Dear Clients & Friends,
News from the Middle East dominated the US stock market in the first quarter. Stocks jumped 6% in the first two weeks of the quarter on better than expected earnings. However, the discovery of chemical weapons shells brought investors to the realization that war with Iraq was just over the horizon. Over the next six weeks, as attempts to resolve the crisis through diplomacy failed, the S&P 500 fell 12%. As coalition bombing commenced, the S&P 500 rallied 10% in hopes that the war would be over in days. However, stocks slumped through quarter end as the fantasy of a quick war dissipated. Actual economic news had only minimal impact; daily volume slumped 25% compared to last quarter as investors sat on their cash.
Wars are won by the numbers, so how does this war stack up?
· Two weeks ago, Hussein controlled a land mass the size of California, now controls a land mass the size of Rhode Island.
· Coalition forces launch 1000-2000 air strikes/day, the Iraqi air force 0, US launched 800 missiles vs 14 from the Iraqi side.
· 70 US and British troops killed vs thousands on the Iraqi side.
· It took coalition forces 12 days to move within 50 miles of the capital of Iraq vs. 3 months to move within 50 miles of Kandahar (the center of Taliban power in the Afghanistan war.)
· Only 12 oil wellhead fires were set vs 700 at the end of the first Gulf War in Kuwait.
· US & British forces can move freely back from the front lines, moving up vehicles, supplies and troops. Coalition aircraft harass Iraqi supply convoys, particularly fuel trucks. At a certain point, the defending forces will come to the realization that they’ll be killed if they remain in place, killed if they attempt to move in a vehicle. At that point, full scale routs become possible.
· Coalition forces number about 300,000 vs. 500,000 on the Iraqi side. Traditional military thought dictates attackers should outnumber defenders by at least 2:1; in this case, technological advantage negates this shortcoming.
What could go wrong for the US side? Chemical and biological weapons haven’t been used yet, but attacking forces have discovered caches of protective suits and anti-toxin syringes. Iraqis seem to have no compunction about forcing civilians to act as human shields or conduct suicide attacks. Low-level harassment by “Fedayeen” paramilitary could prevent distribution of food, water and medicine to Iraqi civilians, creating a humanitarian crisis.
What could go wrong for the Iraqis? Targeting by US air strikes could create a leadership vacuum – it has yet to be established whether Hussein or his sons escaped the opening night salvo unscathed. Meanwhile a dozen Iraqi senior officers have been captured, and are now revealing tactics and strategy. Communications facilities, including broadcast television, have survived better than expected, but at a certain point the command structure may break down. Iraqi forces appear to be retreating from the Northern cities and oil fields to increase defenses around Baghdad.
US war planners are operating under several scenarios. In the first scenario, the first night missile strike would have killed Hussein and his senior staff, and resistance would have collapsed within a week, obviously not the case. In the second scenario, Iraqis would rise up and join the attacking forces, with the war ending within a month. As we have now learned, Iraqis are very hesitant to join with or even talk to coalition troops for fear of reprisals. Which leads to the third scenario – US and British troops simply wear down Iraqi opposition through superior air power and mobility as we saw in the war in Afghanistan.
Military maps show coalition troops reaching up from Kuwait like a hand, with fingers running up the Euphrates River and the thumb running up the Tigris. Within days, we expect this hand to close around Baghdad. Perhaps the war lasts as long as six weeks, certainly not longer than 6 months.
Assuming Hussein is captured or killed, and US forces take the capital, what happens next? Iraq, after 35 years of the Hussein dictatorship, is a dysfunctional society. Hundreds of thousands of Iraqis have been killed by the Hussein regime over the last decade. 60% of Iraqis are dependent on the UN food-for-oil program for survival. As the regime collapses, tens of thousands in the Iraqi government may attempt to blend in with the rest of the population. As in post-1945 Germany, Iraq will have to undergo a period of “de-Nazification” as functionaries of the Baathist party are removed from authority. As in post-war Germany, citizens at best will be resigned to US presence, scarcely joyful. Iraqis may take reprisals against members of the former regime. Medical problems will be widespread from degradation of the water supply, environmental damage from the war, mal-nutrition and lack of medical supplies.
What about the world beyond Iraq? We said some time ago that, “attacking Iraq would be like hitting a hornet’s nest with a baseball bat.” The buzz from the Arab “street,” European, Asian and American “street” is pretty hostile, with protestors numbering in the hundreds of thousands. Coverage of the war outside of US media channels tends to focus on the civilian casualties, ignoring the fact that Iraqi forces inflicted most of those casualties. The US presence near Iraqi holy cities such as An Najaf causes the same problems as having US forces near holy cities in Saudi Arabia (which first inflamed Osama Bin Laden’s hatred of the US after Gulf War I.) It’s highly likely that we’ll see an upswing throughout the region of suicide and terrorist attacks Interestingly, threats from Osama Bin Laden from 6 weeks ago have failed to materialize – the capture of Khalid Mohammed a few weeks ago may have substantially disrupted the Al Qaeda organization. On the plus side, removing Hussein removes a major source of funding for terrorist activities in the Middle East and blocks the flow of terrorists and weapons through the region. The US cannot drop its guard following the completion of this campaign, but must look into other trouble spots for potential terrorist threats in countries such as Syria, Iran, Pakistan and North Korea.
What’s an investor to do? For the last ten weeks, market action was driven entirely by headlines about the war. Economic reports, reflecting poor business and consumer confidence, have generally undershot expectations. Airline ticket sales are down sharply, and most of the major carriers are in or near bankruptcy. Retail sales are down sharply, combination of bad weather and buyers staying home watching TV. Car sales down slightly. Manufacturing prospects are poor. Housing sales and construction, however, remain strong. Net, it looks like we’re heading into a “double dip” recession, except that what we’re really seeing is a postponement of decision making to the post-war quarters. We commented last month that many companies would not make 1st quarter revenues, because quarter-end contracts wouldn’t get signed. If the war wraps up as quickly as we think, however, those revenues will accrue to the second and third quarters. So we expect earnings to undershoot for Q1, overshoot for Q2 and Q3. Estimates from First Call are Q1 8.3%, Q2 7.0%, Q3 13.2%, Q4 21.2% growth in S&P 500 earnings. Even discounting these estimates by 25% each leaves the S&P 500 substantially undervalued at current levels.
The stock market tends to anticipate economic recoveries, with money flowing out of “safe” sectors back into “growth” sectors. Over the last 6 months, technology was the best performing sector, up 17%, while consumer staples was the worst performing sector, down 12%. The stock market, therefore is confirming our opinion that a period of higher than average economic growth is in the offing. Bond prices, gold prices and oil prices (today, $28.75/barrel, down from $40 in mid-March) are all lower, while the dollar is higher against the Euro and Yen. These price movements are all bullish for the stock market.
Our strategy
is as follows:
We have started moving cash back into stocks, particularly as the news from Iraq gets more bullish day by day. Bond yields are at a 43 year low, which mean bond prices are at a 43 year high. We are avoiding government bonds and municipal bonds (whose price closely tracks that of governments.) We like corporate bonds because the interest rate spread is still very high. If the spread narrows faster than government bond yields rise, investors still get capital appreciation in corporate prices. Meanwhile, yields in that sector average 6-8% vs. 3-5% in the governments.
Yours sincerely,
David Edwards, President
Heron Capital Management, Inc.
(800) 99-HERON
http://www.HeronCapital.com