US Equity Income & Capital Appreciation Strategies
2009: A Great Ride for Equities

Another outstanding quarter! The fourth quarter of 2009 closed with the Dow Jones and S&P 500 indices up 8.1% and 6.0%, respectively. For the year, the two indices were up 22.9% and 26.5%, respectively, with the S&P up 65% from its low on March 9th. The best performing sectors for the quarter were health care, consumer products, and technology. As a result Oakwood clients enjoyed solid positive returns in 2009.

Economic recovery: picking up steam

Gross domestic product (GDP) grew at a 2.2% annual rate, up sharply vs. the second quarter’s negative rate of -0.7%. The economy’s much slower pace of growth than the 2.8% initially reported was due to weak business investment and slightly more aggressive liquidation of inventories. But it was still the fastest pace of growth since the third quarter of 2007, and it ended four straight quarters of decline.

Last month’s data releases suggest significant acceleration in fourth quarter GDP growth, from 3.5% to approximately 4.5%. A major contributor to this acceleration was the increase in business inventories in October and November.

The Federal Reserve’s latest assessment notes:

• improving jobs market - the labor issue is now framed in terms of a lack of hiring rather than in additional firing.
  
  
• income growth is now described as “moderate” rather than “sluggish”
  
  
• no change in describing inflation as “subdued for some time.”

Despite the improved outlook, the Fed reiterated that “economic activity is likely to remain weak for a time,” thereby reducing investor concerns that the Fed will raise short-term interest rates anytime soon.

Forecast for 2010: getting back on track

Economic activity remains subdued. Structural headwinds, particularly private sector deleveraging and massive public sector deficits, are daunting. Nevertheless, we see a critical mass of data which points to a cyclical recovery that is gathering momentum, particularly in output and sales.

For 2010 we generally expect 4% to 4.5% GDP growth, with the year’s first half stronger than the second. The question then becomes whether the private sector picks up the slack from the diminishing benefits of the stimulus package. However, on the other hand, does an improving economy ultimately cause the Fed to increase short-term interest rates? In the near term, no, unless the economy truly kicks into higher gear. As we go through the year, investors could potentially get buffeted between tepid growth and higher borrowing costs, along with the potential for higher taxes.

At the current rate of public debt expansion, the US is heading toward a 13% deficit-to-GDP this fiscal year. That alarms us. We have seen countries approaching this level of deficit to GDP (one example, Greece) which has triggered skyrocketing interest rates in their sovereign debt. If our debt level continues to climb, at some point creditors may shy away from funding our debt obligations, causing higher interest costs.

We expect minimal inflation in the coming year, due to continuing excess capacity as evidenced by 15 million job seekers, 5 million vacant apartments, and an economy running at 71% capacity, well below the four-decade average of 81%. However, corporate profits should continue to rebound. According to Thomson Reuters and Standard & Poors, corporate earnings are expected to rise dramatically in the coming quarters as banks move back into the black. The profit-growth projections for the S&P 500 sectors are shown below:

The 2009 S&P 500 earnings are likely to fall about 8% to $60. For 2010, we expect earnings to climb back to around $80. At Oakwood, we favor sectors with accelerating earnings e.g., energy, materials, capital goods and technology (see chart). These sectors offer large cap stocks which participate in expanding overseas markets. The bottom line, however, is that 2010 will not be a Goldilocks economy and will not duplicate the stock market of the late 1990s. Rather, it will be a year of consolidation in which crosscurrents will impact the market. At Oakwood, we remain flexible in our market outlook, adjusting company and sector selections to take advantage of value pricing
in stocks.

Investment strategy: anticipating new currents

In the third quarter of 2009 we increased our exposure to stocks in the Equity Income and Capital Appreciation strategies, believing the economy was slowly coming out of recession and that risk/reward favored stocks. During the fourth quarter, after experiencing market appreciation, we lowered the risk profile of our portfolios slightly by selling two technology stocks in each strategy. In the Equity Income strategy, we purchased one of the country’s largest pharmacy chains and a large agricultural products company. In the Capital Appreciation strategy, we sold a bank to reduce our weighting in the financial sector and we purchased two companies in the consumer discretionary sector – a retailer of home improvement products and a specialty coffee company that produces high-quality Arabica coffee.

As we go through the year, we anticipate a gradual shift in the strategies to a more defensive posture by lowering risk and by favoring the consumer staples, energy, health care and capital goods sectors. We also anticipate increasing the income component of the strategies by purchasing additional high-quality dividend-paying stocks. We intend to reduce the potential risk/volatility in the second half of 2010, when a number of cross currents may become more evident. The potential exists for any or all of the following: an increase in short term interest rates, higher employment, higher taxes, a new government stimulus, an improved housing market, the election of new legislators, and changes in world economies and geopolitical events, especially in Iran and Pakistan. No matter what eventually happens, we remain focused on our primary goal which is to help you meet your investment objectives, particularly the preservation of your capital.