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Overall Market Outlook
The stock market came back with vengeance in the last quarter of 2004—much as we expected—but is the Santa Claus rally over? Well, in a sense it is—the 2004 Christmas is long gone; the New Year parties have left only memories and, for the most adventurous partygoers, slight hangover. But the stock market may just not know it yet. We may hear still more “January effect” and “as goes January so goes the year” stories from our favorite talking heads on CNBC—though jittery early January is not uncommon after strong 4th quarter. The reasons for us to expect the strong stock market in 2005 are, however, far from seasonal. Instead, let us offer you a brief overview of underlying economics as we see it.
First of all, the US economy is thriving. Our GDP just keeps setting new record levels—hey, doomsday scenario aficionados, try to defy the chart on your right! Real per-capita GDP is at record levels as well, as the US output growth is much higher than about 1% population growth. In fact, growth in all of 2004 was faster than the average of the last 10 years, including the heydays of late 1990s. Our productivity is at record levels as well, growing at a very fast 3.1% year-on-year. And it is not all services (that US is indeed producing at quite high levels) as some pessimists claim—US industrial production is at record levels as well, and is up 4.2% from a year ago.
The pessimists’ main complaint about the US economy is that the economy is not benefiting the general population: the personal incomes just keep up with the inflation, and the unemployment is average at 5.4%, and the employment is still some 430,000 below its record high of March 2001. Well, we have our doubts about these official numbers. Just look around and see yourself how many people now are not employed by the large companies as was the case in 2001 and are instead working over the Internet or doing various consulting projects? EBay recently estimated that there are some 430,000 (what a coincidence!) self-employed people who sell their products on the eBay—this alone would account for the “weak” employment. Oh, yes, many of the H1 workers have left too—subtract that from your 2001 payroll data. Looks like we are hitting record employment numbers (and income levels) as well.
Still, we ourselves always insist that good economy does not mean good stock market. Maybe, despite the booming economy, the stock market is way overpriced and is headed for crash…? Well, forget years 1997 through 2003 we say. The volatility is not there
anymore—be it, as some suggest, because the day-traders are not there to generate it, or, just because even the speculators are again trading by the numbers and not by their emotions. Our favorite measure of volatility, VIX, has come down from above 40 in 2002 to below 12 in recent trading. And here is why:
The market is back to normal. No, do not look at the P/E—it is not a reliable measure of value. Look at the types of investment mechanisms that are available—the stocks and bonds that is. The 10 year treasuries now yield mid-4% returns, while the S&P yield in 2004 was 20% and in 2005 expected to be 10%. Our favorite variation of the Fed model tells us to expect 2005 S&P 500 return of about 10% as well—in line with long term averages, and similar to 2004. We know, these numbers are boring, but they convey the essence of the current market: do not expect +30% or –20% years in the near future. Investors are now spending more time thinking and less time pushing buttons of the online trading machine—and thinking is a much slower process of the two.
We cannot reliably predict what is going to happen in 2005, especially given all the war on terrorism, oil prices, tsunamis and such. But we can clearly say that the waves of the violent market-quake of 1997-2003 have finally passed and the waters are once again calm.
Year 2004 Performance Review
We entered the fourth quarter of 2004 with a positive economic outlook and cautious optimism for the equities market. And indeed the fourth quarter turned out well. For the year 2004, our equity programs, Vega Equity+™ and Vega Equity*™ were up on average +12.1% and +17.6% correspondingly 1, compared to (S&P +9.0% DJI +3.2% Nasdaq +8.6%)—see the table
| Year
2004 | Year
2003 | Annualized Rate
of Return | Max
Drawdown | Return/Risk
Ratio | Beta | Excess
Return (α) |
|---|
| Vega Equity+™ | +12.05% | +38.00% | +21.77% | -3.60% | 6.0 | 1.1 | +5.58% |
| Vega Equity*™ | +17.58% | +40.10% | +26.51% | -5.10% | 5.2 | 1.3 | +8.10% |
| S&P 500 | +8.99% | +26.40% | +16.68% | -10.20% | 1.6 | 1 | 0.0% |
| NASDAQ | +8.61% | +50.00% | +27.90% | -10.70% | 2.6 | 1.8 | -0.43% |
| Dow Jones | +3.15% | +25.30% | +15.61% | -11.30% | 1.4 | 1.2 | -5.57% |
Strategic direction for year 2005
Our stance at the beginning of the year 2005 stands at the moderately aggressive with target beta of 1.0. The primary reason for the word “moderately” is that the market was very strong in the fourth quarter, and may, in fact, stall in January on profit taking and technical overbought condition. In the grand scheme, even if this happens, the strong fundamentals we outlined earlier in this newsletter, will most likely limit the downside. In the first quarter we will also enter a seasonally slow period for the stock market.
Under these circumstances selectivity in the stocks becomes the primary driver for the performance of the portfolio—and we are certain to pay very close attention to details of each new position. We will definitely be looking at hedging out some of our energy exposure that benefited us in 2004—possibly through purchases of stocks that anti-correlate with energy prices.
Vega Fixed Income Strategy Update
2005 will not be a good year for fixed income. There is just not much spread left in the bond yields. The Fed rate was just 1% in the beginning of 2004 and is now 2.%, yet the yield on the 10-year treasuries, and the rest of the bond markets with it, has not moved much (in fact, some of the benchmark yields actually went down). So, assuming the Fed will continue to raise rates, as it should to keep the inflation in check, the bond market will go down. Thus, speculating in the bond market will not be our game—instead our bond portfolios will keep doing what they are designed to do in most cases—be a safe zone for your hard earned money that generate tax-optimized income and provide a certain buffer for your unexpected needs. The yields on the Vega Safety™ and Vega Wise™ programs are bound to stay low, though by the end of the year we expect these to rise together with benchmark rates.
Vega Alternative Strategy Update
For the information on performance of our hedge fund products please contact us directly as by SEC rules we are not allowed to make such information publicly available. In general, however, our hedge fund strategy follows the same guidelines as our equity portfolios enhanced with additional instruments such as short positions and derivatives.
Yuri Drozd, CFA, Chief Investment Officer
Dr. Vladimir Naroditsky, CFA, Head of Research
1Vega Capital Group LLC ("Vega") is an independent adviser registered with the Securities & Exchange Commission. The performance shown reflects actual performance for representative accounts. One representative account is selected for each strategy. The selection of representative account is based on the following factors: cash flows into or out of account for the reporting period, size of account sufficient to be representative of the strategy, average trading expenses. Performance of other accounts managed under the same strategy may vary. The firm maintains a complete list of its' accounts performance, which is available upon request. Past performance is not indicative of future results. Accounts under Vega's management are not insured against loss of principal, and may loose value. The U.S. Dollar is the currency used to express performance. Returns are presented net of management fees and include the reinvestment of all income. In addition to an advisory fee, performance shown includes any additional custodial or service fees. The advisory fees are calculated as follows: for Vega Equity Plus accounts, the fee of 0.5% per quarter is charged quarterly, in advance, based on the closing balance on the last date of the previous quarter; for Vega Equity Star accounts the quarterly fees consists of management fee of 0.375% per quarter charged in advance, based on the closing balance on the last date of the previous quarter plus performance fee, charged in arrears equal to the 10% of investment gain for the quarter above all relevant watermarks and hurdle rates for the account. Vega's schedule of advisory fees vary based on product and type of client and is contained in Form ADV-II. Additional information regarding the policies for calculating and reporting returns is available upon request.
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