By Christopher M. Wright

NAME: Byron R. Wien TITLE: Senior Investment Strategist, Morgan Stanley AGE: 72 EXPERIENCE: Byron Wien was a portfolio manager for 20 years before he joined Morgan Stanley in 1985. He received an A.B. with honors and an M.B.A. with distinction from Harvard. In 1998 he was named by First Call as the most widely read analyst on Wall Street and in 2000 was ranked the number one strategist by SmartMoney.com based on his market calls during the year. Wien was named to the 2004 Smart Money Power 30 list of Wall Street's most influential investors, thinkers, enforcers, policy-makers, players and market movers. He has appeared on Charlie Rose on PBS and has written for or been quoted in the Wall Street Journal, Barron's, and many other publications. In 1995 he co-authored a book with George Soros on the legendary investor's life and philosophy ["Soros on Soros: Staying Ahead of the Curve," by Byron Wien and Krisztina Koenen] and currently serves as a director of Soros Fund Management. Wien is a member of the Investment Committees of Lincoln Center and the John D. and Catherine T. MacArthur Foundation, among other activities.

Morgan Stanley Senior Investment Strategist Byron Wien is well-known for his annual list of "Surprises of the New Year." On his list of surprises to watch for in 2005 were long-term interest rates at 6 percent and a flat S&P 500. Portfolio asked him why he holds these views and how he sizes up the REIT sector for the second half of 2005.

Portfolio: What do you think of REITs as an investment proposition?
Wien: I am not a REIT expert. I'm a generalist. One of my key themes this year has been yield, and therefore I have a favorable orientation toward REITs because they do provide high yield. I continue to be positive on high-yielding securities, and REITs are certainly at the leading edge of that.

Further, I am in the camp that there is not a housing or commercial real estate bubble. In the case of commercial real estate, I don't believe there's a bubble because I don't think there's been an excessive amount of overbuilding in this cycle. Therefore, I think occupancy rates have remained relatively high. In terms of apartment, office and retail-oriented REITs, I have a favorable orientation. The most important thing is the ability to increase dividends rather than the absolute level of the dividend. So REITs offering dividend growth are more attractive in my view than REITs that are just going to have a static return.

Portfolio: At the beginning of the year, your list of surprises predicted there's a better than even chance that the yield on 10-year U.S. Treasury Notes would rise to 6 percent in the second half of the year. Do you still hold to that view?
Wien: Maybe that's a little too ambitious at this point, but I definitely think they'll still exceed 5 percent.

Portfolio: What would you expect that to do to REIT share prices?
Wien: Higher long-term rates are negative for real estate generally, and they're negative for REITs because bonds become more competitive with REITs. But I think as interest rates rise, it puts more of a focus on up-front returns, and so it also tends to favor higher-yielding securities like REITs. On balance, I think it's probably a slight negative but not a severe negative for REITs if rates move above 5 percent.

Portfolio: Your list of surprises also forecasts that the S&P 500 will end the year flat despite a strong economy and improvement in corporate earnings. Is that still your view?
Wien: It very much is. The economy has been strong, earnings have come through, and the market has gone nowhere. The improvement in earnings and the strength of the economy is going to be offset by rising interest rates and a declining dollar. So my view is that the market is going to continue to struggle for the rest of the year.

Portfolio: You predicted a sharp drop in the dollar with the euro going to $1.50. What will take it there?
Wien: The U.S. is running a $700 billion trade deficit. We can't finance that internally. We're totally dependent on foreign financing of it—that's mainly Japan and China. There's some evidence that those countries are going to be less willing to buy our Treasuries, and that's going to cause the currency to weaken. So far that hasn't happened, but you have had rumblings of disaffection with the dollar in Korea and to some extent in Japan. The purchase of Treasury securities at recent auctions has been less than it was a year ago. You don't have to have anybody sell Treasuries to have the dollar weaken. You just have to have people buy fewer of them. If they just reduce their buying appetite somewhat, that could cause a weakening of the currency.

Portfolio: You've used a widely followed valuation model for the S&P 500 for 25 years. The model predicts fair value based on expected earnings growth and a discount rate. Tell us a little bit about your model and what it's indicating for the second half of '05.
Wien: The model has had some ambitious assumptions in terms of the growth rate of earnings at 9.8 percent and the risk premium at 2 percent. Over the past year, I've experimented with less ambitious earnings estimates closer to 7 percent and a risk premium of 3 percent. If you use my original assumptions, the market looks undervalued today. But using the assumptions I just stated, based on a mature economy going forward and the risks that are being faced by equities, I think assuming the market is slightly overvalued is probably more realistic. So that's one of the reasons why I believe that the market is not going to make any progress between now and year-end.

Portfolio: Overvalued in reference to what?
Wien: Stocks compete with bonds, so this dividend discount model determines at what point bonds and stocks are priced in equilibrium. So when I say the stock market is slightly overvalued, I am comparing it to 10-year Treasuries yielding 4.35 [percent].

Portfolio: You correctly predicted that stocks were overvalued in 1999 and that the market would recover in 2003. Were these predictions based on your model or something else?
Wien: The model played a role, but the predictions were also based on sentiment. The job of a strategist is to decide what's relevant. There are hundreds of variables that reflect on the stock market, and some of them are very important at certain times and unimportant at other times. The skill of a strategist is to know what counts and when.

In 1999, the market according to my model was about 50 percent overvalued, and I was quite shrill at that point in saying that the market was extremely dangerous. The market was continuing to go up. When you're an older person telling everybody that the market is very dangerous, yet the market continues to rise, people think that the tools you're using are no longer effective and maybe it's time for you to seriously think about retirement. At any rate, in March of 2000 the market started down, and the message of the model turned out to be accurate.

In July and October of 2002 the market reached a selling climax, and sentiment at the beginning of 2003 was quite pessimistic. At that point, the market was much undervalued according to my model. I said at the time that the market would go up 25 percent in the first six months of 2003. It didn't do that, but it did go up close to 30 percent for the full year. In strategy, as in making love, sometimes taking a little longer to reach your objective isn't a bad thing.

Sentiment was very positive at the beginning of 2005, and the market looked fully priced to me. That's part of the set of reasons why I thought the market would make little progress this year.

Portfolio: You've noted that portfolio turnover has grown from 12 percent in 1960 to 54 percent in 1992 and 104 percent in 2004. You've been quoted as saying, "We are clearly living in a more frenetic trading environment. More and more stocks are being rented, not owned." What are the implications of that?
Wien: There's so much trading activity, and it's causing high friction costs among portfolio managers. I think a portfolio manager who does his homework, really identifies good, long-term situations and is willing to buy and hold them, the rewards can be great because other people are dissipating their returns by excessive turnover.

Portfolio: You also noticed years ago an annual slump in the stock market in July and August. Has the pattern persisted, and what might account for it?
Wien: There's an old saw on Wall Street, "sell in May and go away," because the market tends to go down, particularly climaxing in October and then performing better from October to May. In the early part of the year, people usually are enthusiastic about the year ahead. In particular, analyst earnings estimates tend to be too ambitious, and as we move further into the year, the realization of those earnings estimates becomes less likely. That becomes clear in the second half, and has a negative influence on stock prices. Moreover, many people take vacation in the summer and are less focused, and that makes the market vulnerable to heavy selling because there are fewer buyers.

Portfolio: So there is something to the pattern, but serious financial literature concludes that it's never really possible to profit from anomalies like this. What's your view?
Wien: I'm usually suspicious of so-called mechanical things like what happens the first year after a presidential election, what happens in years ending in "5," "as January goes, so goes the year," and so on. There are a whole slew of things like that.

I really think that every year is different. You really have to analyze the variables that are in place during that year and not use these formulaic approaches to stock market performance. The stock market is ultimately moved by fundamentals. Sentiment factors play a role, and it's important to understand them, but they shouldn't be the ruling influence. I think you have to take each year separately. If I'm right, and the market [S&P 500] goes nowhere this year, that doesn't mean that every stock goes nowhere. You just have to be very careful in your stock selection.

Portfolio: In 1994 you said, "The economy is doing well, and the market is doing terribly." Sounds like dé jà vu all over again. Why is it that good news on Main Street sometimes is taken as bad news on Wall Street?
Wien: It depends on what the valuation level of a market is going in. The market this year was pretty fully priced going in. So even though the economy is doing well, the market may not reflect it. Secondly, profit margins were at all-time highs at the beginning of this year, so the likelihood of disappointing profits was greater than the likelihood of upside surprises. That's the way earnings revisions are now coming through. Therefore, the stock market can have disappointing performance if it's already anticipating the economy doing well.

Portfolio: What else is on the mind of a top strategist these days?
Wien: The most important question facing America right now is its overall competitiveness. Manufacturing has declined in the U.S. over the past 50 years, and the U.S. is more of a service economy than a manufacturing economy. So you have to ask if America can remain the preeminent economy in the world with our enormous trade deficit, large budget deficits, a low savings rate and a declining manufacturing base.

That's a serious challenge that the private sector and the public sector are going to have to face. The 19th century was Europe's century, the 20th century was America's century, and it looks like the 21st century is going to be Asia's century. The largest question in my own mind is whether America is ready for that competitive threat.