The US economy expanded 1.7% (final revision) in the 4th quarter on the back of strong consumer demand (particularly in housing) and increased government spending. The economic slowdown of 2001, therefore, doesn’t officially qualify as a recession (requires two negative quarters in a row.) Business spending remained down sharply however, and overall S&P 500 earnings declined for the 5th quarter in a row. Thus, even though the S&P 500 is off 25% from the March 2000 high (and the NASDAQ remains 62% off its all time high) the P/E ratio of the S&P 500 remains high. It’s possible that earnings growth in the S&P 500 will resume this quarter, certainly by the second quarter, so overall stock market valuations are fair.
As we projected in last quarter’s letter, government bond yields have been rising, which exerts downward pressure on the stock market. The Fed left short-term rates unchanged in the most recent meeting (after 11 cuts since mid-2000,) and traders speculate that the Fed will increase rates at the May meeting. However, the fact that the Fed sees economic activity picking up is bullish for stocks; economic reports recently have surprised to the upside. Overall, we estimate a 12% gain in S&P 500 earnings in 2002, but about an 8% gain in the stock market as rising rates limit valuations.
Since our last report, the US has continued rolling up the Al-Qaeda terrorist network, although threats remain. The potential for war between India and Pakistan has diminished, but the situation in Israel/Palestine has deteriorated sharply. It’s impossible to see how that conflict will be resolved. In light of this past week’s, declaration at the Arab Summit that an attack against Iraq would be considered an attack against all Arab states, the probability of a new war between the US and Iraq is diminished (but not eliminated.) As tensions wax and wane between Arab and Western states (as in the Cold War, these tensions could flare up for decades) oil prices and stock markets will fluctuate.
Bearish factors for this quarter:
Rising energy prices
Rising bond yields, likelihood of Fed Funds increases
Corporate earnings growth sluggish despite good economic reports
Bullish factors for this quarter:
Investor money continues to flow back into stocks, out of government bonds.
Fallout from collapse of Enron limited
Inflation negligible given low capacity utilization, low commodity prices (other than oil)
Overall valuations fair, with room to move up with resumption of earnings growth
Our strategy is as follows:
We’re fully invested at this point in anticipation of economic recovery leading to earnings growth. We’re spending a lot of time evaluating the situation in the Middle East.
Yours sincerely,
David Edwards, President
Heron Capital Management, Inc.
(800) 99-HERON
http://www.HeronCapital.com