After a year of soaring stock prices, investors have been marking time since the beginning of this year.  For example, a group of 186 closed end diversified equity funds experienced a 16 percent gain in their net asset values during the last six months of 2003.  In the first six months of 2004, the gain has been 1.8 percent. 

Ninety-eight closed end international equity funds increased their values by an average of 28 percent in the second half of 2003 and lost one percent so far this year. 

Bond funds have lost money since the beginning of this year while money market funds, while not losing, have returned less than one percent. 

Clearly, there have been exceptions.  The median home appreciated in price by nearly 9 percent in the past twelve months.  With the average family having a mortgage of more than 50 percent, that provides a nice double digit return on home equity. 

Some countries, such as in Eastern Europe (including Austria), Mexico, and Japan, have been winners; but China and India, two of the fastest growing countries in the world, have not been good investments so far in 2004.

Some hot technology sectors, such as broadband, the internet, and wireless, have continued to soar.  But semiconductors, which provided almost 40 percent gains in the last six months of 2003, have lost about 13 percent so far in 2004.  Even within that group, Taiwan foundries have increased in value while other foundries have, well, foundered. 

I cannot predict what the best investments will be in the second half of 2004.  If I could, I would be much wealthier than I am. 

However, I have several rules that I tend to follow (at least when I am at my best, which is advising others).

First, what are happening to the key determinants of enterprise value in an economy?  Are future profits tending to intensify (meaning the business cycle is just beginning to surge) or are they stagnating (as the economy gropes for direction).  Also, are interest rates beginning to rise, or are they stable or declining?

If profit growth is slowing and interest rates are rising, that is not very conducive to rising equity values.  However, the above examples show that even if the overall economy is not helping equity values, there may be sector or geography specific conditions that are.  So,

Second, are there policy changes that are helpful or hurtful to enterprise development?  For example, the correct time to invest in China is when they were admitted to the World Trade Organization.  Now, the advantages from that move have been absorbed.  In Eastern Europe, inclusion in the European Union has aided the export prospects of those countries.

Third, are there sectors or geographical areas that are providing superior returns without exposing investors to superior risk?  I actually looked at the 3, 5, 8, and 10 year performances of a host of open ended mutual funds.  The best performances without much risk as measured by the variation in annual returns over that time were managed international balanced funds (meaning both equities and bonds) and small capital managed domestic funds. 

Fourth, if I do not believe I have expertise to allow me to beat an index, then I invest in the index.  You will notice that some managed funds actually outperformed the index funds with less risk.  However, they might have greater tax consequences than the index funds. 

Fifth, tax savings is an addition—not the reason for my investment decisions.  I certainly want to extend my winnings and not pay taxes if possible.  As a result, I do most of my stock trading in my IRA, where gains are not taxed until funds are withdrawn from the IRA.  My long term investing is in my personal account, where I hold until I no longer expect my positions to provide acceptable rates of return over time. 

Sixth, last year’s winners are last year’s winners.  I am investing for next year’s winners.  Is there a reason why they can be the same, as internet applications clearly have been?  Is there a reason why the laggards should remain behind?  Apparently, investing in the 5 worst Dow stocks of the past year provides stronger returns than investing in last year’s 5 best performers. 

There are more but I will just tell you my conclusions.  I believe there will be a legitimate second leg to this bull market that will provide 10-12 percent returns in the next year.  I believe the gains are slightly more likely to occur domestically, although I still like Japan and Eastern Europe.  The laggards of pharmaceuticals and telecommunications are where I see value.  The previously strong materials, including this year’s surprise winner of energy, should slip back.

And I also hope I will win the lottery, if I ever get around to purchasing a ticket.