Equity Market Strategy

We think a lot of companies have been using the Iraq War as a reason to justify why their earnings are not growing as fast as they originally anticipated. As war uncertainty and higher oil prices increasingly stymie anticipated growth in the short term, company after company have announced a 5 - 10% shortfall in anticipated earnings for 2003, citing various war related reasons. While some of these corporate announcements have had deleterious effects, most underlying common stocks are selling at such washed out prices that a small downward adjustment in expectations will no longer register much of a ripple in a stock’s price on an intraday basis. Whether or not it gets reflected in the stock price the fact remains that hundreds of companies have published cautionary statements, have attempted to guide this year’s estimates downward, have curtailed capital spending plans and have laid off workers. A disproportionate number of these corporations cite the low business visibility occasioned by the geopolitical situation as the chief reason why such announcements are necessary.

Oakwood’s portfolio managers are charged with the task of looking beyond the current consensus and assessing the kind of market environment in which stocks will be trading once the uncertainty is resolved, that is, AFTER the Iraq War. As this backdrop is defined, we can determine if any opportune adjustments will benefit our client portfolios and generate good returns without incurring unknown, untoward or unacceptable risk.

Here is what we could see happening in the second half of this year:

1. Aided by inventory rebuilding, lower oil prices and fiscal stimulus, the U.S. economy will resume a higher level of growth than the 1% GDP growth for the first quarter of the year. Corporate profits will follow that growth and earnings estimates, and in the aggregate, can once again be revised upward.
   
   
2. The recent deflationary environment will dissipate.  Since the high levels of commodity prices imply that price increases would be accepted, a reflationary process can begin. Reflation will accelerate growth in corporate earnings for all companies except those that are heavy users of appreciating commodities. Reflation will occur everywhere except in housing prices which will be curtailed by increasing mortgage rates.
   
   
3. Growth in the money supply will slow as demand shifts in large measure from money to productive assets.
   
   
4. As the economy gathers significant momentum, the Fed will again raise interest rates. This is likely to be forestalled until at least 2004, given the current economic environment.
   
   
5. Growth will be rewarded in the stock market but it will be a new definition of growth, one that combines a visible and sustainable growing revenue stream with equally visible and sustainable growth in earnings and cash flows.
   
   
6. Astute sector rotation will add value. It is no accident that consumer staples was the worst performing sector in February and technology was the best performing sector. This reversal of relative fortune occurred as investors began to view many technology companies as becoming cheap compared to forward expectations. Consumer staples companies, the beneficiaries of a previous flight to quality, began to look more expensive.
   
   
7. Price/earnings multiples will neither expand nor contract. The positive impetus to multiples associated with an improving, even robust economy will be offset by the compressing effect of higher interest rates.
   
   
8. We believe stocks will likely outperform bonds in 2003.

Our portfolios have been somewhat defensively positioned this year. In addition to more conservative security selection we are also carrying a modicum of cash. As the market’s euphoria over the success of the military operations in Iraq wanes, we believe the market will begin to shift its focus toward company fundamentals during this earnings reporting season. This may well result in more downward pressure on stock prices. Our higher than normal cash balances will help protect value as well as provide us with the liquidity to take advantage of opportunities as they present themselves.

We do see many reasons to be positive about the future of U.S. equities. Equity exposure in private pensions is down to 41%, levels not seen since the third quarter of 1974. Cash on the sidelines as a percentage of the Wilshire 5000 index’s market value is 28%, near a high for that indicator.

We are also taking a close look at the spread between inflation expectations and dividend yields. While most people who look at yield ordinarily examine the yield on the S&P 500, we believe a better measure is to look at the stocks that are actually paying a dividend. If one examines only stocks that actually have a yield it is found that the median yield is 2.4%. Simultaneously, it appears that inflation is expected to be around 2.4%. Thus, the spread between inflation expectations and dividend yield is effectively zero. The last time this occurred was in December of 1974.

Because the U.S. economy is so fragile, because the Iraq War could still contain some nasty surprises, because price/earnings ratios have not substantially contracted and because any reasonable scenario going forward calls only for modest growth we are tempering our optimism with very measured caution. However, the three year bear market has certainly wrung out some excesses and there are signs that we may be in a bottoming process.

We expect the market to trade in a range of 800 to 950 on the S&P 500 over the course of the next couple of quarters. During this time we will continue to look for opportunities to invest in companies where the stock is currently priced at a material discount to the long-term intrinsic value. Our focus continues to be on identifying attractively priced companies with high returns on capital, positive free cash flows and solid earnings prospects with shareholder oriented management.