Juggle Your Small and Large Cap Stocks

As 2003 wound down, its annual observations became prominent guides for what investors and advisors should be aware of in 2004. The fourth quarter of 2003 produced financial information that physician-investors should take into consideration when preparing for the new investment year. Before the discussion on predictions and outlooks for 2004, let's first step back to January 2003.

Unexpected Stock Shift

In January 2003, eBay was thought to be a top performer. Analysts expected eBay to continue to experience the same healthy growth in 2003 as it did in 2002. These predictions became a reality. The profitable company went on to make a significant value-added acquisition in PayPal, a Web site that offers a secure way to send and receive money online. The PayPal acquisition is believed to be accretive to earnings in the short term. On Jan 20, 2003, eBay was priced at $34 ($68 before splitting). At close on Dec 31, 2003, eBay was up to $64.61. Still, criticism came from many investors speculating that eBay was too risky to buy.

The fourth quarter of 2003 surprised both investors and advisors. Many advisors continued to purchase more and more of the same big-name winners from the first, second, and third quarters of 2003. An unexpected stock shift occurred in the latter part of the fourth quarter. The previously idle large cap stocks, which did not move during the 18-month bull market, suddenly started an upward rotation. Some of the stocks that started to break out include General Motors, US Steel, the Walt Disney Company, General Electric, Time Warner, and ExxonMobil. All of these companies were underperformers for several years.

Looking back, there are numerous reasons why an upward rotation occurred. Confidence in the American economy sparked reassurance in companies that are well established. This increases the likelihood that consumers worldwide will continue buying products from these companies. The decline in the US dollar against the euro also affected the rotation.

Gains and Losses

Investor's Business Daily's

The rapid short-term sell-off of small and mid cap stocks left the stage open to large cap stocks, and the natural progression of "smart money" sparked spending. Noting index movement is a vital procedure. In the third week of December, the Dow was at its peak price. The S&P 500 sold off its high by 1.5%; the small cap S&P 600 sold down 3.5% from its high; the Nasdaq sold off 4% from its high; and New American Index fell 8% from its high. High-risk investment indexes rotated off their highs more dramatically than the other indexes.

Capital gains and losses are always a concern for investors with taxable assets. Capital losses occur when an investor sells an asset for less than the original purchase price. Capital losses that exceed capital gains by $3000 can be spread out through the following years. The December sell-off was phenomenal: Investors took profits without the effect of any year-end taxes due because of the previous carry-forwards. Investors experienced huge gains in small cap stocks in 2003 and wanted to counterbalance past losses, so they sold their small cap positions and moved into large cap holdings for the tax break. Once investors had successfully equalized capital gains to previous losses, they jumped back into small caps.

This is where market observers saw the small cap dip and recovery. This type of rotation created a buying opportunity for the suddenly sold-off small and mid cap winners. The ability to understand the rotation assists portfolio managers on entry points. Those portfolio managers who could not understand the rotation panicked, thinking it was a double-dip recession, and abandoned the market. Analysts anticipate a potential reoccurrence of this activity in 2004.

2004 Investment Forecast

With this retrospective, what should investors accomplish in 2004? In addition to international stocks, investors should increase their large cap holdings and slightly reduce their exposure to small cap stocks. Long-term agency, fixed-income items, and long-term corporate bonds should be completely liquidated.

In the 2003 bond market, convertible bonds were one of the most attractive types of fixed-income investments, showing notable procession throughout the year. Convertible bonds are company-issued bonds that can later be converted into stock, and are generally issued by small and mid cap companies to raise funds in the capital markets. Convertible bonds fluctuate in parallel with their company's stock price. If the stock goes up, so does the value of the bond. The average yield for convertible bonds is around 4%.

For 2004, convertible bonds look to be just as appealing. With interest rates potentially moving upward, corporate bonds will become vulnerable to diminishing total returns. However, attractive convertible bonds are smart because they provide yields, have a potential upside, and have short-term time durations, if purchased correctly.

John Valentine specializes in portfolio management and in developing high-net-worth strategies. He is the principal investment advisor at the Valentine Capital Asset Management of San Ramon, Calif. He welcomes questions or comments at 925-275-0200, or visit www.vcrpg.com.