Global equity markets continue to climb a wall of worry

Michael L. Avery

Ryan F. Caldwell

Co-portfolio Managers, WRA/Ivy Asset Strategy Fund

September 2009

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Below, Waddell & Reed Advisors Asset Strategy Fund’s investment team discusses the Fund’s current positioning, last summer’s strength in the stock markets and global economic conditions.

In September, U.S. and global equity markets extended the rebound that began in March, and the portfolio fully participated in this advance. However, it has been a grudging rally given that investors’ attitudes have become somewhat pessimistic. We are watching for signs that investors’ desire for return on capital is displacing their fear of loss of capital.

Cash, psychology and fixed-income allocation: Three things to watch
We have been paying close attention to the level of cash that has been on the sidelines since this time last year. Currently, we estimate the level of cash in the market is about $3.5 trillion, down from a $4 trillion peak in mid-January. This puts the market at a cash level right about where it was prior to the Sept. 15, 2008, Lehman Brothers bankruptcy filing, but still $500 billion more than in early 2008.

In our view, this excess cash may help the U.S. and global equity markets continue to drift higher. It would take another 20 percent rise in equity values for the Standard & Poor’s 500 Index to get back to pre-Lehman bankruptcy levels.

We also are paying close attention to the psychology of the U.S. market, which we have found can sometimes be an inverse predictor of future market performance. For example, it appears that just about every casual investor “knows” that September historically is one of the worst months for the market. We have been counseled by some that there’s “always” a correction in September and asked “Why aren’t you better prepared for that?” The market also “knows” that the period following September tends to be the strongest seasonally — notably October through January — with November, December and January being the strongest months of the year. However, this is an equity market that has not followed historic norms.

Also grabbing our attention is how willing U.S. retail investors are to move out of equities and into fixed-income products, despite the fact that the difference in interest rates between U.S. Treasuries and corporate bonds has narrowed substantially. We are not only back to pre-Lehman bankruptcy levels in terms of this spread, but back to pre-Bear Stearns bailout levels of March 2008.

Equities and gold bullion remain attractive
Fixed-income products have outperformed equities over the last 10 years; a pattern that we believe is not fundamentally sustainable. While we believe periodic bond market dislocations may continue to create exceptional tactical opportunities for investors in high-yield and investment-grade corporate bonds and municipal securities, such as we saw last autumn, we believe current prospects for above-average total return in this asset class are limited.

We continue to maintain a low weighting in fixed-income within the Fund’s portfolio, having reduced our exposure to bonds dramatically last spring. We have also continued to reduce cash and increased overall equity exposure to more than three-quarters of the portfolio.

One portion of the portfolio that has remained fairly consistent in 2009 is our allocation to gold bullion, which currently represents a mid-teens percentage of net assets. We believe that gold bullion will remain in favor as an alternative currency, and that it has price-appreciation potential in a global environment in which central banks, and the Federal

Reserves in particular, are inflating the size of their respective balance sheets. We may face 12 to 18 more months of short-term interest rates as low as zero as central banks continue to stimulate the global economy. In addition, some central banks have been suggesting they may increase their gold reserves.

Consistent thematic approach to equities
The equity portion of the portfolio, which drove our results in the third quarter, is currently not hedged and remains focused on the emerging global middle class. Sectors in which we have invested the most include financials, information technology, energy, consumer discretionary, property, entertainment and education, on the premise that they offer the greatest potential. We feel individuals with rising discretionary income will look for alternatives for new wealth once basic needs are met.

We agree with economists who say that U.S. third-quarter gross domestic product (GDP) growth may rebound to the 3 percent range. We feel it is likely that the fourth quarter may be strong as well. In our view, this could be the final catalyst to attract more cash off of the sidelines and into the equity markets.

However, we are also mindful that as the level of the S&P 500 Index goes back to the pre-Lehman bankruptcy level, we are looking at much higher P/E ratios on a much lower level of corporate earnings. At that point, we believe the market may begin to discount a lower P/E multiple that should be applied to a U.S. economy that is likely to have moderate growth beyond first quarter 2010.

Balance sheet recession continues
A major reason for our pessimism regarding growth is that the U.S. still faces a balance-sheet recession, a de-leveraging cycle on the part of the consumer. We believe we will continue to see savings rates move up and debt levels, particularly installment levels, come down. Consumer sentiment will continue to be weak if there’s a lack of job creation and an environment that forces families to rebuild balance sheets and reduce liabilities as rapidly as possible. Given that the U.S. economy still relies on the consumer for 70 percent of output, the current stimulus-fostered rebound seems limited.

Better prospects remain in China
In the course of our investment research and on-site meetings with corporate leaders, we continue to spend quite a bit of our time focused on China, specifically the 300 million people who live in the smaller, Tier 3 cities in the Western provinces of China. In fact, members of our investment team are scheduled to visit the region in the coming weeks.

Why do we go there? We have three reasons:
Size — China has 300 million people in the Tier 3 cities, roughly the same as the U.S. population.

Expectations —This target population’s income and net wealth is growing rapidly. As a consequence, it is moving up the consumption curve of quality-of-life goods and services.

Policies — Officials in Beijing are providing for a greater level of infrastructure, education and health care spending to reduce west-to-east migration within China, and to create a higher level of domestic consumption demand to help sustain a 7 to 8 percent overall GDP growth rate.

Overall, China is also benefiting from a baby boom it had in the 1970s. A large segment of its overall population is now age 30 to 45 — the most economically productive part of a person’s life. Education levels for this generation are generally high, and this segment of the population is expected to grow until 2025. We believe that GDP per capita in China can more than double from the current level of $3,300 a year to close to $8,000 per year over the next 15 years. As many as 250 million of China’s 1.1 billion people are likely to join a more urban way of life and create higher consumption patterns.

Another reason we are confident about China is that most large companies appear to have very clean financial records. Unlike in the U.S., corporate fraud in China can result in the death penalty. Our experience in China suggests that few business people will take that level of risk. A handful of large global accounting firms also have their pick of potential Chinese clients, and they tend to avoid taking on clients whose numbers are the least bit suspect.

Inflation the greatest risk
To us, the greatest risk in regard to the sustainability of growth in China over the next six to 12 months is not a trade war with the U.S.— as the recent Obama Administration flap over imported tires might suggest — or more protectionist policies globally. To us, the number-one investment risk in Asia is inflation, because China is not self-sufficient in a number of key natural resources and commodities, such as oil, natural gas, iron ore, copper and soy beans. China needs to import many commodities. We think if global demand picks up, commodity prices will be pressured globally. If we have inflation pressure, the Chinese central bank may start to tighten monetary policy, and growth may be curtailed. While our primary focus is the growing affluence of the consumer in China, we believe the Fund is well-positioned to also take advantage of China’s long-term need for commodities. Currently about one-fifth of the portfolio’s assets are invested in companies in sectors that benefit from higher commodity prices, such as energy, metals and agriculture companies.

Why Waddell & Reed?
Since 1937, Waddell & Reed has helped millions of Americans develop financial plans to help them get where they want to go in life. By building personalized plans supported with highly competitive investment products, we enable our clients to not only identify their goals, but to take consistent action toward achieving them. Waddell & Reed is:

• Experienced: With 70 years in the financial planning and investment management business, we are well equipped to be your partner in planning your financial future.
• Focused: We do our own work, believe in our own research and act on our own ideas. Our steady approach is guided by a belief in fundamentals over fads.
• Committed: As we work for you, based upon your specific needs, we do so with openness, perspective, and a profound respect for the trust that you place in us.

Past performance is not a guarantee of future results. Past performance is not a guarantee of future results. The opinions expressed are those of the Fund managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through September 15, 2009, and are subject to change due to market conditions or other factors. The Fund allocates from 0-100% of its assets primarily among stocks, bonds, and short-term instruments, across domestic and foreign securities. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. With regards to fixed income securities in which the fund may invest, these are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. Because the Fund may concentrate its investments, the Fund may experience greater volatility than an investment with greater diversification. The Fund may use short-selling or derivatives to hedge various instruments, for risk management purposes or to increase investment income or gain in the Fund. These techniques involve additional risk. Investing in physical commodities, such as gold, exposes the Fund to other risk considerations such as potentially severe price fluctuations over short periods of time. Holdings information is not intended to represent any past or future investment recommendations. Holdings and allocations can and do change frequently. S&P 500 is an unmanaged index of common stocks.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus containing this and other information for the Waddell & Reed Advisors Funds, call your financial advisor or visit us online at www.waddell.com. Please read the prospectus carefully before investing.