What a year it was. For all that happened this year with the numerous economic and geopolitical events that shaped global markets, I think 2004 will be measured by history as a "return to normalcy".

Not a very provocative topic for a year-end newsletter but then again neither was the presidency of Warren G Harding who is responsible for the phrase. From my vantage point, however, 2004 may mark an important transition from the boom and bust cycle of the last decade. The real question is a transition to what? My sense is that despite the heightened volatility of a post 9-11 world, the US stock market is gearing up for rather ordinary performance, by historical standards. I do not mean to suggest tranquility or a lack of volatility; simply annual rates of return should trend back toward the mean. In other words, it appears that after a decade or more of significant up years and significant down years, US equity prices should stabilize and trend on fundamentals and economic activity for the next several years.

Predicting future market returns is a perilous sport so before I go too far out on a limb, let's begin with a brief statistical look back over the last ten years in an attempt to give some perspective. Then I will share some thoughts on the year and what we will be looking for in 2005. Over the last decade, the overall US equity market as measured by the S&P 500 Index has returned an average annual return of 12.07 % (assuming reinvested dividends). Over the last 5 years the market has been considerably weaker - at 2.30% per year. 2004 measured in at 10.88%. These numbers are significant in gauging 2004 because in many ways one would think that with an economy growing at 4.4% (GDP), interest rates historically low, massive government stimulus (spending &tax cuts), 2.2 million new jobs, and record corporate profits, stock performance in 2004 would have been significantly higher than the 12.07% average over the last decade, but it wasn't.

This tells me a few things. One, despite strong economic fundamentals, investors remained relatively cautious throughout the year weighing the considerable uncertainty of geopolitical events, the election, and a genuine concern that high energy prices might stall the economy in its recovery tracks. Another sign of this caution is that individual investors stashed hoards of cash on the sidelines. Similarly, corporations have parked more than 2 trillion dollars of cash on their balance sheets. The second thing this relative underperformance to the ten year average tells me is that unless the economy and corporations are able to experience a repeat performance in 2005, investment returns are not likely to keep pace with 2004.

It is pretty clear that corporate profits will not come close to matching the growth of 2004 and I would be surprised if the overall economy was as strong next year. So where does that leave us? In my view the trends that shaped 2004 will continue to affect markets in 2005 in similar ways. The markets will continue to be shaped by issues relating to interest rates, energy prices, corporate profits, geo-political events, the US consumer, productivity trends, and the US dollar and its affect both here and in international markets. In addition to these trends, two others should play an important role this year: how the US consumer will respond to rising interest rates and higher prices, and what corporations will do with all this cash.

The consumer trend is the more challenging of the two to predict, but my sense is that the trend will be to a gradual weakening of consumer spending in the 2nd half of the year and this should moderate US full year 2005 GDP numbers into the 3.25%% -3.75% range. On the corporate front it appears that the record levels of cash on the balance sheets will likely make 2005 the year of mergers, increasing corporate dividends, stock buy-backs and hopefully more willingness to invest in business expansion. All in all 2005 is shaping up to be a year of decent economic activity. As a result we expect bond prices to decline, real estate prices to flatten, and the US equity markets to advance moderately.

These are challenging times for us both as citizens and investors. As a result we will have our work cut out for us this year. Thank you for your continued confidence.