HCMI Client Letter - February 7th, 2002
Dear Clients and Friends,
Five weeks into the new year, the major stock
market averages are negative YTD and back to the levels last seen September 10th
prior to the WTC attack. The earnings reports released over the last three
weeks generally met or exceeded greatly lowered expectations, but company
managements are very hesitant to forecast results for 2002. With little
earnings guidance, investors have focused on whether the accounting issues which
forced Enron into bankruptcy are widespread; companies like Tyco which are
considered to be vulnerable on this issue are off 50% YTD. You can be sure
that, in board rooms everywhere, directors are grilling their CFO's, audit
committees and accounting firms about any flaky activities.
The critical question for the health of the stock
market is how quickly the US economy resumes normal (2.5-3.0% average)
growth. The current recession, mild as it is, started in March 2001; GDP
growth went negative in Q3 2001, but, surprising economists, eked out a 0.2%
gain in Q4 2001. This report is the first of three estimates, so it could
well be revised negative, but probably not more than -0.5%. Recent
economic reports, including a fall in the unemployment rate, a strong
productivity report, a down trend in new unemployment filings, strong retail
sales, higher than expected durable goods orders all indicate that the worst is
past. The Federal Reserve, at the most recent FOMC meeting left rates
unchanged citing stronger conditions. However, since inflation remains
negligible, the Fed does not need to raise rates for a while.
As the economy grows, corporate earnings growth,
which was sharply negative last year, should turn higher. The consensus
among stock analysts is that earnings will grow 11.5% in 2002 with most of the
growth occurring in the second quarter on later. However, the range
of estimates, reflecting higher than usual uncertainty about forecasts, is from
5% to 15%. The S&P 500 is fairly valued right now if earnings grow
10%, over-valued if earnings grow 5% and under-valued if earnings grow
15%. We lean towards the higher growth estimates because interest rates
are low, inventories are low, another upgrade cycle in technology is due in
2003, federal spending is increasing dramatically and money supply growth is
high. These factors all point to a dramatic increase in business spending,
which accounts for 1/3 of the economy. Consumers hardly scaled back their
spending in the last 4 months despite an unemployment increase and the terrorist
attacks.
The Al-Qaeda threat, while reduced, is by no mean
eliminated. Al-Qaeda typically launches an attack every two years (1993
WTC bombing, 1996 bombing of US military barracks in Saudi
Arabia, 1998 African Embassy attack, 2000 Cole attack, 2001 WTC and
Pentagon attacks.) We have no idea whether this timing will hold in the
future (indeed, the December "shoe bomber" attack was probably a test of post
9/11 security measures). A thousand Al-Qaeda operatives have been captured
world wide, the Afghanistan training camps are no longer
operational, thousands of documents and computers have been retrieved
documenting potential targets and providing leads on Al-Qaeda cells.
However, most of the Al-Qaeda leadership is still at-large, although with
credibility in tatters. So investors must factor in a "terrorist risk
premium" which will rein in any thought of stock market
"exuberance"
Our strategy remains as follows:
Keep our
focus on economically sensitive stocks while maintaining our usual 25%
allocations to technology, healthcare and financial services. Invest our
cash balances (which currently average about 9%.) Avoid government
bonds.
Yours sincerely,
David Edwards, President
Heron Capital Management, Inc.
(800) 99-HERON
http://www.HeronCapital.com