HCMI Client Letter - November 15th, 2001
With world events so fluid over the last 10 days,
it's been challenging to put out a comprehensive update on the state of the US
stock market. These are the factors we are concentrating on to forecast
the direction of stock prices:
The War against Terrorism
Weekend developments in Afghanistan wildly exceeded
anyone's expectation for the prosecution of war against the Taliban rulers in
pursuit of Bin Laden and Al Qaeda.
5 weeks of intense bombing deprived the Taliban,
previously entrenched in frozen positions against the Northern Alliance forces,
of communications, mobility, artillery, weapons, and fuel. At the same
time, fresh supplies of weapons, uniforms and fuel enabled the Northern Alliance
forces to overcome Taliban forces despite numerical inferiority, and lead to a
broad retreat of Taliban forces from the Northern half of
Afghanistan.
As a result, the territory in which Bin Laden and
Al Qaeda leadership can hide has been reduced by 75%. US and International
forces can now be based within Afghanistan for faster response to local
intelligence, either in the form of captured documents and computer records, or
from native informers, on Bin Laden's whereabouts. The pursuit of Bin
Laden may well continue through next summer, since there are still thousands of
caves to hide in and he may attempt to flee into Pakistan, but the probability
of his escape is now significantly reduced. Northern Alliance forces claim
to have entered Kandahar, the seat of Taliban authority, this morning, but those
reports have not been confirmed.
The collapse of Taliban resistance delivered a
giant propaganda victory to the United States. Not only will country wide
bombing cease before Ramadan, fulfilling a request from Pakistan's President,
but international relief agencies will now be able to deliver food in quantity,
averting the famine death of possibly a million Afghanis this winter. We
hope that Middle East news services are as willing to broadcast news of
celebrating Afghanis as they were of anti-US protests a few weeks
ago.
The war against terrorism does not end, however,
with the death or capture of Bin Laden. There will be a 10 or 20 year "war
of containment" to identify and neutralize other Islamic extremists (in the
Middle East, Europe and North America.) US foreign policy, which has been
fairly isolationist since the conclusion of the Gulf War, must create a
"Marshall Plan" for the Middle East to attack the root causes of extremism
- lack of information about the West and lack of employment opportunities
for young men who can be seduced by religious leaders into terrorist acts.
The Israeli-Palestinian conflict must be resolved.
"Homeland Defense" stumbles on, hampered by
politics and inexperience. It is despicable that two months after the
hijacking of 4 aircraft, Congress is still bickering over the Airline Security
bill, bogged down by ideological concerns over federalizing security
inspectors. The nation's leadership hastily abandoned Federal office
buildings at the first sign of Anthrax, but felt no compunction to shutter
infected postal facilities, despite the deaths of several post office
employees. The "Economic Stimulus" packages currently under consideration
overwhelming favor the well-off members of our society, not the marginal workers
whose jobs were lost in recent weeks. At this point in time, we favor
scrapping any stimulus packages which concentrate on tax cuts and rebates; these
will only create future budget deficits reversing the positive trends of the
last 8 years. A simple extension of unemployment benefits would get money
to the people who need it most, in the most timely fashion.
The US Economy
The US Gross Domestic Product decline 0.4% in the
third quarter. The economy was already week through September 10th, and
the September 11th attack deprived the economy of a week's worth of
production (no one could fly, no goods were shipped, no one went
shopping.) Still, the decline was forecast at -1.0% so the number was
better than expected; inflation was effectively 0.0%. Jobless claims
soared in October, taking the unemployment rate to 5.4%, the highest level
since January 1997 but a long way from the 7.7% high-water mark set during the
1994 recession. Economists consensus forecast for 4th quarter GDP is also
negative (two negative reports in a row constitute an official recession.)
Retail sales surged in October; 0% financing options drove US car sales to a 1
month record.
The Fed dropped interest rates by 1.5% since
markets reopened on September 17%; at 2%, Fed Funds are at the lowest level
since 1961. Two weeks ago, the US Treasury announced that 30 year treasury
bonds would be retired, which sharply increased the demand for 10 year bonds
and drove yields in that sector to the lowest level since 1968.
Home mortgage loans are tied to 10 year treasury rates; low mortgage
rates support a wave of refinancing and increases disposable income much
more effectively than tax cuts. Business borrowing fluctuates with 5
year treasury rates. Although business investment is low right now after
the surge of spending in 1999-2000, businesses that borrow can do so
at very favorable rates. The Fed has also sharply
increased the rate of growth in the money supply. Give these favorable
economic conditions and goods new on the anti-terrorism war, any recession in
the US looks to be short and shallow. It would not surprise us to see GDP
grow in the 0.5% range for the 4th quarter.
Energy price collapsed over the last 8 weeks.
Oil was at $28/barrel before the attack, spiked briefly to $30, then slid
rapidly to $20 on expectations of declining world wide demand and cheating on
production by OPEC members. Commodity prices, in general are at multi-year
lows. Industrial capacity in the US and worldwide is slack. For
at least a year, as the economy recovers, the risk of inflation remains
low.
Outlook for Stocks by Sector
We guide our stock sector selections by this
model
When we last published this chart in Spring 2001,
we thought that growth in the economy, which had slowed from a blistering 8.1%
in the Q4 1999 to 0.3% in Q2 2001, was poised to rise again. The September
11th attacks postponed this recovery by a quarter or two, but the conclusions
remain the same: the most attractive sectors right now include technology,
capital goods, and consumer cyclicals. Defensive sectors like healthcare
(consumer services), utilities, and consumer staples, which did well over the
last year, will probably underperform.
This chart, which shows sector performance since
September 7th, confirms that investors' money is starting to flow towards
economically sensitive sectors and away from defensive sectors. The energy
sector, hit hard by the slump in oil prices, is starting to look attractive if
we assume an economic recovery in the US and worldwide in 2002.
Overall Strategy
We reduced our equity exposure from 90% to 80% in
the first week after markets reopened in September, selling a few companies like
Boeing which we thought would be badly hurt over the next 2-3 years, and also a
handful of "development stage" companies whose prospects of turning a profit
looked dim. Our fixed income exposure remained at 10%, and we have held
the balance of our accounts in cash. We have seen a huge surge among our
"blue chip" technology stocks (for example, 58% in Sun Microsystems, 46% in Dell
Computer, 61% in Cisco.) We did not anticipate earlier this year how
sharply earnings in this sector would fall after the boom of investment spending
in technology in 1999-2000 (companies preparing for the Y2K transition and
adapting to the Internet economy.) We see spending on technology
accelerating through 2003 as technology in use becomes obsolete.
Our healthcare stocks are unchanged on the quarter,
financial services stock such as JP Morgan-Chase, Citigroup and Federal National
Mortgage are up. Overall, we've gained back about 1/3 of the losses
sustained through the end of the third quarter, which is progress, and we look
forward to further gains through year end.
We've already taken tax losses for this year; the
remaining question is what to do with our 10% cash balances. We don't
want to put money in the US Treasury markets - as the economy recovers next
year, interest rates will rise, depressing the value of Treasury bonds.
Corporate bonds, particularly in the high yield sector, look attractive
right now give current yields over 9.5% (versus 4.3% in the 10 year bond.)
Depending on the client, we may put some money in corporates and we will
probably move more money into stocks, depending on news out of Afghanistan,
between now and year end.
Yours sincerely,
David Edwards, President
Heron Capital Management, Inc.
(800) 99-HERON
http://www.HeronCapital.com
