Lakeview Investment Advisors, LLC
Commentary Date: Spring 2005
by Bill Westhoff, CFA
Lakeview Update: Personal Update
After a nice spring in Arizona we returned to Minnesota in time for the annual Minnesota Iron-man Bicycle Ride. This was to be a tune-up for the big ride from Minnesota to Maine. Unfortunately during the ride, I had an accident, fell from the bike, and broke my collar bone. Even though the healing process is well under way, the big ride has been deferred until 2006.
I often mention a book tape from our travels, but this time I want to highlight a book that I haven't yet read or listened to—The World Is Flat by Thomas L. Friedman. Friedman is the foreign affairs correspondent for the New York Times, and he was recently in Minneapolis to discuss the book. As I listened to his review of the book, I was impressed by the clarity of his words and explanation of the current state of “Globalization” (more detail below).
Market Performance—2005 YTD (May 12)
Although the market has shown some improvement in recent days, the environment from mid-February to May 12 was poor. The following quote is from a recent edition of Investors Business Daily, describes the difficult market environment of 2005: “The market has staged short rallies and corrections, but it's made virtually no progress going back to October. In other words, it's a tough market in which to make money, whether you're buying or trying to short stocks. This environment calls for constant vigilance and discipline.”
The table below shows how the market has struggled, in spite of solid economic growth, attractive interest rates and continuing increases in corporate profits.
Source: Wall Street Journal 5/13/05
Source: Investors Business Daily 5/13/05
The combination of falling stock prices and rising earnings has created very attractive valuation levels for the market. The price to book value for the Dow is near its five year low; the dividend yield is at a new five year high; and the price to earnings ratio for the S&P 500 Index is at its long term average of about 16X. Interestingly, as stock prices have declined, bond yields have decreased (note positive return on the Lehman Aggregate Index YTD), making stocks even more attractive. Market sentiment is also poor as indicated by the public shorting stocks at over three times the level of stock specialists. Typically, when valuation levels are quite attractive and market sentiment is poor, the market has a good chance to rally (as it has this last week).
The following comments are from the June issue of the Argus Update, prepared by Argus Research indicates that they recognize the attractive valuations currently in the market.
"Stock prices tumbled during the first-quarter earnings period and the Dow Jones Industrial Average recently had its worst week in two years. We advise investors to keep the recent trends in context. Given interest rates that are still historically low, an Economy that continues to grow and corporate profits that remain on the upswing, we think the sell-off represents a buying opportunity. To make the point we recently altered our Tactical Asset Allocation Model for balanced accounts to further focus on stocks. Our new recommended allocation is 70% stocks, 20% bonds and 10% cash. We think that the second half of the year could hold an upside surprise, if earnings expectations come down further while the economy continues to expand...In short, we see an opportunity here."
Economists surveyed by the Wall Street Journal forecast economic growth of near 3.5% for the next year. The Federal Reserve remains committed to its policy of increasing short term interest rates at a measured pace and recently raised the fed funds rate for the eighth time in the last two years. The fed funds rate has now increased from 1% to 3%. The Fed seems caught in a dilemma&rising oil and other commodity prices threaten to start an inflationary spiral, while job growth remains well below historical norms for this stage in the expansion.
The market is sensitive to this issue and has been whip-sawed between concerns of too rapid growth leading to inflation and not enough growth to sustain employment growth and consumer spending. As the market worries, the economy continues to grow at a solid level. With a few exceptions, corporate profits are meeting or exceeding expectations, leading to rising dividends, increased share buy-backs and healthy acquisition activity. This environment should eventually lead to rising stocks prices; unless the Fed acts too aggressively.
Market Outlook (Current stock view: +, moderately positive exposure to stocks and bonds versus the benchmark)
Although I expressed some caution in the last Commentary, I continued to rate the stock market outlook as Moderately Positive (+). The decline in stock prices and the compelling valuations strengthen my conviction in this view. The age or length of the current economic expansion and a Fed committed to further increases in short term rates, prevents me from increasing my view to maximum positive (++) on stock exposure.
I will not discuss Security selection is this commentary but devote this space to the topic of Globalization. One cannot do justice to this topic in a paragraph or even a few pages. However, the book mentioned at the beginning of this piece seems to help explain the current state of globalization in language we can all understand. As mentioned above, I recently heard a review of a new book (The World Is Flat) by its author, and I was struck by the power of the points he was making.
The genesis of the book was a trip to Bangalore, India to view outsourcing from the other side. As Friedman interviewed the leaders of business in India he was awed by the speed of the transformation of the economy, the businesses and individuals, and the impact of this transformation on the United States. He claims that a quote from one interview was replayed numerous times in his head until he came home and told his editors he needed to take time off to focus exclusively on writing this book. The quote: "The playing field is being leveled, and the United States is not ready." As he kept repeating the thought, he realized that the combination of new economies, technology, and communications was making the world flat for the production of goods and services in ways that we could not imagine just a few years earlier.
One fact really jumped at me from his commentary: this combination of newly opened economies (China, India, and the countries of the former Soviet Union) with new technology and communication has created three billion new producers of goods and services. Note that he said producers, not consumers. Yes, these new participants in the world economy want products; but first, they want jobs. This has the potential to increase global growth rates, but it also has major implications for wage rates, inflation, and standards of living in the United States.
Please contact me at Billw@lakeviewadvisors.net if you would like to discuss any of the ideas reviewed in this commentary.
© 2004 Lakeview Investment Advisors, LLC
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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.
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
William C. (Bill) Melton, PhD., President, Melton Research, Inc., formerly Chief Economist, American Express Financial Advisors
Former Advisory Board member Ray Goodner has moved to Seattle. Jim Walline has returned to the working world, accepting a senior position with Piper Jaffray.