Equity Market Strategy - 2004: Flight to Quality

The year 2003 was an extraordinary one for the stock mar-ket, with the S&P 500 Index returning 28.6%, its first annual increase after three consecutive years of declines. The year’s return seems even more extraordinary when you consider that some of the very factors that spelled gloom and doom at the beginning of the year - a declining US dollar, geo-political tensions and instability, and high unemployment - became positive catalysts for the market during the course of the year.

For most of 2003, we were underweighted in technology stocks relative to the S&P 500 Index weighting and we held above average cash balances in equity portfolios. Surprisingly, many of the market leaders were stocks that have weak, low quality financial fundamentals and high P/E ratios. This high risk group includes shares from airline companies struggling to avoid bankruptcy, telecommunications equipment manufacturers struggling with excess capacity and information technology and internet stocks trading at late 1990’s “tech bubble” price earnings multiples. The stock market performance in 2003 can best be thought of as a “flight to speculation” rally. Given our more conservative positioning, and despite this “flight”, our equity portfolios delivered good competitive performance in 2003.

While many concerns about the past year’s markets continue into the new year, the outlook for the 2004 equity markets remains positive, particularly the prospects for growth in corporate earnings. Those earnings are expected to experience double-digit growth rates in 2004. The top-down consensus forecast from Wall Street strategists is for a 12% increase in corporate earnings, and the bottom-up consensus from sell-side analysts is for a 24% increase. The actual growth rate will probably be in the bottom half of that range, between 12% and 18%. If P/E multiples remain constant, adding the market’s current 1.6% dividend yield to an earnings growth rate of between 12% and 18% implies a 2004 stock market return in the range of 13.6% to 19.6%. We are encouraged by the prospects for earnings growth in 2004; at the same time, however, we don’t believe P/E multiples will remain constant.

The current P/E multiple of the market is 18 times 2004 earnings. A useful tool that many investment professionals use to look at valuations in the stock market is to examine the inverse relationship between the yield on the ten-year Treasury note and the current P/E multiple of the market. This reciprocal relationship is sometimes called “the Greenspan model”, owing to the fact that Federal Reserve Chairman Alan Greenspan referred to it in his indelible “irrational exuberance” speech. Over time this inverse correlation has proven to be relatively strong, although far from perfect. Using this model, the reciprocal of the yield on the ten-year Treasury note of approximately 4.25% implies a market P/E of 23.5 times earnings. Conversely, the reciprocal of the current market P/E of 18 implies a yield on the ten year Treasury note of 5.5%. The divergence from the model’s implied yield (5.5% versus an actual of 4.25%) and implied P/E multiple (23.5 versus an actual of 18) indicates that the stock market has again followed Market Rule #1 and has already priced in some increase in interest rates in anticipation of an improving economy and a return of pricing power. Be that as it may, we still believe we will see some contraction in P/E multiples in 2004. By what magnitude multiples contract depends on the strength in corporate earnings (higher earnings growth rates lead to higher P/E multiples) and the inflation and interest rate picture (higher inflation and higher interest rates lead to lower P/E multiples). That said, given the likely increase in corporate earnings, current dividend yields, and a probable contraction in P/E multiples, we envision an environment of more normal stock market returns of 10% to 12%.

In addition to high corporate earnings growth expectations, other potential positive catalysts for stocks in 2004 include:

• A return of pricing power as witnessed by a modest increase in inflation that would improve top line revenue growth, operating margins and would be viewed quite positively by the stock market. The current, almost non-existent inflation picture may change in the year ahead. Inflation expectations are being lifted by the elements of a weaker dollar, twin trade and budget deficits, competition for capital between the government and private sectors, stronger global economic and earnings growth, and a deflation-fighting Fed. While the core rate of inflation is quite low with little material change to date, the expectations may ultimately lift inflation.

• Economic growth will continue to improve in 2004, consistent with corporate earnings growth expectations. Reports indicate that economic activity in the manufacturing sector is increasing, along with indications that manufacturing hiring should continue to improve.

• The recent cuts in Federal tax rates will be increasingly felt over the course of the coming year. Certainly the financial squeeze and resulting tax and fee increases at the state level will be a moderating effect, however, the net effect of the Federal tax cuts will be a positive for the consumer and, ultimately, for corporate earnings. Consumers will benefit from large Federal tax refunds as a result of the 2003 tax cuts.

While we are generally bullish on stocks in 2004 there are some remaining areas of concern and caution that include:

• The strong money supply growth in the first eight months of 2003, reaching a high in excess of 10% in July, has declined dramatically, turning negative in the last quarter of 2003. This may be an early signal of the Fed returning to a less aggressive monetary posture. Any monetary tightening and resulting increase in interest rates by the Fed may be interpreted by the stock market as a sign that the Fed is becoming concerned about inflationary pressures. While modest increases in inflation would be viewed as a positive development by the stock market, material increases in inflation could lead to a compression in P/E multiples.

• Energy prices as measured by oil and natural gas prices appear as though they will remain stubbornly high. This is the result of increasing consumption from a growing global economy (especially China) and OPEC seeking higher oil prices in response to a falling dollar. Higher energy prices will constrain discretionary spending by consumers and pressure corporate profit margins. Oakwood’s portfolios continue to benefit from an overweighting in energy issues.

In the present market environment, we continue to focus on higher quality securities. While 2003 was a “flight to speculation” market rally, 2004 may become a “flight to quality” market. Another area of continued focus for Oakwood portfolios is high quality large capitalization multinational firms that will benefit from a shift towards increasing global growth, the weaker dollar and the ability to lower costs through non-US outsourcing. In managing client portfolios, we will continue to focus on companies with positive cash flow characteristics, strong returns on capital, increasing dividends and healthy earnings growth prospects that are trading at attractive valuations.