If I told you in advance that in January: 1. Reports would show that earnings growth for last quarter of 2004 was well above expectations and over twice the historical average; 2. Commodity prices and inflation would be contained; 3. Long-term interest rates would go lower; 4. There would have been some significant merger news; 5: The Iraqi election would be viewed as successful; and I told you that historically January is one of the better months for the market, you’d have likely guessed that stocks would start off 2005 with a nice pop. Instead, that popping sound was the bursting of investors’ expectations.

Good News But A Bad Market
What happened? One answer is the easy-to-fall-back-on "profit-taking" explanation, but there is more than a kernel of truth to that. With the strong gains during the last quarter of 2004, many of the more active investors in the market (including hedge funds) sold their winning positions to lock-in their profits. In fact, for many ‘hedgies’ all their profits were earned in the fourth quarter and they were not anxious to see them evaporate. Another factor adding to downward pressure was that insider selling by corporate executives has been at multi-year highs of late. It is also true that some of January’s good news did not come until very near the end of the month, such as the Iraqi elections.

However, exacerbating the whole process were investors’ expectations. On the heels of such a strong market in December, investor expectations were very high heading into 2005. As we noted in last month’s Report, individual investor bullish sentiment readings had reached extremes as 2004 came to a close. The contrarian in us noted that this wasn't exactly a positive for the stock market. That’s because when investors are extremely bullish they usually have little cash left on the sidelines and thus they represent little latent buying power.

Indeed, as the market began declining during the first weeks of the January, not only did individual investors have little buying power to offset those who were selling, their formerly bullish expectations quickly faded and they joined in the selling. Remarkably, if preliminary numbers hold, there is a chance that stock mutual funds actually experienced net cash outflows in January -- rather than the usual net inflows -- for the first time since fund flow tracker AMG Data Services started reporting this data in 1992. January’s flows are usually positive as money from year-end bonuses, 401(k) funding, and company profit-sharing contributions gets invested in the market. For example in January of 2004, stock funds enjoyed a net inflow of $40.1 billion!

Sentiment Now More Supportive
The silver lining from January’s disappointing start, as shown in the graph below, is that individual investor bullish sentiment has fallen sharply since the end of last year and is now at (low) levels where it can be considered a positive for stocks. This is the same chart that we ran in the December Report which showed a bullish reading of 67.5%, by the end of January that figure was down to 44.7%. Indeed, the market started to rally at the end of January and into early February.

Individual Investors Have Become Overly Pessimistic

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However, not all sentiment indicators are quite this "positive" and on balance sentiment is mixed. But that still represents an improvement over last month.

For our monthly take on sentiment and four other key factors we evaluate when gauging the condition of the market go to our website www.kobreninsightmanagement.com and click on the Five Factor Equity Model near the bottom of the home page.

Other Contrarian Ideas
The contrarian in us also noted last month the bearish extreme in sentiment regarding the dollar. We also detailed several fundamental reasons why the dollar could reverse its downward course in the short-term. While we too are bears on the dollar over the longer-term, this sentiment extreme gave us pause in adding to our international positions. The dollar indeed rallied sharply in January.

There has been lots of talk about the federal deficit and how bad it is for our economy, currency, etc. While we have also joined that chorus to a certain degree, in another contrarian viewpoint, we think that the concern over the deficit may be overstated. First, we need to recognize that the economy now appears to be chugging along, thus removing the need to "prime the pump" by increasing government spending. In addition, given the cynic in us, the election is now over and the need to "buy  votes isn't as strong. Perhaps most importantly though, the economy has recovered and it's reasonable to expect that tax revenues should recover.

In addition, when viewed from an historical perspective, government spending does not appear to be at extremes. Currently (as of the latest data of 9/30/04), government spending as a percentage of GDP is at 19.8%, which is not that far above the 50-year average of 19.1%, and well below the early 1980 peaks of around 24%. Furthermore, it appears to be falling in both short and intermediate terms.

The deficit itself as a percentage of GDP is 3%. To be honest, given the recovery of the last few years, this number should probably be better (lower) than it currently is. Nonetheless, it could be argued that, once again, in a historical context that is not especially terrible -- at least over the last 30 years. It remains below the peaks of 4-5% reached in the mid-80’s and again in the mid-90’s. In sum, the deficit, may not be as negative for the dollar and the markets as many investors now expect.

"Investing Success In Two Easy Lessons"
A recent article passed our desks recently written by one of the luminaries of the investment industry, Charlie Ellis (Jan/Feb issue of Financial Analysts Journal). In his "Investing Success In Two Easy Lessons," his lessons are: (1) work for your long-term objectives, and (2) avoid large losses. It sounds simple, but it's not.

On his first point, and to quote him liberally, he used the analogy of a marathon. Why do so many people run if they are not going to win the race outright?

"The powerful message: Each runner had achieved his or her own realistic goal, so each was a true winner ... If, as investors, we each thought and acted the same way -- understanding our capacities and our limits -- we could plan the race that would be right for us and, with the self-discipline of a long-distance runner, run our own race to achieve our own realistic objectives. In investing, the good news is clear: Everyone can win. The secret to winning the Winner's Game in investing is simple: Plan your play and play your plan to win your game. And if you do not think and work that winning way in investing, you will, by default, be playing the Loser's Game of trying to "beat the market" - a game that almost every individual will eventually lose."

And, on the point of not losing big by always going for the big investment kill:

"Large losses are forever - in investing, teenage driving, and in fidelity. If you avoid large losses with a strong defense, the winnings will have every opportunity to take care of themselves. And large losses are almost always caused by trying to get too much by taking too much risk."

While we don't necessarily agree with everything Charlie writes, he is always intelligent, thoughtful and interesting. His classic book, "Winning the Losers Game," is well worth the read. And in this case, his two lessons are a pretty good summary of the approach we take towards managing your money at Kobren Insight Management. Often, when an investment theme we are playing is successful, such as foreign stock exposure the last couple of years, clients ask why we don’t put even more of their money there, especially if another area in their portfolio isn’t doing quite so well. We don’t do it because if we heavily weight your portfolio in just one area -- no matter how attractive it may look -- we would be exposing you to that "big loss."

Over the long-term, maintaining a well-balanced portfolio is the best way to achieve your goals. As you know, we do overweight areas that we believe offer the best combination of return and risk but we won’t go overboard. Our goal is not to beat the S&P 500 or some other benchmark by the biggest amount possible each year. Try and do that and by definition you are taking substantial risks. Instead, we aim to deliver a long-term level of return sufficient to achieve your financial objectives, while taking as little risk as possible for that return.

As we have already seen, 2005 promises to be a more challenging, and likely more volatile, year than we have experienced in a while. While the "technicals" of the market are sound, and should provide support for stocks, there are ample reasons for concern and certainly the risks to the market this year have increased. So for now we are approaching the market with caution.

Thank you again for your confidence. If you have any questions, please feel free to contact us.

Sincerely,

P.S. Another interesting item that hit our desk this week was a survey from TD Waterhouse regarding investor perceptions of fee-based financial advice. Their key finding was that most investors don't realize that investment advisors (such as Kobren Insight Management) have, by law, a fiduciary responsibility to act in an investor's best interest in all aspects of the financial relationship, while stockbrokers who provide similar advice do not have that same responsibility. There is currently a regulatory exemption for stockbrokers offering fee-based financial advice called the "Merrill Lynch Rule." Long story short, stockbrokers are not subject to the same set of regulations that investment advisors are and as a result, investors get unequal levels of protection.

We will explore this topic of contrasting investment advisors and stockbrokers in more detail in a few weeks on www.kobreninsightmanagement.com, but on the issue of investor protection, there are some very clear differences that investors should be aware of.