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Lakeview Investment Advisors, LLC

Commentary Date: Fall 2003

by Bill Westhoff, CFA

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Lake Views

Lakeview Update

The summer and fall were busy for me. First, Ruth and I are looking forwarding to a wedding in March. Our daughter, Kelly, was engaged to Quang Nystrom on July 4. Second, my plans to bicycle across the US have started to take shape. My friends and partners-in-peddle Bill Melton, Ray Goodner, and I set June 10, 2004, as our departure date. The first leg of our trip will begin in Seattle. We hope to reach Minneapolis by early July and finish the second leg in 2005. I intend to use the bike trip as an opportunity to raise funds for American Lung Association; but before I can push off, my legs (and backside) must be ready to go. Therefore, I am currently in Arizona putting miles on the bike. Through these busy times, Lakeview’s business, which is now one year old, has continued to experience rising market values and gains in assets under management. In addition, Lakeview welcomes its newest clients.

Market Performance YTD (10/31/03)

Historically, October has been a difficult month for the stock market. This year, however, October broke that trend. Preliminary GDP (Gross Domestic Product) numbers announced in the month showed exceptional growth. The economy increased at a rate of 7.3%. This apparent economic growth has served to increase confidence in the market. The stock market has now staged a broad-based rally with all areas showing very strong performance. So far, the most volatile and risky assets are performing the best year-to-date (see * below).

Measures of valuation, such as price/earnings ratio (P/E) and dividend yield have moved from their attractive levels of early March. However, these valuation measures are not stretched to extremes. Even though prices of stocks have moved up sharply, the forward estimates of earnings are increasing, which keeps the P/E ratio on future expected earnings at a reasonable level.

New tax laws passed this year lowered the tax on dividends. US corporations are now responding to these lower rates by announcing significant dividend increases. At the same time, the Federal Reserve has repeatedly stated that it will maintain low interest rates. All of these factors are working together to provide support for a continued rally in stock prices.

The chart below shows performance of various indexes through the month of October. Other market statistics are included.

Index

Level

YTD change

Dow Jones Industrial Average 9801.12 +17.50%
NASDAQ Composite 1932.21 +44.68%*
S&P 500 1050.71 +19.42%
Russell 2000 (small stocks) 528.22 +37.88%*
MSCI EAFE (Europe, Australia, Far East) 1171.47 +22.97%
DJ World (ex. US) 132.97 +27.21%
Nikkei 225 (Japan) 10559.59 +23.09%
DJ Corporate Bond Index 171.82 +7.91%
Lehman Bros. US Bond Aggregate 1067.64 +2.80%
Merrill Lynch High Yield Bond Index 629.83 +22.66%*
10 year Treasury Note (Yield) 4.29%  
3-month Treasury Bill (Yield) 0.94%  
Euro (Currency in US dollars) 1.1584  
Japanese Yen (Currency in US Dollars) 109.54  
British Pound (Currency in US Dollars) 1.6944  

Source: Wall Street Journal 11-3-03

Valuation Statistics

Current

5 yr. High/Low

Price to Book Value - DJI 4.44 8.29/3.45
Dividend Yield - DJI 2.01 2.6%/1.28%
S&P 500 P/E (Argus Research) 19.55 NA
52-Week Highs & Lows (11/3/03) 1,078 vs. 8  

Source: Investors Business Daily 11-4-03

Economic Outlook

The Economics and Markets Advisory Board (see end note) continued to meet throughout the fall. In light of recent economic news, our meeting on October 21 brought about many interesting ideas.

As Bill Melton said, “The best economic numbers will come in at the end of the third quarter and beginning of the fourth quarter. Employment, industrial production, and consumer spending all have a data lag and reporting lag.” In other words, the economy may be improving for some time before it is actually reported.

Melton also reported, “Q3 GDP is expected to be between +6.5–7% (it was actually reported at +7.3%). This large GDP number will be combined with a reduction in Hours Worked (another statistic followed by economists); the implication is that Productivity Growth could be monstrous! (Reported productivity growth was 8%).”

The Advisory Board remains optimistic about economic growth. We believe it will hold in the 3–4% range into the coming year. In this environment, market interest rates for US Treasury bonds are likely to increase from current levels. The Federal Reserve is comfortable with interest rates on Federal Funds. All factors indicate the Federal Reserve will stand pat on the Federal Funds rate until there are further signs of sustainable growth and/or inflation starts to increase. Perhaps we can expect a rate increase in the second half of 2004.

The employment report announced on November 7 showed improvements over figures reported earlier this year. The most recent report announced a growth in employment. Numbers show employment gained +125,000. This is up from September’s figure of +57,000. At the same time, this figure was accompanied by a decline in the unemployment rate to from 6.1% to 6%. While the employment numbers still need to expand into a range of +150,000 to 200,000 per month to keep up with population growth and to drive the unemployment rate lower, the trend appears to be positive.

Since employment has been the focus of the political arena this year, the Advisory Board spent time reviewing statistical measurement problems. There are two government surveys that make up the monthly employment report: the Establishment Survey (ES), and the Household Survey (HS).

The ES is a much larger sample and actually asks employers how many employees they had on their payrolls in the last month. This survey develops the payroll number, the report of the number of jobs added or removed from payrolls.

The HS surveys a smaller sample of households. This survey asks if members of the household are employed or not and if they are currently seeking employment. The gathered information develops the unemployment rate.

Market participants debate the importance of one survey over the other; however, the markets seem to focus more on the payroll number, while the media and politicians seem to place more emphasis on the unemployment rate. For those of us who watch and hear the differing numbers, it is essential to remember that the surveys measure different things.

Each report is necessary to develop a strong understanding of employment conditions in the economy. However, at turning points such as now, the establishment survey will not capture the start of new businesses. Thus, payrolls may in fact be expanding, but it is not captured by the survey of existing employers. The result is under-measurement and a lag in improvement in the payroll number. Whatever the case, the better employment numbers reported in early November do not appear to be just a statistical fluke; more likely they are the start of a more favorable trend.

Market Outlook (Current stock view: ++, or maximum stock exposure)

The last issue of Lake Views suggested appropriate allocations of assets between cash, bonds, and stocks. This issue will focus on valuation in more detail; it will also take a favorable look at industrial companies.

In early 2003, the Advisory Board discussed a valuation target of 1,050–1,100 on the S&P 500 Index by the end of the year. Interestingly, the S&P 500 closed at 1,050 on October 31. Does this mean it’s time to reduce exposure to stocks? Not necessarily. The year 2003 is almost complete, and the market is now looking to 2004 for earnings. Since the economy has been forecasted to grow at a more rapid rate, and since economic profit forecasts for 2004 and 2005 are being positively revised, the upper end of the valuation target is rising. The under-valuation of the market in October 2002 and again in March 2003 is now history. The market movement from this point will be driven by earnings growth.

In an October report, John A. Mendleson of the Charles Schwab Market Analysis Group said, “...I have estimated an upside target for this market of at 10,500 on the Dow Jones Industrial Average and at 1,150 in the S&P 500 Index...” This is an increase of 7.1% for the Dow and 9.5% for the S&P.

The November edition of the Argus Update read, “We estimate a fundamental fair value range for the S&P 500 of 900–1075 over the next 12 months. This is subject to upward adjustment if earnings stay strong and interest rates stay below 5%. If stocks rise outside this range in the short term, we may lower our asset allocation recommendation to equities.” (Emphasis added).

The bottom line is that there is support for further gains in the stock market. An additional fact is that the average duration of bull markets is 39 months. We are only 8 months into this bull market. The market is no longer cheap; therefore, it is necessary to watch valuation closely. By doing so, one can determine when to change the stock view from maximum exposure to equities (“++”) to a more conservative posture.

In earlier commentaries, the combined effect of a large trade deficit and a large budget deficit was discussed. While forecasting currencies is difficult, most economists would venture to say that this combination is not good for a strong dollar. In fact, this combination could well lead to declines in the value of the dollar compared to other currencies. This speculation has sadly become a reality as the past year has brought the decline of the dollar to the Euro, the Pound Sterling and the Yen. Lakeview does not recommend its clients purchase foreign currencies. Yet there are ways to find beneficiaries of the dollar’s devaluation versus other currencies.

A potential beneficiary is industrial companies, and they deserve a closer look. Many industrial companies have been hurt by global competition, and much has been written about excess capacity in some industries. However, a weak dollar makes US exports cheaper. In addition, excellent cost structures have been put in place by many companies throughout the last several years of recession. Finally, stronger growth in China (and now the US) is increasing demand for many industrial commodities, which in turn pushes up product prices. This combination of rising prices and increased volumes should result in strong profit growth for a number of industrial companies.

Recently, the exposure to industrial companies was increased in all client portfolios owning individual stocks. One or all of the following names were added: Freeport McMoran Copper and Gold (FCX, a mining company), Johnson Controls (JCI, a manufacturer of industrial controls), and Praxair (PX, a manufacturer of industrial gasses).

© 2004 Lakeview Investment Advisors, LLC

Any information provided in these materials is believed to be from reliable sources. Lakeview Investment Advisors, LLC makes no representation as to its accuracy or completeness and is not responsible for any damages incurred as a result of your use of these materials. These materials do not constitute a solicitation to sell or offer to sell investment advisory services to residents of any state in which Lakeview Investment Advisors, LLC lacks authority. Part II of Form ADV, which details the business practices, services offered, and management fees charged by Lakeview Investment Advisors, is available upon request.

The Economics and Markets Advisory Board consists of the following members:

Theodore H. Busboom, CFA, President, Prospective Value, formerly Senior Vice President and Portfolio Manager, American Express Financial Advisors

Ray S. Goodner, CFA, Private Investor, formerly Senior Vice President and Portfolio Manager, American Express Financial Advisors

William C. (Bill) Melton, PhD., President, Melton Research, Inc., formerly Chief Economist, American Express Financial Advisors

Jim Walline, CFA, President, Walline Capital Advisors, LLC, formerly Vice President and Portfolio Manager, Thrivent Financial Services

Lakeview Investment Advisors, LLC participates in a Board of Advisors consisting of professionals in the investment field; however, members of that Board who are not employees of Lakeview Investment Advisors, LLC do not participate in providing investment advisory services offered to clients.

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