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Lakeview Investment Advisors, LLC

Commentary Date: Summer 2004

by Bill Westhoff, CFA

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Lakeview Update

Two significant events have occurred since the last commentary in February. First, we celebrated the wedding of Kelly and Quang in March. The wedding was a joyous occasion with many family and friends in attendance. The bride was beautiful, the groom handsome, and all in attendance had a good time. Second, I completed the first half of my planned bike trek across the U.S. The ride covered almost 2,000 miles from Seattle, Washington, to Annandale, Minnesota, over 24 days and concluded on the Fourth of July. Most of you followed the ride by e-mails provided by American Lung of Minnesota. Thanks for your words of support and sponsorship!

The growth of Lakeview’s business slowed as significant time was devoted to these activities. However, several new clients have come aboard, and the market allowed modest gains through the end of June. Please check out Lakeview’s Web site, if you haven’t already done so. I hope to have new this commentary and information from my bike trek posted soon.

Market Performance 2004 YTD (July 30)

The chart below shows the performance of various indexes through July 2004. Other market statistics are included. The market is behaving in a volatile fashion and having difficulty sustaining any gains. Although the economy shows signs of continuing improvement, expectations were for stronger results, and a combination of factors seems to be pulling the market between optimism and pessimism.

Index

Level

YTD change

Dow Jones Industrial Average 10,139.71 -3.01%
NASDAQ Composite 1,887.36 -5.79%
S&P 500 1,101.72 -0.92%
Russell 2000 (small stocks) 551.29 -1.01%
MSCI EAFE (Europe, Australia, Far East) 1,283.96 -0.37%
DJ World (ex. US) 145.36 +0.35%
Nikkei 225 (Japan) 11,325.78 +6.08%
DJ Corporate Bond Index 176.52 +0.90%
Lehman Bros. US MBS 1,071.66 +1.14%
Merrill Lynch High Yield Bond Index 670.58 +2.70%
10 year Treasury Note (Yield) 4.48%  
3-month Treasury Bill (Yield) 1.42%  
Euro (Currency in US dollars) 1.2024  
Japanese Yen (Currency in US Dollars) 111.20  
British Pound (Currency in US Dollars) 1.8211  

Source: Wall Street Journal 8/2/04

Valuation Statistics

Current

5 yr. High/Low

Price to Book Value - DJI 4.10 8.29/3.45
Dividend Yield - DJI 3.06% 3.09%/1.28%
S&P 500 P/E (Argus Research) 8/19/04 16.59 NA
52-Week Highs & Lows (8/2/04) 121 vs. 71  
Public/NYSE Specialist Short Sales 2.1 2.52 (7/9/04)/0.69 (11/12/99)

Source: Investors Business Daily 8/2/04

I hesitate to put a snapshot of the market in print, because the results of profit or loss have changed course several times this year. Through the end of July, most stock markets were down year-to-date and headed lower. Japan is a notable exception, but it is also down from its earlier gains. Bond markets are now showing modest gains after recording losses through May. Strong economic growth in the first quarter led many market participants to believe that interest rates were headed markedly higher. This had a depressing impact upon both stocks and bonds. The combination of moderating economic growth over the summer months and repeated Federal Reserve assurances of “measured” responses to the growing economy allowed bonds to recover from their earlier losses. Stocks are trying to assess if economic growth is too hot, or too cold—“just right” doesn’t seem to be an option.

Please review the valuation statistics above, as one new statistic has been added: Public/NYSE Specialist Short Sales (I’ll touch on this shortly). On a price to book value basis and on dividend yield, the market is currently trading on the cheap side relative to the last five years. The Price to Earnings ratio is near its long-term average of around 16X (15.6X, 1935–2003). On the basis of these statistics, many will argue that the market is cheap, while others will argue that it is not “cheap enough.” The market is cheaper than it was in February when it was trading at 20X. I believe that the market is fairly valued when you factor in the level of interest rates, giving patient investors an opportunity to make money in a diversified portfolio of stocks. Election year uncertainties and terrorism fears are factors that make the historical comparisons more challenging.

Regular readers will remember comments that over time the market is driven by fundamentals, while in the short term it is driven by sentiment (fear or greed). The short sales statistic was added as a way to gauge sentiment. NYSE Specialists must maintain a market in the stocks they trade on the NYSE. This means they must be willing to buy shares from sellers when there is an imbalance between buyers and sellers on a given day. Conversely, they must sell shares to buyers when there are not enough sellers to meet demand. In other words, they must often go long or short to maintain an orderly market. In a falling market, you would expect to see Specialists sorting shares in significant amounts to make money.

When you examine history, you find that Specialists are more likely to short shares at a market top and not near a market bottom. The public usually does just the opposite, shorting aggressively at a market bottom and not at a market top. The Specialists are professionals at protecting their firms’ capital. The above statistic, shown in a ratio, shows that the public is currently shorting two times the amount the Specialists are; the five-year high on this number occurred on July 9 of this year when the public short volume was 2 1/2 times the Specialists. Note that the five-year low on this statistic was in November 1999, when the public was shorting only 0.69 times the amount shorted by the Specialists. Late 1999 were historical highs in the stock market and public speculative activity. My bet is with the Specialist.

Economic Outlook

The Advisory Board** still sees economic growth in a range of 3–4%, which is strong growth by historical standards. Productivity growth remains high, and weakness in the dollar in 2003 has supported strong export growth in 2004. This porridge has been just right for strong corporate profits but too cool for strong employment growth. The Federal Reserve Board has started raising interest rates and has made two moves of 25 basis points each in July and August. Interest rates should continue to increase into 2005. Oil prices have been the surprise of 2004, as strong global growth and fears of supply disruptions have pushed the price of crude to near $50/barrel. We believe that oil prices should retreat from this level but will likely remain above earlier expectations as China’s consumption growth has made a shift in long term demand.

Market Outlook (Current stock view: +, or over-exposed stocks, but below maximum stock exposure)

This assessment is a change in my view from the ++ outlook in February.

The following quote from the February Commentary is provided for historical perspective:

“Usually, the second year of a bull market is not as strong as the first. I believe this pattern will be evident this year. Because the valuation discount is gone, the appreciation in stock prices will not be as strong in 2004 as in 2003. However, an economy that grows at 4 percent will support solid growth in corporate profits. The prospect of continued low but moderately rising interest rates means that stocks should outperform bonds for another year.”

In retrospect, I should have reduced stock exposure at that time. Through July, bonds have performed moderately better than stocks, but I remain optimistic that this will reverse by year end.

My reasoning for the change:

  • Stocks are good value. They have been cheaper at times, and one must recognize that stocks could get cheaper with terrorists threats continuing.
  • Tax cuts, interest rate cuts, and a declining dollar are yesterday’s news. Each provided important stimulus to the economy in 2002–2004. Looking forward, this stimulus has run its course, and each of these sources of economic stimuli will fade or reverse.
  • Higher oil prices are an impediment to economic growth. Although the effect of rising oil prices is reduced from the 1980s, oil prices still impact the price of almost every good we purchase.
  • Bush or Kerry—it is a toss-up, but it does seem that the public’s desire for smaller government has waned from the days of the mid-90s.

I could probably find more reasons but don’t want to sound too pessimistic. I like stocks and think you should own more than bonds. In recent weeks, I have used the build up of cash reserves to increase exposure to high quality short-term bond funds. These funds still enjoy a significant yield advantage over money market funds and will be less affected than intermediate and longer term bond funds from further increases in interest rates. Should something happen to push stocks valuation levels below the current “Fair Value,” these short bond funds will be used as a source of cash to increase stock exposure.

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

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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