A Word From The Advisor

Bonds, in contrast to common stocks and impelled by easing activity on the part of the Federal Reserve Board (“Fed”), had an excellent year in 2002. Fixed income instruments, as measured by the Lehman Intermediate Government/Corporate Index, experienced a total return of +9.8% last year. The average taxable intermediate bond fund, as measured by Lipper Inc., was up +8.1%.

On the other hand, reflecting one of the most difficult economic and market environments in a generation, common stocks continued a slide last year that had begun with the bursting of the Internet bubble in 2000. By the time the closing bell rang on New Year’s Eve, the Standard and Poors 500 (“S&P 500”) had experienced a decline of -22.1% for 2002. Worse, the NASDAQ Composite, a measure of the performance of growth stocks, fell -31.5%.

The three year decline in common stock prices has seen a peak-to-trough pullback in the S&P 500 of -50.5%, devastating equity portfolios. The growth-oriented NASDAQ Composite has declined -78.4% from its 2000 intraday peak to its 2002 intraday low, exceeding the decline that occurred in the 1973 - 74 bear market. This multiyear pounding has been truly disquieting. The last time that occurred was in 1939 - 41, over sixty years ago. It may be, however, that the drubbing stocks have received is nearly over. After all, earnings are showing definite signs of improvement and the U.S. economy, while not robust, is getting healthier.

Simultaneously, bonds have turned in positive results for the same three year period. Oakwood clients who balance their portfolios by allocating a portion of their assets to fixed income have protected themselves from much of the downside of the stock market while earning very acceptable returns at the same time.

At present, common stock investors appear to be interested in only one question: Will the stock market turn in a fourth straight year of negative results or will it finally show positive returns for 2003? Bond investors, on the other hand, are interested in the following question: Do prevailing yields, in this low interest rate environment, offer enough return potential to justify their continued commitment to fixed income instruments?. Answers to these questions are complicated by the fact that many of the factors that swamped the market last year - the specter of an Iraq war, terrorism, a deflation-driven return to recession, corporate governance and quality of earnings concerns, overcapacity and lack of demand, underfunded pension plans, housing “bubble” concerns, the weak dollar, defaults, municipal downgrades - continue to have the ability to negatively impact the markets this year. We discuss many of these in the accompanying article.

Our answer is that we do expect that common stocks will show positive returns in 2003. While there is still a chance of negative returns, the upswing in economic activity that is underway appears to be very real and is in the process of being reflected in stock prices.

We recognize that bond returns are likely to be more muted this year. While we do not expect a significant rise in interest rates to occur, our bond portfolio structures do currently reflect a more cautious stance. The U.S. economy is not turning aggressively upward which is the scenario that would give rise to broadbased inflation fears, occasioning a tightening. In fact, the economic recovery is fragile and the risks of inflation are small. It is unlikely that the Fed would move to raise interest rates in such an environment.

Many investors are considering whether or not they should begin to increase their allocation to common stocks. In this process, each investor must first establish clear, long term investment objectives, based on such considerations as income requirements, time horizon, risk aversion and life goals. For a middle aged person with average risk aversion, this is frequently 60% stocks, 40% bonds. However, some investors, in response to the fear of further market declines, have reduced their equity allocation over the past couple of years and may even have taken a portion of their assets to cash. We believe that investors who have done this should now begin to develop a plan for returning to their normal equity exposure levels.

In determining whether or not to raise equity allocations back to normal levels investors should consider the parallels with 1973 - 74. In 2002, the villains were Andrew Fastow, Dennis Kozlowski and Sam Waksal, not Richard Nixon, John Erlichman and John Haldeman. War is contemplated in Iraq, not being waged in Vietnam. In 2002, overcapacity and deflation limited corporate growth; in 1974, inflation and high oil prices limited buying power, which depressed corporate growth. Stock prices bottomed in the fourth quarter of 1974; they may have bottomed in the fourth quarter of 2002. Yet stocks were up 40% in the 24 months following the 1974 bottom.

We are not predicting a repeat of the 1975 - 76 stock market results. Positive returns, if achieved, are far more likely to resemble the long run average annual return on stocks, around +11%, than the +36% total return number achieved by the stock market in calendar 1975. And, arguably, the environment today is better than that which prevailed in 1975. Inflation is under better control, interest rates are lower, our markets are more diverse and more global and our corporations are more productive. Thus, a compelling historical case could be made for returning to normal stock allocation in the very near future.

The timing of an investor’s return to maximum common stock allocation should be dictated by two things: (1) whether or not the investor has conviction in a positive stock market forecast and (2) how bad the investor would feel if stocks declined after the investment was made, or regret risk (a component of risk aversion). If the investor has conviction in a credible positive forecast of stock prices and is a risk taker, returning to a position of maximum allocation to stocks should be accomplished right away. For most investors, however, the degree of conviction is not high while the magnitude of regret risk is somewhat high. These investors should opportunistically and ratably scale into their maximum exposure to equities over some period of time, say 12 months, until such time as the maximum allocation to stocks is again reached.