What Lies Beneath?
Stimulus Leads to a Show of Strength, but is it Sustainable

A popular saying among today’s youth, “It’s all good”, is this generation’s catchphrase. It is an encompassing epithet, one that can be applied to any manner of events, ranging from a response to a parental probe on grades to a report on the condition of your new car following its borrowing for a date. A cursory look at returns in the second quarter of 2003 might deserve an “It’s all good”. Wall Street ended the second quarter of 2003 with the best gains since 1998. The S&P 500 Index’s three-month overall climb of 15.4% was the eighth-best quarterly performance since World War II. The Dow Jones Industrial Average and the NASDAQ Composite Index, returning 13.1% and 21.0%, respectively, had their best quarters since the last three months of 2001.

These advances occurred with surprisingly low volatility, as measured by the standard deviation of daily returns in the indices. The S&P 500 Index quarterly return was the least volatile in three years, while the quarterly return for the typically mercurial NASDAQ index was the least volatile in five years. And the rally permeated all ten of the S&P 500 industry sectors that Oakwood utilizes, with even the worst performer, energy stocks, advancing 6.4%. Not since the S&P 500’s subdivision into sectors in 1989 had all of them managed a gain of at least 5 percent in one quarter.

The enthusiasm in the equity market was matched by the allure to investors of the bond market. Deflationary concerns, coupled with extremely small yields in money-market funds, pushed bond prices to their highest levels in years. The bond market’s strong rally, although slightly waning at the end of the quarter, provided a healthy 3.5%, using the taxable Lehman Brothers Government Corporate Index as a proxy for the broad bond market, with the taxable Intermediate Index returning 2.7%.

So, is it all good?

A lot lurks beneath the veneer of an “all good”. As with a parent’s discovery that with respect to grades this phrase translates into “At least it’s not an F”, a delve into the superficial “all good” of the market rally induces a familiar uneasy feel, bringing to mind the excessive days of 1999. Current levels of the S&P 500 Index are at a price-to-earnings ratio (P/E) of a little over 31; at the index’s March 2000 zenith, its P/E ratio was also 31 - double its historic average. Granted, given the current low interest rate environment, P/E multiples this high can be supported. However, when interest rates eventually rise to more normal levels, these multiples are at risk.

Companies are struggling to meet expectations. Even as cost-cutting has helped profits inch up, many companies are struggling with stagnant sales, continuing high energy prices and little leverage to raise prices. At the same time, much of the economy remains saddled with unused capacity. With these fundamental hurdles to overcome, a missing ingredient to propel economic growth, increased capital expenditures won’t be forthcoming any time soon. The industrial capacity utilization rate remains low at 75%, not helped by the lackluster news that orders for durable goods remain weak.

Caught up in the maelstrom of New Economy concepts that held more panache than payout, many companies grossly overpaid for acquisitions or started new divisions with little realistic assessment of profitability, leaving many large US companies to take massive write-offs, with more to come. This substantially decreases their asset base, which increases debt-to-equity ratios, often significantly. The added weight of pension fund losses due to the bear market further erodes capital structures. Companies of the S&P 500 carry an aggregate pension deficit of $239 billion, corresponding to an average underfunded rate of 22%. A checkup on capital structures this year shows a downgrade of four debt issuers for each one upgraded, according to Standard & Poor’s. This is a slight improvement over 2002 (4.5 downgrades for every upgrade) and 2001 (5.5 to 1), but certainly is not an optimistic sign. The public attention that a downgrade brings exerts additional pressure for companies to lower their debt loads, and makes the likelihood that many companies will undertake expensive capital projects uncertain. Tax breaks in the form of accelerated depreciation write-offs won’t provide the hoped-for business stimulus in this environment of weak pricing power either.

In turn, the continually deteriorating employment situation lingers on. Hesitancy in placing orders or building inventories due to war worries has forced US manufacturers to cut production schedules and lay off workers. June’s unemployment report shows a spike up to 6.4% from the previously reported 6.1%, unprecedented since April of 1994. The manufacturing sector, long considered one of the economy’s weakest areas, continued to falter. Factory employment fell by 56,000 in June, its thirty-sixth straight month of decline. The Institute for Supply Management’s (ISM) Purchasing Managers Index (PMI), a measurement of economic activity in the manufacturing sector showed the sector was contracting, but at a lesser rate. The June PMI index rose to 49.8, an increase of 0.4 percentage point when compared to 49.4 in May. Orders to factories rose 0.4% in May, encouraging at first glance, but the gain is slight when compared with the 3% drop in April orders.

So, is it all bad?

There are signs that the economy is responding to resuscitation. Payroll job losses continued in manufacturing, but were partly offset by employment increases in other industries. The ISM’s non-manufacturing index, which measures activity in the services sector, rose to a surprising 60.6, the best level since September 2000. A reading above 50 in the respective indices indicates that particular sector of the economy is generally expanding; below 50 indicates that it is generally contracting. A Purchasing Manager’s Index (PMI) in excess of 42.9%, over a period of time, generally indicates an expansion of the overall economy. The past relationship between the PMI and the overall economy indicates that the average PMI for January through June (49.2 percent) corresponds to a 2.3 percent increase in real Gross Domestic Product (GDP).

Our preliminary estimate for second quarter real GDP shows that growth will most likely hover around the first quarter’s downwardly revised 1.4% annual rate, matching the sluggish fourth quarter 2002 rate. The drag from the weakness of the first quarter and through part of the second should reverse itself with higher activity as we move through the year. Currently, this falls short of the long-term average growth rate of 3.5% that is needed to keep unemployment from rising.

The Federal Open Market Committee (FOMC), with their thirteenth interest rate cut since early 2001, lowered the Fed Fund rates to 1.0%, their lowest level since 1958, with the perennial topics of risk - economic growth and price trends - cited as the rationale for the 25 basis point cut. The Fed’s statement recognized that economic conditions may be improving, alluding to recent signs of stabilization even in the weakest links of employment and manufacturing, albeit with the economy not exhibiting any sustainable growth.

Although the Fed indicated that the risk of deflation continues to outweigh the risk of higher inflation, we note an upward move in gold prices accompanied by a weakness in the dollar that implies just the opposite. In addition, the Federal Reserve has been inundating the economy with liquidity and easy credit for the past several quarters, paving the way for strong growth in the near future. We feel that the pressure that a US interest rate cut would exert on the European Central Bank (“ECB”) to cut rates in the European Union (“EU”), now at 2.0%, is part of the rationale for the most recent rate cut. With the specter of deflation looming over Germany, whose economy is crucial on a global level as well as within the EU, even a mild case of deflation could have far reaching consequences.

The continuing low interest rate environment helps the housing boom unabatedly sprint on. National sales of new single-family homes rose 12.5% in the quarter, a record rate. On the down side, these rising housing prices make Americans feel richer, and consumers have become hooked on the additional purchasing power they can wring out of this asset class with re-financing and home equity loans. This wealth euphoria has Americans at a record level of personal indebtedness, with household debt in excess of 80% of GDP, 15% higher than the ratio in the early 1990s.

The intended economic stimulus of the Federal government’s tax cut package is for people to have more disposable income. American households will have an additional $47 billion of cash to spend in the coming months, courtesy of the combination of income-tax cuts, child tax credits and “marriage penalty” relief passed last month by Congress. This may be offset by the sobering reality of the dismal fiscal conditions of our states. The current state deficits are deeper than they have been at any time in the last half-century.  Given the magnitude of the deficits, states are highly likely to cut basic services such as health care and education and/or impose new tax burdens.

So, it’s not all good, but it’s not all bad.

Just as you experience skepticism when you go out to inspect your car after the loan for the big date and, indeed, you find out there’s no big dent but its gas gauge is on empty, we are skeptical as to whether another round of tax cuts and repeated monetary stimulus will be enough to support forecasted growth. The month of May gave us the first month of relatively “clean” economic data, free of the war-related impact on facts and figures, and the economy is showing signs of life. The latest Leading Economic Indicator Index (“LEII”) moved upward in the quarter.

The weak dollar, down about 20% in value compared with other major currencies, makes exports cheaper overseas and imports from other countries more expensive, giving the advantage to US products and could provide a boost to manufacturing weakness.

Earnings will increase, with profits expected to rise 13% in the third quarter and increase to 21% in the fourth. For the year, estimated earnings will be up by around 12.5%, says Thomson First Call. A lot of those earnings come from cost-cutting measures, such as layoffs and pay cuts, rather than higher sales. But with all the attention on accounting malfeasance’s and fair disclosure practices, corporate executives are talking down earnings expectations - thus increasing the chances of positive surprises. We continue to position our portfolios to take advantage of areas of strength and to defend against pockets of weakness.