Dear Clients and Friends,
The S&P 500 lost 13.7% over the second quarter period and the NASDAQ declined 20.7%. The S&P 500’s 3 month return was the 4th worst in the last 20 years (exceeded only by the 1987 stock market crash, the outbreak of the Gulf War in 1990 and last fall’s 9/11 attack.) This result is particularly frustrating because under circumstances of low interest rates, rising corporate earnings and a recovering economy, investors should be buying stocks with both hands. However, investor confidence is at a 10 year low, driven down by a handful of bankruptcies in the telecommunications sector, worries about the war against terrorism and a crisis of confidence in corporate managements, the accounting profession, the FBI, CIA, Catholic Church and Martha Stewart. The irrational exuberance of the late 1990’s has be replaced by an equally irrational despair. There are plenty of stocks trading at bargain levels – indeed the S&P 500 is at a 4 year low, the Nasdaq at a 5 year low, but we still must await some catalyst (capture of Bin Laden, another solid quarter of GDP growth, some positive earnings surprises) to get investors interested in stocks again.
The US economy expanded 6.1% (final revision) in the 1st quarter as businesses liquidated inventories and demand for housing remained at record levels. We are looking for 2nd quarter GDP to grow at least 3.5%, and for S&P 500 earnings to grow 3% in Q2 (after 5 quarters of losses.) In the context of the 10 year treasury bond yielding 4.82%, the S&P 500 is undervalued by about 15% (low yields increases the value of dividends and earnings from stocks, which pushes the P/E on the S&P 500 higher.)
Investors had hoped after the rapid successes of US and allied forces in Afghanistan last winter that the Al Qaeda network would be quickly rolled up. Instead the conflict has dispersed across multiple fronts and it appears that most of the leadership is intact. We had projected last October that the terrorist war would last 20 years and we still think this is the case. It is encouraging that the US administration continues to focus an enormous amount of energy on building the alliances necessary to deny staging areas to the Al Qaeda organization. Much more international cooperation, particularly from Europe and Saudi Arabia, would help. The element of surprise, which contributed substantially to the success of the 9/11 attack, has been lost by the terrorists.
Bearish factors for this quarter:
Continued worries about accounting issues
Negative investor psychology
Weak dollar
Bullish factors for this quarter:
Low and stable interest rates
Inflation negligible given low capacity utilization, low commodity prices (other than oil)
Continued solid economic reports
Overall valuations fair, with room to move up with resumption of earnings growth
Our strategy is as follows:
Cherry pick among many of the fallen angels like Sun Microsystems which are 70-90% off previous highs, yet have solid cash flow, real products and real revenues.
Yours sincerely,
David Edwards, President
Heron Capital Management, Inc.
(800) 99-HERON
http://www.HeronCapital.com