US Equity Income & Capital Appreciation Strategies
Are Bears Hurting?

Another great quarter! The third quarter of 2009 closed with both the Dow Jones and the S&P 500 indices up +15.9% and +15.6% respectively. Year to date these indices are up +13.7% and +19.4% respectively. Financials, Materials and Industrial sectors led the advances.

A frugal uptick in GDP

In the second quarter of 2009, gross domestic product, which measures total goods and services output within the US economy, was adjusted upward, to a mere 0.7% drop in the annual rate, compared to the Government’s first estimate of a 1.0% decline. This was a substantial improvement from the first quarter-drop of 6.4%. The economy, which is expected to slowly revert to growth, is targeted for positive growth of 3-4% in the third and fourth quarters. Because of the consumer’s heavy debt burden, as shown in the graph below, and the continuing high rate of unemployment, the 2010 economy is projected to only grow a modest 2-3%, substantially below previous recessionary turnarounds. Bear in mind that the data showing economic growth will not be in a straight line, but will be up and down over the next two years due to the consumer debt burden and a slow decrease in the rate of unemployment.

Future watch

While the muted recovery is a concern, we need to keep perspective. By 2012 the economy will have gone through an extended period of healing. With a steep yield curve and improvement in the rate of unemployment, financial institutions should be able to make notable progress in repairing their balance sheets and the government’s fiscal stimulus should have been worked off. Also, household balance sheets should have improved as debts are reduced or written off, foreclosures fade, home prices creep higher, stock prices rebound, and the savings rate increases. All of these factors will aid the recovery.

In addition to the financial and household sectors, the manufacturing sector also shows signs of recovery. The three-month moving average of the Chicago Fed’s National Activity Index continues to improve.

We monitor this index because it is a composite of 85 different indicators drawn from five categories: i) output and income, ii) employment, unemployment and hours worked, iii) personal consumption, housing starts and sales, iv) manufacturing and trade sales, and v) inventories and orders.

Although we are positive on the economy by 2012, right now, frankly, it’s still on life support. We want to believe that the government’s stimulus package and its unwinding will succeed, but either one could be a stumbling block to a successful and full recovery of both the economy and the financial markets.

Role of trade imbalances

Economist Dr. Ed Yardeni wrote recently that the global financial crisis of the past two years has been caused by Americans who could “not say no” to spending and borrowing more, and saving less. As a result, both the US trade and federal budget deficits swelled. The two biggest US trade-surplus nations are Japan and China, buying the most in US securities, especially Treasury and mortgage-backed securities. In a recent meeting in Pittsburgh, G20 nations pledged to cooperate to end the imbalances. While balancing the global economy is a worthwhile long term goal, a more important goal is increasing world trade. With world trade and economies improving we are comfortable in currently owning international stocks, especially emerging countries.

Earnings reports

The third quarter earnings season is about to start. The beginning of the year was marked by the continuing disaster in the Financial sector. Today, thanks to the April 2nd suspension of mark-to-market accounting, large-capitalized banks have an opportunity to produce positive earnings surprises for the third quarter. The change in accounting is one of the major reasons investment banks and large commercial banks have performed well since April 2nd, powering the market’s upward movement. The S&P 500 consensus earnings estimate for the third quarter, as well as estimates for 2010 and 2011, are reasonable and add to our comfort in owning stocks, but remember that the economy is fluid and can change direction, affecting these valuations.

Oakwood equity strategy

Because of our cautious approach to the economy and its impact on company earnings, we were slow to invest and preferred to own high-quality, low-debt and positive-cash-flow companies. This deliberate strategy muted our portfolio’s returns as the market took off. We note that the best performing stocks since April were low stock price, low-quality, high debt, cyclical, or no earnings, high p/e ratio companies – not the kind of stocks we want to own for our clients. We knew that these low-quality stocks would outperform in a straight-up market, but given our cautious nature we chose preservation of capital and quality as overriding goals during that precarious time.

As time has passed, and as we have gained confidence that the government has a handle on the economy, we have slowly broadened our investment exposure. For our Equity Income clients, we increased our weighting substantially in the Capital Goods sector, adding four multinational companies representing a broad spectrum of industries. In addition, we swapped our gold company into a more cyclical company which mines copper and gold. We also increased the weighting in the Technology sector, adding a major computer/printer firm, a company that manufactures CDMA-based integrated circuits, and a company that markets small-business accounting software. For our Capital Appreciation clients, we added a company that develops semiconductor packaging technology.

Because of favorable price appreciation, we trimmed the weightings for three stock positions, two in Capital Appreciation and one in Equity Income. Also, in the Equity Income strategy, we sold one security due to deteriorating fundamentals and swapped a large international oil firm into a more leveraged oil sand play in Canada. We continue to be very positive on oil over the long term and will maintain an overweighted position in this sector.

As the stock market offers opportunities, we will continue to restructure the portfolios to maximize returns.