Lakeview Investment Advisors, LLC
Commentary Date: Year End 2004
by Bill Westhoff, CFA
Year-end 2004: “Frozen” Lake Views
We are back in Minnesota after a trip to Arizona for a Thanksgiving/early Christmas holiday celebration with family. Again we listened to several book tapes to fill the hours and found each book to offer insights and value. Two books offered interesting insights into the workings of the Bush White House: House of Bush, House of Saud: the Secret Relationship Between the World’s Two Most Powerful Dynasties by Craig Unger and The Price of Loyalty by Ron Suskind. While I did not always agree with the conclusions, each provided entertainment. The more challenging book from a personal view was A Purpose Driven Life, by Rick Warren. At this point in life, I thought I had my purpose figured out, but re-examining one’s purpose is a good exercise.
Market Performance 2004 YTD (December 27)
In spite of continuing war in Iraq, major natural disasters, weak job growth, a divisive presidential campaign, and concerns over weak Christmas spending, the market in 2004 has actually produced solid—if not spectacular—returns. The chart below shows market returns through December 27. The chart below includes more indexes than usual to show the wide range of returns in the market this year. The other point is to indicate Dow Jones Industrial Average was not representative of the broader market at all this year.
Source: Wall Street Journal 12/29/04
Several observations: First, in spite of scary headlines all year, the underlying economy was pretty decent in terms of economic growth, attractive interest rates, moderate inflation and corporate profits. These ingredients are all helpful to rising stock prices. Second, leadership was distinctly different in the market this year than in the last cycle. In the 1996–early 2000 period, large-cap growth stocks were the place to be (with a heavy emphasis on technology). In this cycle, small stocks, value stocks, transports (rails, truckers), energy, and international stocks have all provided multiples of return over the nearly 4% return offered by the Dow 30. The decline in the U.S. dollar is improving the competitive position, the revenues and ultimately the profits of a whole different set of industries in this cycle. The stock market recognizes this; eventually the headline writers will as well.
The foundation to every discussion of the economic outlook is the GDP forecast, or Gross Domestic Product. The GDP is one of the broadest measures of economic activity in a country. Based upon a number of forecasts by respected economists and market strategists,* the U.S. economy is expected to show real (adjusted for inflation) GDP growth of 3–3.5% in 2005. This is solid economic growth; fast enough to support job and another year of corporate profit growth, but not so fast as to create an overheated environment with shortages of key inputs and rapidly rising prices.
In this moderate growth environment, inflation is expected to move up to a range of 2–2.5%, allowing the Fed to stay on its expected path of gradually increasing interest rates. Fed Funds rates should reach a range of 3–3.5%, and ten year U.S. Treasury bond yields should increase from their current level of around 4.25% to 5–5.5%. This is a very sanguine view and in part explains why the market has moved up sharply since the uncertainty of the election has been lifted from the scene.
*GDP forecasts: Goldman Sachs +3.4%, Macro Economic Advisors +3.5%, Argus Research +2.5–3.5%.
Market Outlook (Current stock view: +, over-exposed to stocks, but below maximum stock exposure)
Based upon the economic forecast above, I remain comfortable with a moderate over-exposure to stocks for the immediate future. To quote the last Commentary, “At this point, I believe the market is poised for a good finish to the year and wish to maintain a healthy exposure to stocks. As you read this, the election may be decided. The market has struggled with this uncertainty all year and could respond favorably, regardless of the outcome (unless there is a protracted court battle to determine the winner).” The last six to eight weeks have been a lot of fun after the way the market struggled for the rest of the year.
Goldman Sachs' estimate of fair value for the S&P is 1325 for year-end 2005, or 9% above the current level of 1213. Argus Research forecast for the S&P is a trading range of 1100 to 1350, with a year-end 2005 target price of 1300, or about 7.5% above the current level.
While I expect the headlines to turn more positive, I believe it will be appropriate to tap the brakes at some time during the next year. The market multiple has now increased to over 18x expected S&P earnings for 2005, which is above the long term average P/E of about 16 times. Additionally, the risk free rate (Treasury Bills) will be increasing at a time when the expected market return is expected to be 7–9%.
Mutual Fund Selection
In the last commentary, I returned to a practice of describing my security selection process, but on a mutual fund rather than an individual stock. I will continue this again with the review of another equity mutual fund.
Leuthold Core Investment Fund (LCORX):The Leuthold Core fund is a Moderate Allocation fund managed by Steve Leuthold in Minneapolis. As another investment professional in Minneapolis, I have heard him speak and read his research often over the years and have always been impressed by his diligence and interesting observations on the market. Instead of trying to fill a particular style box (e.g., small-cap value by using the Ariel Fund), I researched this fund to see the record developed by this individual and his team.
My research showed a fund with a very strong performance record and number of attractive characteristics, with many parallels to my findings on the Ariel Fund. First, Leuthold Core Fund has been managed by Steve Leuthold since the inception of the fund of about five years. However, Leuthold has managed institutional portfolios in this style for many more years and is the founding partner of the management company that manages the fund. Leuthold Core brings another talent to the table—asset allocation instead of stock selection. As a demonstration of this focus, the fund currently holds 73% of its assets in U.S. stocks, 18% in international stocks, less than 1% in bonds (in fact, the fund will at times go “short” bonds by selling bond futures), and 8% in other (which their quarterly report currently describes as industrial materials).
This eclectic view and asset allocation process has produced excellent long term results. Morningstar rates the fund as having above average risk, but high returns, relative to its peers. The overall Morningstar rating is five stars. Over the five years ended 9/30/04, Leuthold Core has shown an average annual return of 10.72%, exceeding the average annual return of the S&P 500 by over 12% per year, and ranking in the top 2% versus its peers in this time period. The volatile nature of the market through September 2004 has not produced much return (up only 1.55%), but still exceeding the return of the S&P. As the market environment has turned more positive at year end, the Leuthold Fund has again started to move and is positioned well for a continuing global expansion with very strong growth in the emerging economies. Of course, past performance is no guarantee to future results.
In summary, the Leuthold Core Fund demonstrates a unique philosophy that leverages the strengths of their investment team. The Fund’s quarterly report lays out the investment strategy clearly. Management of the fund has an ownership stake in the management company; reducing the risk of changing styles due to management turnover. Finally, the philosophy has demonstrated ample success versus the S&P 500 Index and industry peers.
Leuthold Funds’ Web site is one of the links posted on Lakeview’s Web site. Part of my research included reviewing the company’s Web site and the information posted. This site was also easy to navigate and full of interesting facts and articles on their philosophy. The investment philosophy on asset allocation is well developed, clearly stated, and provides interesting insights for potential moves in Lakeview’s client portfolios.
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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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.