HCMI Client Letter - July 24th, 2002
Agonizing.
Under historical circumstances, the US stock
indexes gain 2-3%/quarter, but over the past few weeks these averages have been
losing 2-3%/day. By one calculation, at this rate, the entire US stock
market will be worth $0 by September 1st. Can the trend actually
achieve that? No! but that's not how investors are reacting right
now.
Through June 30th, our average account was down
13.3% and that loss has more than doubled to 28.1% in the last three
weeks. In some ways, this market reminds us of a slow motion repeat of the
stock market crash on 1987 (the S&P 500 fell 22% in a day.) Talk to
the average fund manager and there are plenty of bargains to be had
(Citigroup with a P/E of 8!) However, every afternoon at 2PM, the fund
companies look at the day's cash redemptions and are forced to sell more stocks
at fire-sale levels.
We are in the second week of the major earnings
reports and so far 50% of companies reporting (about half of the S&P 500)
are ahead of estimates, 40% are meeting estimates, and only 10% have failed to
make estimates. Companies have aggressively talked down their numbers over
the last 6 months, so this only amounts to a 1-2% gain over last year's
numbers. Still, as we had discussed previously, this is the first return
to gains in 5 quarters. Q3 gains are currently estimated at 14.7% and Q4
gains are estimated at 26.3%. These are year over year
numbers, reflecting how badly earnings were depressed in the second half of
last year and how earnings have snapped back this year as corporate
spending resumes normal levels (following a late 90's boom, bust in 2000 and
2001.)
Overall stock market valuations are driven by
earnings expectations over the next year, adjusted for the interest rate
environment. Based on earnings of the last 4 quarters (including this
quarter's results) the S&P 500 has a P/E of 17.3, and based on expectations
over the next year, the S&P 500 has a P/E of 14.2. At the height of
the bull market in early 2000, the S&P 500 had a P/E of nearly 40. At
the end of the 1973-74 bear market, the S&P 500 had a P/E of 12.
However, in the 1970's, interest rates were much higher, implying a lower P/E
ratio (in high interest rate environments, the value of future cash flows
whether from bond coupons, stock dividends or company earnings are all
discounted at the higher rate.) In the current interest rate environment,
with treasury yields at 30 year lows, the conventional calculation (called the
Fed model after research at the Federal Reserve Bank) indicates that the S&P
500 is fairly valued around 1100, which implies that the S&P 500 at 798 is
UNDERVALUED by 38%. At the March 2000 peak, the S&P 500 was OVERVALUED
by 70% according to the same model.
Many investors are worried about a new requirement
that companies certify their accounts by August 14th or face criminal charges if
accounting irregularities is discovered. Their concern is that more
problems will be announced in the remaining 3 weeks. In fact, this concern
is way overblown. There are over 15,000 publicly traded companies,
but fewer than 10 companies, including Enron, WorldCom, Tyco, Adelphia
Communications, Global Crossing, and Peregrine Systems have actually been shown
to have fraudulent accounts. Any management considering such fraud in the
future has to consider the example of Bernard Ebbers (former CEO of Worldcom)
who was a member of the Forbes 400 list as recently as Fall 2000 but now
bankrupt, or the example of the Rigas family, who were led away in handcuffs
this morning following a fraud investigation at Adelphia. Accounting firms
will also enforce standards more aggressively. As a result of a
failure of a handful of partners to police Enron properly, the entire Arthur
Anderson accounting firm is defunct. This means that thousands of partners
with 10, 20 even 30 years of net worth tied up in the AA partnership are
wiped out. There's hardly any legislation Congress could devise to top the
shame and financial ruin visited upon managers who overreached.
The US GDP report is due out next week and should
show a gain of 3.0-3.5%. Unemployment is peaking at 5.9% (well below the levels
that prevailed in the 1970's and 1980's) and is expected to fall through the
year. Most real estate markets in the US are at record levels, reflecting
very low interest rates and good demand. The loss of about $7
trillion in US stocks over the last 2 1/2 years is offset in household
wealth by the gain of about $4 trillion in real estate value (we're not
recommending, by the way, that you rush out and buy real estate at these levels)
so consumer confidence is dampened but not crushed. The terrorist threat
remains, but FBI and US armed forces are chalking up many wins. The time
to worry about the next major Al Qaeda attack is after September 2002 (attacks
against the US Cole, African Embassies, WTC etc. are generally 18-24 months
apart.) Another worry - whether the US goes forward with military
action to unseat Saddam Hussein in Iraq.
As we finish this note, US markets are
rallying after opening sharply lower. Still can't call a bottom
because 3 stocks are down for every 2 that are up, but widely held stocks such
as General Electric, Pfizer, Microsoft and Citigroup are up 1-4%. Grizzled
veterans of the stock market (those with 25-45 years fund management experience)
are generally sanguine that the bottom is near. They also feel the markets
won't go straight back up, citing, for example, the somewhat choppy markets that
existed for several years after the 1987 stock market crash. But the risk
now is more in missing the next leg up than suffering further
declines.
As always, please call or e-mail us with your
concerns.
Yours sincerely,
David Edwards, President
Heron Capital Management, Inc.
(800) 99-HERON
http://www.HeronCapital.com