Lakeview Investment Advisors, LLC
Commentary Date: Winter/Spring 2006
by Bill Westhoff, CFA
Lakeview Update: Desert Views
We are spending the winter in sunny, warm Arizona and, sad to say, somehow winter has faded into spring and the Winter Commentary did not get completed. Los Angeles, Las Vegas, and Rocky Point, Mexico, have been included as interesting side trips to our Arizona visit. Bicycling has also resumed in an effort to prepare for the completion of the ride across the country (last year's plans were delayed by a broken collar bone). Writing the Commentary just seemed to get crowded out.
The last Commentary mentioned our pending new role as Grandparents—nothing to report yet, but we are as anxious as the expectant parents. Check out www.gonomad.com/globalroam, for an update on our traveling daughter and son-in-law; Kelly and Quang are currently in Vietnam and sharing some great travel experiences.
Lakeview's business is expanding at a manageable pace, and a better market environment in 2006 is adding to the enjoyment.
Market Performance 2006 YTD (March 22, 2006)
“Last year was a grueling, grinding year for stocks.” (WSJ 1/3/06) As I have said many times before, the most important determinant to rising stock prices, i.e., growing corporate profits, just did not translate into stock prices. In 2005, the Dow Jones Industrial Average declined 0.61%, the NASDAQ was up only 1.4%, and among the broad indexes the S&P 500 was the winner with a gain of 3% (before dividends). Thankfully, 2006 is off to a better start with the broad indexes up about 5% through 3/22/06.
In an effort to gain a better understanding and to illustrate my thoughts more effectively, I have changed the line-up of indexes included in the table below. For a broad overview of the market, only the S&P 500 is now listed, instead of including the Dow and the NASDAQ. The Dow includes only 30 stocks and the NASDAQ is heavily weighted to technology, so each has shortcomings not present in the S&P 500. The S&P 400 and S&P 600 will now be included to illustrate what is happening in mid-cap and small-cap companies (which continues to be quite different from the results of the bigger companies in the S&P500). An overview of the international markets will be accomplished by reviewing the MSCI EAFE (developed markets, such as the Japan, Germany and the U.K.), and the MSCI Emerging Markets Index (e.g., developing markets like Korea, China, and India). Leading and Trailing Indexes (top and bottom two) and the Top Sectors will be included. The Web site iShares.com is the source most of this additional information. This is a great Web site with up-to-date information on performance of various indexes and sectors of the market.
The bond market review includes the total return from a broad based index (Lehman Aggregate) and a high-yield index (Merrill Lynch High Yield), as well as the yield of the 90-day Treasury Bill and the Two-Year and Ten-Year Treasury Notes.
Sources: WSJ, IBD and iShares.com 3/23/06
Comment: Market performance shows a preference of risk over safety, with smaller stocks performing better than large stocks and emerging markets performing better than developed markets. The better performance is also reflective of better earnings growth; however, rising interest rates have a way of eventually surprising participants in smaller, less liquid markets when they become too complacent.
The Federal Reserve continues on its path of raising interest rates. The current Fed Funds rate of 4.5% is widely expected to go to 4.75% and perhaps 5%, before the Fed stops. Valuation statistics show a fairly valued market—neither cheap nor over-valued. The hot energy sector has cooled as oil prices have stabilized around $60/barrel. Rising interest rates and a continuing war in Iraq keeps market participants edgy, making it difficult for P/E ratios to expand.
Katrina left its imprint upon New Orleans and the growth rate of the economy in 2005. Real Gross Domestic Product averaged a solid 3.5% in 2005, but slowed to only 1.6% growth in the fourth quarter. Growth is expected to rebound in 2006, and again average 3.5% for the year. GDP is expected to decelerate by the end of the year. Inflation, measured by the Consumer Price Index (CPI) was boosted to 3.4% by energy prices for 2005, and this is expected to decline to 3.1% for 2006.
The Federal Reserve, not comfortable with inflation rates in the 3% range has engaged in a policy of steadily raising interest rates to keep the economy from over-heating and causing more rampant inflation. From all indications, the Fed will likely raise interest rates one or two more times to tame inflation. Core inflation (excluding the volatile food and energy components) has averaged a more acceptable 2.1% for the twelve months ended 2/28/06. This has given market optimists reason to believe the Fed will soon pause.
Corporate profits are expected to slow to 8% growth in 2006, following 20% growth in 2004 and 16% growth in 2005. The Fed's interest rate policy is impacting corporate profit growth. The rapid growth of profits in recent years has also made comparisons more difficult. As U.S. growth and profits slow, economic growth in other major industrial economies such as Japan and Europe is becoming more solid.
The Advisory Board discussion in late February focused upon the fact that many interest rate tightening periods end with “injury to some market participants.” As the business cycle matures the yield curve flattens, corporate profit growth slows, and sources of return become more difficult to find. Thus, some investors add more and more risk to achieve results. Ultimately, excess risks in portfolios produce disastrous results. At times, the level of risk is so great that a “contagion” spreads and all market participants feel some pain.
We are not predicting a “contagion event” spreading to the entire market; but recognize that the key catalyst (rising interest rates) has been a fact of life for the markets for the last one and one-half years. Being aware of this potential problem leads one to seek out higher quality investments and reduce risk in a portfolio, rather than add risk.
*Source material: Wall Street Journal, Goldman Sachs Strategy Documents, and Argus Research Monthly Updates
Outlook (Current stock view: 0 or neutral exposure to stocks and bonds versus the benchmark).
In the last commentary, I moved to a more neutral view of the market. The move to a more conservative position will not occur at once, but over the balance of the year. In spite of rising interest rates and slowing profit growth, stocks should still out-perform bonds this year. Both Goldman Sachs and Argus Research place a target value of 1400 on the S&P 500 at year-end 2006, or 12% above the closing value of 1248 at 12/31/05. I believe each firm is using conservative earnings projections and reasonable P/E ratios to arrive at this valuation forecast.
Short maturity (two to five year maturity), high quality bonds are becoming attractive at yields of near 5.5% and will be added to portfolios as profits are taken in stocks. Over the last three years, small-cap stocks have out-performed large-cap stocks and value stocks have out-performed growth stocks. On a valuation basis, large-cap growth stocks now appear attractive. At the margin, as profits are taken in small stocks and value stocks, assets will also shift to larger growth stocks.
Markets have continued tightening by the Federal Reserve baked into their expectations. Also, market participants seem to expect continuing bad news in Iraq. Should one or both of these issues resolve more favorably than expectations, stocks could provide a substantial up-side surprise.
Please contact me at Billw@lakeviewadvisors.net if you would like to discuss any of the ideas reviewed in this commentary.
© 2006 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.
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.