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Lakeview Investment Advisors, LLC

Commentary Date: Winter 2004

by Bill Westhoff, CFA

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Lake Views

Lakeview Update: Desert Views

I write to you this February from Arizona. Ruth and I got out of Minnesota just in time to miss a week of subzero temperatures followed by a week of snow. At times like that, we remember just why it was that we bought a home in the desert. We drove to Arizona this year, bringing with us our beloved dog and books on tape. It’s hard to say which kept us more entertained on the road. However, The Da Vinci Code wins my bet. Now in Arizona, I have again found the warm and dry roads of the desert are a perfect training ground for my long bike ride this summer.

Lakeview’s business benefited from the strong stock market in 2003. For the first time since 1999, the market provided positive returns. This means that Lakeview clients saw solid absolute returns on their investments. In addition, many new clients joined Lakeview in 2003. In fact, to help handle client growth, Lakeview Investment Advisors acquired a new software program called Centerpiece, which will improve performance measurement and client reporting. An intern from the Carlson School at the U of MN is assisting with the transition to the new software and other projects. Lastly, Lakeview has a web site under construction at www.lakeviewadvisors.net. I am very excited about the web site, and I hope it will be up and running before the next commentary.

Market Performance 2003

The market produced a very broad-based rally in 2003. Many things came together to create this rally. Tax cuts, defense spending, and the lowest interest rates in 40 years worked to build general confidence of economic growth and, in the end, produced attractive returns. The past three years have been bear markets, but in 2003 the bull was ready to make a comeback.

The top performing stock this year, with a return of 504 percent, was not a technology or biotech stock, but a metal processor and fabrication company: Schnitzer Steel. Schnitzer benefited in 2003 from the booming Chinese economy.

Interestingly enough, the American market was not the only world market to see a rally. The Japanese market turned in a return of over 24 percent this past year.

As mentioned in the last commentary, valuation measures, such as the price/earnings ratio, have continued to increase. However, they still remain below the peak levels of 1999. In the meantime, overall earnings have increased sharply. In 2004, earnings are again expected to rise. The Federal Reserve continues to keep interest rates low, repeating its pledge to remain “patient.”

The chart below shows the performance of various indexes through the end of 2003. Other market statistics are included. In spite of extremely strong earnings reports and further confirming evidence of a strengthening economy in 2004 so far, the broad indexes have made muted advances. The strongest returns continue to be with smaller stocks and international markets.



YTD change

Dow Jones Industrial Average 10453.92 +25.32%
NASDAQ Composite 2003.37 +50.01%
S&P 500 1111.92 +26.38%
Russell 2000 (small stocks) 556.91 +45.37%
MSCI EAFE (Europe, Australia, Far East) 1288.77 +35.28%
DJ World (ex. US) 144.86 +38.58%
Nikkei 225 (Japan) 10676.64 +24.45%
DJ Corporate Bond Index 174.95 +9.87%
Lehman Bros. US MBS 1082.65 +3.07%
Merrill Lynch High Yield Bond Index 103.3 +27.2%
10 year Treasury Note (Yield) 4.26%  
3-month Treasury Bill (Yield) 0.88%  
Euro (Currency in US dollars) 1.2579  
Japanese Yen (Currency in US Dollars) 107.37  
British Pound (Currency in US Dollars) 1.7859  

Source: Wall Street Journal 1-2-04

Valuation Statistics


5 yr. High/Low

Price to Book Value - DJI 4.69 8.29/3.45
Dividend Yield - DJI 1.95% 2.6%/1.28%
S&P 500 P/E (Argus Research) 20.25 NA
52-Week Highs & Lows (12/31/03) 667 vs. 9  

Source: Investors Business Daily 1-2-04

After three negative years, the market turned in excellent returns in 2003. Considering these negative years, it is interesting to see that the ten-year returns for the major indexes are all very near their long term averages.

For example, the ten-year annualized returns from December of 1993 to December of 2003 for the Dow, NASDAQ, and S&P 500 were (respectively) 10.8 percent, 9.9 percent, and 9.1 percent before dividends. This is very near the market indexes long term returns of 8–12 percent.

Small stocks, as measured by the Russell 2000, only had an 8.0 percent annualized return during this time period. As stated by Argus Research, “Over the long haul, small-cap stocks have outperformed large-caps—and indeed they have over the last year or so. So it is obviously important to keep a long-term perspective and design portfolios with the appropriate time horizon and risk tolerance in mind.”

The lesson, of course, is that by taking a long-term look, one will realize that stocks have gone up over time. In the end, the long-term return on stocks is about double to the return on long term bonds.

Economic Outlook

In the last commentary, I devoted considerable space to the discussion of employment rates by our Advisory Board. As time moves forward, this topic continues to demand attention. Again, at the most recent Advisory Board meeting, we found ourselves discussing jobs. Certainly, we can not solve the issue, but I would like to share some additional thought in order to demonstrate how central the employment rate is to a number of the investment themes playing out in the market today.

First, some high-level comments on the economic outlook from Dr. Melton:

  • Good GDP growth (4%+ for the year; stronger first half than second half)
  • Subdued inflation
  • Continued dollar depreciation
  • Modest increases of bond rates
  • Average performance of equities
  • Sub-par growth of jobs

The key factors for our current economic growth are the low interest rates and federal tax cuts. In terms of dollars, the tax cuts promise to be larger in 2004 than in 2003. The source of economic growth in 2004 will shift from consumers to businesses. Companies will look to replace outdated equipment, forcing manufacturing and inventory counts to rise.

Although the official unemployment rate is a benign-looking 5.6 percent, job loss in the previous 2 years has been substantial, while job growth is virtually non-existent. When the economy stalled, there was no need to hire new workers. What makes this current unemployment rate linger is the above-average productivity growth and outsourcing of production to foreign markets. Many observers are now concerned that hiring will not pick up as it has in the past.

One of the ways economists measure the Gross Domestic Product (GDP) is to track everything produced in the economy. But when measuring the GDP, economists also consider all the income earned in an economy. Normally product growth and income growth produce similar results. However, because of outsourcing, the US currently shows a huge discrepancy between production and income. In fact, the Federal Reserve is watching this closely. Many believe this is a key reason the Fed stated it would keep interest rates on hold “for the foreseeable future.” The Fed changed its language in its most recent meeting, now using “we can be patient...”

How is all of this playing out in the market? In terms of monetary policy, low interest rates encourage spending and discourage foreign investors from investing in the dollar. Meanwhile, American consumers maintain their appetite for goods, particularly imports since goods have been outsourced overseas. The result is that the trade deficit expands and downward pressure is placed on the dollar.

In terms of fiscal policy, economic stimulus through tax cuts is a good idea. While tax cuts have encouraged American consumers to spend, they have also expanded the budget deficit. Yet current low interest rates combined with recent tax cuts have pulled the economy out of a recession. However, neither policy has addressed the issue the key reason for outsourcing—cost savings. American labor needs to be made more cost competitive, and adequate retraining must be provided for those workers who have lost their jobs to outsourcing.

This conundrum will continue to put pressure on the dollar. Politicians can wring their hands or offer up rhetoric, but an investor in today’s market must look for the opportunities created.

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

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 earnings growth 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.

Argus Research provides a good valuation model that shows a downside risk of 1050 on the S&P 500, down 10% from current levels. This scenario, while unlikely in their view, would come into play if earnings don’t develop as they project, or if interest rates rise faster. Their most likely target is 1250 over the next year, or up 8–9% from current levels. At that level, they believe the market is reasonably valued. The upper end of their price target for the S&P is 1350, or 17% appreciation from current levels. To achieve this, everything must go perfectly and the market would be “fully valued.” Thus the most likely scenario is for solid returns from stocks in 2004, but less than one-half of the returns in 2003.

It is important for an investor in today’s market to look for opportunities. While the dollar may be experiencing devaluation, that means opportunities exist to purchase stock in areas not traditionally considered. John Mendelson, a market technician associated with Charles Schwab, has noted that the stock leadership in the market is changing. Cyclical stocks which have under-performed growth stocks over the last twenty years are now breaking this trend and exerting patterns that demonstrate sustainable out-performance in the future. It seems that many market forces are in place for US manufacturing companies to make a comeback. They will benefit from the weakening dollar and a global rebound in economic activity.

© 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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