like picking stocks, or an index can be used. A
Large Cap Value screen using a minimum 2% annual dividend, minimum $20B cap
size, High ROE, Low Cash Flow multiple and Low Relative Strength (to capture
out-of-favor stocks) reveals some of the following stocks: Diageo (DEO),
Annheuser-Busch (AB, note Warren Buffet is accumulating this company), Exxon
(XOM), Johnson & Johnson (JNJ), Coca-Cola (KO), Merck (MRK), Altria (MO),
Wyeth, Conoco-Philips (COP), Pfizer (PFE), Dow Chemical (DOW), Dupont (DD),
and Verizon (VZ). This list looks a lot like my list from the last two
years, as large caps have remained out of favor since 2000 and now sport
lower P/E ratios than small caps, a rare event. There are several
established and highly regarded mutual funds covering these same stocks:
several good and diverse funds are: Vanguard Value (VIVAX, 6.31%), Dodge and
Cox (DODGX, 9.37%), Clipper (CFIMX, -0.3%), American Funds’ Washington Mutual
(WSHFX, 3.50%), and Oakmark (OAKMX, -1.7%). We can now use Exchange Trade
Funds (ETFs) to select sectors. A good ETF for large cap value, based on its
low annual expenses and large cross-section is: Russell Value 1000 (IWD,
6.64%).

We should continue to keep a cross section of small caps as my experience in

2004 and 2005 showed. Since small caps are hard to pick, unless you know
something about a company based on personal experience, it is good to use
mutual funds or ETFs for small caps. As mentioned, two good ones (according
to Morningstar) that I own are Neuberger Genesis (NBGEX, 15.77%) and Fidelity
Low Price (FLPSX, 6.72%). There are several others that can be researched by
using Morningstar. Look for low volatility (beta) and high relative return.
Again, we now have an index ETF to help us in this category. I suggest:
Russell Small Cap 2000 (IWM, 5.20%). There are also Value and Growth only
versions of this Russell indexed ETF series.
Emerging Markets: This is a stock (and bond) theme that should play a large
role in any portfolio (5-10% of total). Emerging markets are the source of
future long term growth in the world economy. They provide a good hedge
against dollar weakness, and will increasingly provide a hedge against the
domestic economy (as Asia, for example, becomes a net consumer of products).
The best way to play the Emerging Markets is with managed funds. There are
several closed ends and ETFs in this segment. Templeton Dragon (TDF, 20.9%),
invests in China/Hong Kong, and is a fund I have owned since 1996 but traded
in for the broader market EMF in late 2005. “Emerging Markets Fund” (EMF,
31.65%) has a broader EM scope and provides exposure to East Europe and
Russia. We also now have the option of (EEM, 32.62%) which would have been a
very good choice. It is the “Ishares” ETF for emerging markets. (TEI, -
4.76%) is a closed end bond version of the Emerging Market funds, but did
poorly in 2005 due to the strengthening USD. Pimco also offers a good
emerging markets bond mutual fund (PAEMX, 7.97%). There is also a Fidelity
bond fund for foreign emerging stock markets, with a (FNMIX, 10.65%) ticker.

“High Beta” / high return stocks: Another stock category for the long term is
Biotech. If you look at investing themes that will do well over time, the
first thing to consider is the sectors that are driven by basic human needs.
People probably perceive health care as number three among necessities. One
and two are food and shelter. But these are both commodities and could be
great investments over the near term, in an inflationary environment. Both
categories tend to be good defensive sectors going into a period of inflation
or a recession as was demonstrated by these sectors the past the 70s and
2000-02. “Water” is another good, defensive, basic needs theme. There is now
a “Water ETF” with ticker (PHO).

As dynamic as they are at the end of a recession, Biotechs and small tech
stocks can be hazardous to the investor’s health at the end of a cycle. They
are extremely volatile and subject to investor emotion. Maybe only one of
ten biotech companies will actually produce a viable medicine. No one, not
even the founders of the biotech, knows what the successful compounds will
be. The Biotechs were flat in 2004 and have had small to very good gains in
2005, and have fared much better than large cap pharmas, which have had price
declines due to patent expiration and litigation. This may be a good entry
point, though biotechs are not really cheap as in 2002 for example. A good
biotech ETF that owns many companies and is capitalization weighted (and
includes profitable Amgen, Genentech and Biogen) is either Ishares’ (IBB,
2.44%) or HOLDRS (BBH, 31.29%). The difference in the 2005 return between
these two similarly structured ETFs shows the degree to which active stock
picking matters in high beta funds.

At some point in time, after the market has gone through the multi-year Bear
phase, small cap, high beta technology stocks will again be interesting, as
they were in the mid to late 1990s (peaking on March 10, 2000). Until then,
I will stay away.

The “Hedge”: Better portfolio return is achieved by diversifying as measured

by a low (less than 1.0) or negative beta: when some stocks go down, others
go up. A negative beta will occur when a stock moves in the opposite
direction of the benchmark, usually the S&P500. This is also called
“covariance” by statisticians. A low beta stock, less than 1.0, is also
useful to mute the ups and downs of a portfolio. (The approach, by the way,
is called “Modern Portfolio Theory” or MPT, though I don’t know how modern as
it first was documented in the 1950s by Harry Markowitz). As statistical
research and years of experience have shown, a small dose of hedging, say 10%
of a portfolio’s total value, can reduce risk (volatility) without
significantly reducing return. In 2005 I used David Tice’s (BEARX, 2.02%)
fund to provide a little covariance. This fund is supposedly a mirror image
of the S&P500. I have not found that to be the case. He hedged his hedge
fund in gold, and poorly at that, and BEARX showed a greater loss than the
gain of the S&P. His gold hedge should have improved that performance, as
gold has done well this year. So, I sold my BEARX in mid-February and
decided to use options and shorts to achieve my hedge, along with ownership
in the Vanguard Gold and Precious Metals (VGPMX, 43.79%) fund (more on gold
stocks later).

I added stock options to my portfolio starting in the mid-year of 2004. I

continue using both option contracts and shorts to provide “insurance” for my
portfolio. In 2005, I used a combination of “Way-out-of-the-money” (WOOTM)
put contracts on the NASDAQ 100 (QQQQ) with January 2006 expiry, to provide
portfolio insurance. I bought these contracts in February and sold (closed
them out) in April at the bottom of a market decline, for a nice profit of
50%. Because these put contracts were intended for insurance, not for
profit, I bought more after a small market rise a few weeks later.
Fortunately for my portfolio, but unfortunate for the contracts, they
proceeded on their march towards zero. But during this period, expecting
more of the market bounce, I also bought some DVY (Dow Value ETF) December
call contracts, and sold them three weeks later for another 50% profit. So,
with the two profitable option transactions, I had paid for a good portion of
my annual portfolio insurance premium. At the end of this year, I had
realized significant capital gains on my profitable trades on stocks in my
taxable accounts (I try very hard not to trade my taxable accounts to
minimize taxes), but could offset that by my losses on my options contracts.
This meant my net capital gain for tax purposes was reduced by 50%. And, if
you have more capital losses than gains from your insurance program, and keep
your total investing losses less than $3000 per year, you can deduct all of
them from your income taxes. Trading expenses (which are amazingly low now
on options) can also be deducted. The US government will help pay for your
portfolio insurance.

Bonds:

Short term and inflation-protected bonds (Treasury Inflation Protected

Securities called TIPS) are called for with rates continuing to head up in
2006. Note: I said the same thing in 2004 and 2005 regarding rates and was
wrong on long term, but right on short term rates (like everyone else,
including Bill Gross). With real interest rates (interest return minus
inflation) reduced to negative levels in 2004, the rebound in short term
interest rates were offset by increases in inflation. Since TIPS are “real
rate” instruments, with a guarantee of a nominal market return over CPI
inflation, the TIPS did not do well in 2005, even compared to a simple money
market account. Vanguard provides the low cost TIPS fund, (VIPSX, 2.59%).

Longer term bonds (over 3 years) should be avoided for the immediate future,
though, if 10 year Treasury bonds make a move to 5.5%, it would be a good bet
to buy those, as the next move in interest rates would likely be down. But
my bet is that inflation due to commodities and the eventual devaluation of
the USD is structural and baked-in. Inflation always is poison for long
bonds (10 or more years). Because the economy is likely to weaken, high
yield or junk bonds should also be avoided. They are still at historical low
spreads over safe Treasuries, less than 2.5%, as has been the case for over
18 months. A good time to own junk bonds is when the spread is over 8%,
typically during a recession. Other than short term Treasury and TIPS
options there are other interesting bond possibilities. Emerging market
bonds will take advantage of a weakening USA dollar and provide currency plus
market returns.

Real Estate:

Real estate has been good ballast in a portfolio. It has low correlation to
the stock market, but a high inverse correlation to the direction of interest
rates. Real Estate Investment Trusts (REITs) are the best way for the
average investor to participate in the real estate asset class. It is also
possible to own individual properties, but management of those properties
requires time and effort. Also, it is hard to gain adequate diversity by
owning individual real estate. A minimum of 15-20 properties in several
geographic locations and different property classes (e.g. apartments, shops,
offices) would be required to become truly diverse.

Because of the so-called “real estate bubble” in the housing market and the
coincident runup in the price of the average REIT, it is not a good time to
own REITs. REITs were yielding over 8% in the late 1990s, when the asset
class was out of favor. Subsequent price increases in REIT stocks (and their
underlying real estate) has reduced the return to below 3.5%, less than many
dividend paying industrial equities that often pay out less than 35% of their
cash flow. REITs, on the other hand, must pay out 95% of cash flow according
to the tax code. If the air comes out of the housing market, as I suspect
will be the case, REIT prices will decline in sympathy. That combined with
higher interest rates which discourage home ownership by raising mortgage
payments, will allow leases and rents to increase. That will set the stage
for higher REIT yields over the next 2-3 years and a chance to re-aquire
REITs at a better price. Fidelity (FRESX, 14.9% in ‘05) and Vanguard (VGSIX,
11.89%) both have good REIT funds, as does Cohen-Steers Realty (CSRSX,
14.88%). The Cohen Steers REIT fund has a sister ETF fund that can be traded
intra-day (ICF, 14.57%). REITs have returned well above average for the
fourth year in a row. This will not continue. A price decline of 30% would
return REIT prices to their long term total return trend line (12% annual)
and increase yields to back over 5%.

Fidelity has just introduced an international REIT called (FIREX, 14.94% in

2005). This might be a good place to pick up strong real estate returns the
next few years while hiding from a declining dollar.

Hard Assets / Commodities:

I have been promoting Oil as an investment now since 2002 (actually, I made
my first oil investment in 1997 with Freeport-McMoran with its 14% dividend,
but was early on that one. I sold for a small loss when the dividend was cut
to 4% during the oil price decline of 1998). In last year’s letter, I pushed
the oil theme harder than ever. If you went along with the recommendation,
you are today very happy. It turned out to be a solid bet, with average
appreciation over 40%, depending on whether it was drilling equipment,
producers, natural gas or integrated oil stocks that were purchased. This
will continue to be a good market sector, all though there may be a short
term pull back if the market sees recession. That will imply lower demand,
and hence a lower price for oil. However, the long term trend favors much
higher prices, so a pullback will create another buying opportunity.
Matt Simmons is an industry expert who wrote a book last year called
“Twilight in the Desert”. He recently stated in a Barron’s interview
(January 2 edition):

“I've placed a $5,000 bet (with a NY Times reporter) that oil prices
will average $200 a barrel in 2010. I don't have any idea where oil
prices are headed (next week) but they could easily be above $200 a
barrel. At $65 a barrel, or 10 cents a cup, we are still grossly under-
pricing oil, which is why it (high prices) doesn't have any impact on
demand. As the markets get tighter, sooner or later we are going to
have shortages. And the two times we have ever had shortages in North
America within 90 days, the price of oil went up threefold”.

T. Boone Pickens is also public with similar theses regarding the short term
(down) and long term (up) price of oil, as is industry consultant Tom Petrie
and consultant Robert Wulff of McDep Associates (www.mcdep.com). Energy
should be a large portion of any portfolio for the next 10 years or more,
during the time Chinese and Asian economic expansion puts supply pressure on
marginal production.

Also last year, I began suggesting gold for the first time. This also turned
into a good bet and the gold thesis continues to look good. Gold bottomed at
$250/ounce in 2001. Since then, it has doubled to over $500. As reported
last year, gold has been the “Anti-dollar” since 1971, when the USA (and by
extension, any central bank with currency linked to the dollar or otherwise
using “fiat” currency, e.g. the Euro) went off the gold standard and onto a
paper based standard (the USD). Paper-based standards are backed only by the
government of the issuing country and its economic prospects. If those
prospects decline, so will the currency. When financial assets and the
dollar are strong, gold is weak. When financial assets backing an economy
and its associated currency decline, as during a period of debt-induced
inflation, gold will strengthen.

The dollar became the world’s “reserve currency” after 1971 at the end of the
gold standard from this point on, gold and the dollar have moved in opposite
directions. From 1982 onward, as the Fed Funds interest rates decreased from
near 20% to just a little over 1%, the dollar strengthened. The dollar was
strengthened by investors’ conviction that the dollar was safe. The
relatively high interest rates in the USA from the 1980s provided a further
attraction. The more money flowed into “zero risk” USA Treasury bonds and
bills, the stronger became the dollar, since other currencies were in effect
traded for dollar denominated Treasuries. As the USA interest rates declined
over a 20 year period, buying long term US bonds and bills became a very wise
investment. Bonds appreciate in value as interest rates decline. This
created a “virtuous cycle”, lower rates attracted more foreign currency, and
more foreign currency flowing to America drove down interest rates. But the
bottom is now in at 1.25% Fed Funds rate in 2004. It has now increased by 3%
and sits at 4.25%. As the interest rate cycle is long, we can expect gradual
increases in inflation and interest rates for another 10-15 years.

Last year I wrote: “Even if the worst case does not come about (a dollar
collapse), it is likely that the Chinese must de-link currencies in the next
2-3 years. Our problems are becoming their problems. Our devaluing currency
is expanding their money supply at a time when the Chinese government would
like to throttle back to avoid hyper-inflation, over-investment and
ultimately an economic crash. When China de-links, it will cause their
exports to cost more in USD terms, and we will undergo accelerating
inflation. The end result of these concerns is the need to own either
commodities (in the form of mining, energy or other natural resource
companies), and rare metals (gold, silver, platinum, etc) in certificate or
in fact.”

About this paragraph, I will not change a thing. In fact, the Chinese did
de-link in 2005 for the first time. They have elected to link to a “currency
basket” that they will not define. It is likely they intend to gradually
change the mix of currencies away from the USA dollar. They will gradually
decrease their dependence on American assets. Because there are no other
really good “fiat currency” alternatives, I am betting they will be adding
more and more precious metals to that reserve basket. What does this mean
for us as investors? Vanguard Gold and Precious Metals (VGPMX, 43.79%) was
recommended last year in this space as a low cost way to get the needed
exposure to the precious metals that China will seek as part of its “currency
basket”. VGPMX has a current 3.5% yield. It returned 43.79% in 2005, well
ahead of actual gold. There is operational leverage in the mining stocks
that comprise VGPMX. The fund manager is also free to move between countries
for exchange rate advantage and types of precious metals depending on what is
most undervalued. Individual mining stocks like AU (37.9%), or Newmont
Mining (NEM, 21.4%), or the gold ETF (GLD, 17.76%) are also available to
provide a hedge against inflation.

As for Energy stocks, again, I wouldn’t change anything, other than to

recommend more natural gas and producer stocks, but not until we have seen a
price pullback under $50 / barrel. The large cap integrateds have not done
well. Will they in 2006? At some point, the market will recognize their
value. The integrated energy companies are disadvantaged in that much of
their oil reserves are in countries where the government receives a large
portion of the profits resulting from increasing prices over the production
cost. The best integrated companies own large domestic natural gas reserves
and refining capacity where margins are high. Most trade at less than 10x
earnings. Large cap integrated energy companies like Exxon (XOM), Chevron
(CVX) and British Petro (BP) may be the most exposed to the negatives of this
segment while Conoco (COP) which just bought natural gas producer Burlington
Resources is a good bet. There are several diversified ETFs in this sector.
(IYE, 34.67%) is a good domestic and diverse choice with a 35.5% return in
2004, and more to come. (IXC, 29.47%), up over 35% in 2004, provides more
international exposure, and possible benefit from the resulting currency
trade. (OIH, 62%) and up over 56% in 2004 is focused on only the energy
equipment manufacturers. This provides a higher beta in this group, which
means higher return as long as energy does well. There are also many energy
mutual funds including the Fidelity Natural Resources, (FNARX up 40.94%) that
also provides some mining exposure and Vanguard Energy (VGENX up 40.05%).

In early 2005, I added to my positions in oil and gas producers that trade as
trusts. The best trusts are the Canadian Royalty trusts that are given
special tax treatment to help provide income to retirees. I currently own
Petrofund (PTF) and Provident (PVX) which have done very well in 2005 while
providing a terrific dividend payout over 12%. The high dividends pay out
makes them best for tax advantaged accounts like IRA or 401K. They will
continue to perform well as their reserves gain in value.

Cash:
Cash is good. The good thing about the 13 consecutive increases in the Fed
Funds rate is that it has brought a decent rate of return back to money
market funds and other short term bond funds like stable value. Now, you can
get 4.5% sitting on your cash until the next buying opportunity in the stock
market. Have a lot on hand for investing opportunities later in 2006.

Have a Prosperous and Secure 2006.

Brian McMorris

651-334-0673