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Lakeview Investment Advisors, LLC

Commentary Date: Summer 2003

by Bill Westhoff, CFA

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Lake Views

Lakeview Update

This has been a Goldilocks summer at the lake in Minnesota—not too hot, not too cold, but just right! The loons have been our regular entertainment with their early calls and morning preening. Cedar Lake has certainly proved a better start to the workday than I-94.

Lakeview Investment Advisor’s client numbers and accounts have continued to grow. More important, as the stock market has improved, client balances have also increased. While it’s not bound to happen every month, the growth of the last four months (April–July) has been rewarding to watch. The chart below shows performance through July for various indices and other market statistics.

YTD Performance (4/30/03)



YTD change

Dow Jones Industrial Average 9233.80 +10.70%
NASDAQ Composite 1735.02 +29.91%
S&P 500 990.31 +12.56%
Russell 2000 (small stocks) 476.02 +24.26 %
MSCI EAFE (Europe, Australia, Far East) 638.99 +10.16%
MSCI Europe 887.86 +10.67%
Nikkei 225 (Japan) 9563.21 +9.84%
Merrill Lynch Corporate Bond Index 1369.38 +3.09%
Lehman Bros. US Bond Aggregate 1018.00 +0.47%
Merrill Lynch High Yield Bond Index 593.12 +15.57%
10 year Treasury Note (Yield) 4.47%  
3-month Treasury Bill (Yield) 0.94%  
Euro (Currency in US dollars) 1.1237  
Japanese Yen (Currency in US Dollars) 120.54  
British Pound (Currency in US Dollars) 1.610  

Source: Wall Street Journal 6-2-03

Valuation Statistics


5 yr. High/Low

Price to Book Value - DJI 4.25x 8.29x/3.45x
Dividend Yield - DJI 2.13% 2.6%/1.28%
S&P 500 P/E (Argus Research) 18.86 NA
52-Week Highs & Lows (7/31/03) 460 new highs 36 new lows

Source: Investors Business Daily 8-1-03

Current markets are showing solid year-to-date gains (even Japan is producing a positive 9.84% return). Second quarter earning announcements for US corporations were considered very strong; however, companies continue to voice caution about future outlooks.

This year’s second quarter performance statistics were unique because both bonds and stocks provided positive returns. Yet this pattern was broken in July as positive sentiment about the economy and stocks pushed up bond yields, causing bond returns to be negative. Treasuries showed the weakest performance for the month of July, with the yield on the Ten Year Note increasing 1.20%. It is interesting to note, however, that the year-to-date high-yield bond return of over 15% rivals the returns of many stocks. This is a good indication of confidence returning to markets and investors willing to take risks again.

Among the major indices, NASDAQ is showing the best YTD performance with a return of almost 30%. As a class, small-cap stocks are also having an excellent year. With the Federal Reserve indicating that interest rates will remain low for the foreseeable future, the NASDAQ, small-cap stocks and high-yield bonds should continue to do well.

Summer valuations are not as attractive as the spring, but they are not out of line considering the low interest rates and recently reduced tax rates on dividends and capital gains. While the market has stalled somewhat for the last three weeks and is acting as if it is “out of the office and on vacation,” we continue to have a very positive view of the US equity market. The combination of low inflation, low interest rates, moderate economic growth, and reasonable valuations makes an excellent “porridge” for increasing equity prices.

Economic Outlook

Our Economics and Markets Advisory Board has met numerous times since the last Lakeview commentary, and three themes remain constant: a moderately improving economy, strong productivity growth, and NO job growth.

Bill Melton points out that the economy will likely grow at a 3% rate for 2003. However, the pattern of growth will show quarterly annualized rates below 3% in the first half of the year and over 3% in the second half. Thus, while he believes the growth rate trend will remain at 3% as we go into 2004, the growth rate will feel much stronger at the end of this year. The causes of variation in the 3% pattern are winter weather conditions and the war in Iraq. The reversal of these factors will cause a more rapid reading of growth in the second half of 2003.

Productivity growth is the ability of an economy to increase production faster than employment. Productivity growth is also important to raising standards of living. However, when productivity grows as fast as the overall economy, there is no reason for employers to add employees. While the recently passed tax bill will help various segments of the population, it does little to address this basic issue in the near term. Ultimately, the tax cuts put more money in consumers’ pockets, which they then spend, causing economic growth to increase. But we believe that slow employment growth and remaining high unemployment rates are a fact of this economic recovery.

While job recovery rates are not strong, economic growth accompanied by strong productivity growth means a rise in corporate profits. The second quarter ended June 30, 2003, with strong reported profits. These profits set the stage for an excellent year. Yet one negative factor remains: disappointing revenue growth.

While this is a normal outcome for a moderately growing economy, equity prices have slightly weakened in the weeks since many earnings were reported. Some market commentators are pointing to the weak revenue growth as the reason for market weakness. We at Lakeview believe the market weakness is a normal reaction to the solid run-up of prices in March through June. The sell-off has been accompanied by a lower trading volume, which is a healthy sign of market consolidation rather than an indication of big investors bailing out. Market valuations remain attractive; Bill Melton’s valuation model shows an indicated value of 1,200 on the S&P 500 Index at the end of 2005, or a 20% increase from today’s value of near 1,000.

Another consideration in today’s markets is currency valuations. While we have thrashed out this factor at length, there are two key issues that are important to pass on. First, the dollar has declined by over 20% versus the Euro in the last year. This has been an orderly decline. The fact that this decline is behind us removes a potentially destabilizing issue from the market outlook. Second, additional declines in the value of the US dollar are likely, but the pace will be more moderate. The combination of huge trade deficits (i.e., more imports than exports) and increasing budget deficits do not bode well for a strong currency. The US still remains an attractive place to invest in an unstable world; but less attractive with these factors.

Portfolio Structure

The last issue of Lake Views introduced the idea of portfolio structure and risk management. In this update, I will expand on the topic.

A typical client portfolio will have with a neutral portfolio allocation of 40% cash and bonds and 60% stocks. This is the recommended allocation for a client’s portfolio when bonds and stocks are believed equally attractive. However, if bonds and stocks are seen as equally unattractive, then a client’s cash allocation would increase, while the bond/stock ratio would fall.

The table below shows an allocation grid for a typical client portfolio. Of course, not all clients start with a neutral 40/60 bond/stock ratio.

Bond/Stock Ratio Degree of Stock Attractiveness
52%/48% Fully Negative (--)
46%/54% Moderately Negative (-)
40%/60% Neutral (0)
34%/66% Moderately Positive (+)
28%/72% Fully Positive (++)

Some may wonder why one would own any bonds if there is a fully positive stock outlook or, conversely, why one would own stocks if there is a fully negative view of stocks. There are several reasons to own some of each:

  • The first is very simple—outlooks may be wrong and it would be costly to be completely out of a market that goes in the opposite direction from what had been expected.
  • Next, bonds dampen the overall volatility of a portfolio and provide regular cash flow for unexpected events, thus proving themselves a sound investment choice.
  • And finally, the return on stocks over a long period of time dwarfs the return of bonds. Even in a negative period for stocks, there are companies that will succeed, and their stocks will do well in a relative—if not absolute—sense. Identifying such companies at these times will bring investment returns.

From October 2002 to April 2003, Lakeview’s portfolios were positioned as “moderately positive.” Throughout this time, stocks were valued attractively and economic stimulus had been put in place to increase the growth rate of the economy. Yet there were major questions about the war in Iraq and its pending impact on the economy that kept us from adopting a “fully positive” posture.

In May, we moved all client portfolios to a “fully positive” posture to take advantage of what we believe will be an extended bull market for equities. Several factors discussed in several past Lake Views have led to this positive outlook. Additional factors fell into place in April and May, including the end to major combat in Iraq, another reduction to interest rates bringing them to a forty-five year low, the passage of a major tax cut which is favorable to investors in common stocks, a weaker dollar to spur exports, and indications of solid corporate profit growth combined with small but positive business capital expenditures.

Although we have adopted a very positive stance, we will be watching for signs of weakness or excessive exuberance in stock prices. Substantially-increased interest rates in the government bond market since adopting this stance is a cause for concern. However, at this point we do not see this increase in rates derailing the economic recovery.

As I have said before, capitalism is a mechanism that unleashes economic growth. When obstacles to decision-making are removed and appropriate incentives are put in place, individuals and corporations will invest—and when they invest, the economy and corporate profits will grow.

© 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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