Client Letter 04/02/2003

We had expected the war in Iraq to last between 6 weeks and 6 months, so having hostilities cease after 30 days certainly exceeded our wildest hopes. Although few nations doubted that the US would prevail, many expected (hoped) that Iraq would bloody US forces, reining in future US military adventures. For these nations, seeing the Iraqi forces pulverized was like watching their favorite team get to the Super Bowl (American football) and lose 163-0.

It will be years before we truly understand how one of the largest armies in the world, estimated at 500,000, simply disappeared. Casualties were light all around, about 150 American troops killed versus 450 in Gulf War I, about 1,500 Iraqi civilians versus 10,000 in the previous conflict. Casualties among Iraqi soldiers remain a question mark for both wars. The pivotal event was the second air strike against Saddam Hussein and his sons, believed to be hiding out in a residential district. No evidence was found that these three were actually killed, but 12 hours later, Iraqis were pulling down Hussein's statue in the Baghdad center with none of the Baathist leadership to be found anywhere. Our best guess is that the last air strike missed Hussein by inches, and he took it as his cue to leave town.

As in Afghanistan, it will be years before order is restored to Iraqi society. The most critical question is: "What happened to the chemical and biological weapons?" So far, the most compelling evidence is a pair of trailers equipped as mobile bio-weapons labs. It would be ideal if in fact the United States was completely mistaken about the existence of such weapons - none would be left to fall into terrorist hands. However, why had Hussein fought so hard against inspections? Why were so many chemical weapons suits and Atropine injectors found? How much of the stuff was transported to Syria? How much was simply dumped on the ground?

Any discussion that the US will turn over administration of that country in a year remains a total fantasy. Although V-E was declared May 8th, 1945, Germany remained occupied by US, British, French and Soviet forces for another 5 years. Given the problems with Iraq water, electricity, telephones, destruction of infrastructure by looters and lack of non-Baathist middle managers, not to mention having to overcome 30 years of repression and murder, we see US forces occupying Iraq for at least five years, perhaps longer. The UN Security Council is currently considering a US drafted resolution to ease sanctions and release funds from the Oil for Food program to pay for reconstruction. Meanwhile, US forces have picked out sites for four permanent military bases in Iraq. The Middle East is about the same size as the continental United States, so garrisoning Iraq is like seizing a strip of territory in the United States from Michigan to Arkansas. From these bases, in combination with 20 other bases throughout the region, the US will be able to project force and monitor activity the length and breadth of the Middle East. With a third of the Iraqi "most wanted" in coalition hands and miles of Iraqi secret police files to review, US investigators have years of research ahead of them.

Chess offers a simple model of political affairs - when the king is captured, the game is over. Under this model, the US "wins" when simple goals are achieved (e.g. Hussein, Bin Laden captured or killed.) Go, an Asian form of chess, offers a more complex model of political affairs. In Go, players alternate placing black and white stones on a grid pattern. Winning is determining by which player has surrounded more of the opponent's stones. Strategy is rarely apparent until well into the game. For over a decade, Al-Qaeda held the initiative, placing "cells" throughout Europe, the Middle East, Indonesia and the United States in an attempt to "surround" the Western infidels. Since 9/11, the Westerners, led by the United States, have responded by seizing finance nodes, pressuring the cooperation of states such as Pakistan and Saudi Arabia and building military bases (20-24 in the Middle East alone) from which to project force. Following successful campaigns in Afghanistan and Iraq, it appears that the US has the edge in what, as we have said before, is a 50 year war like the Cold War.

Over the last two years, we have tried to develop an understanding of what drives the appeal of Al-Qaeda. In 750 AD, the Arab/Islamic empire was the dominant culture on the planet, with territory stretching from Western China, through India, to the Middle East, around the Mediterranean to Austria, across North Africa to Spain. At a time when Western European cultures struggled to exit the Dark Ages, the Arab world had literature, architecture, science, mathematics (we use Arabic, not Roman numerals), astronomy and poetry. For the last 1200 years, the Arab/Islamic culture has been in retreat, pressured by Western Europeans starting with the Crusades (1096-1291), extending through the French adventures under Napoleon in the 1830's, to invasions by the British through the end of the 19th century. In the 20th century, a small chunk of Palestine was set aside for Jewish refugees under the Balfour Declaration (1917). The trickle of Jewish resettlement turned into a flood post-World War II. In six subsequent military conflicts, various Arab forces were defeated by Israel, leading to expansion of Israeli territory and humiliation of Arab leaders. So part of Al-Qaeda's appeal is based on centuries of resentment against outside invaders in a climate of cultural decline.

Resentment against the United States is particularly virulent right now, partly because of US support for the state of Israel, partly because of economic disparity. The US, with 5% of the world's population, accounts for 33% of the world's GDP (up from 25% in 1990.) The Islamic world, with 20% of the world's population, accounts for only 3% of the world's GDP. It's popularly thought that countries like Saudi Arabia are rich (we see the pictures of the Saudi palaces, the wild spending sprees in London casino's etc.) In fact, Saudi Arabia is 24th on the world GDP leader board (behind Austria.) Most of the wealth in that country accrues to the 30,000 members of the royal family, leaving the remaining 20 million Saudi's to scrounge for government jobs since there are no natural industries in Saudi Arabia other than oil production (all numbers as of 2000 from the Economist.) Population growth rates in the Middle East average about three times growth rates in Europe and the United States, which creates a large pool of young, under- or un-employed men easily susceptible to the Al-Qaeda message, "If we just kill enough people, we can return to the golden days of Islamic power."

Ironically, in the great body counts of the last 100 years, Al-Qaeda is strictly Little League. Compared to the Cultural Revolution (30 million Chinese killed), Stalinist purges (20 million killed), Nazi regime (7 million killed in concentration camps), Pol Pot regime (3 million Cambodians), the Hussein regime (1.5 million Iranians, Kuwaitis, Kurds and Iraqis,) any number of African conflicts (for example, Rawandan Civil War, 800,000 killed), Al-Qaeda's 4,000 killed (3,000 in 9/11 attack, 1,000 more in previous and subsequent attacks) would barely rate a footnote in the US media except that the attacks were directed against Americans on American soil. The 9/11 attack cost the US economy about $50 billion, so it's worth the expenditure of quite a bit of resources by the United States to prevent a similar, future attack. Getting back to the Chess versus Go models of political affairs, the prosecution of this war depends not on the capture of specific people or territories, but on the containment and disruption of those elements in Islamist societies (a miniscule percentage) which mean harm to US interests. In this context, routing the Al-Qaeda training camps out of Afghanistan, seizing Iraq (which blocks the flow of money, people and weapons through the Middle East), and pressuring the Saudi Arabians to stop funding "Islamic charities" are just different campaigns in a multi-dimensional, multi-year war.

Obviously Al-Qaeda is still active (and Bin Laden is probably still alive, most likely in the border region between Afghanistan and Pakistan) but the nature of recent Al-Qaeda attacks indicate that the organization is less effective than before. Prior to 9/11, Al-Qaeda went after "hard" targets (for example, the US Cole, American embassies in Africa, US Marine Barracks in Saudi Arabia, the US air transport network.) Post 9/11, Al-Qaeda has only attacked "soft" targets (a synagogue in Tunisia, a French oil tanker, tourists in Bali, an Israeli hotel in Kenya, western residential compounds in Saudi Arabia, tourists in Morocco.) These attacks, while devastating for local economies and the families of those killed, have no impact on the Western economies. Meanwhile, each attack uses up one cell (comprising of up to twenty Al-Qaeda suicide attackers and their supporters.) This Kamikaze approach, against an enemy with infinitely greater resources, seems doomed to failure provided that Al-Qaeda is prevented from obtaining nuclear weapons (even biological and chemical attacks offer little more than temporary disruption as seen in the 1995 Tokyo Subway Sarin attack.)

Al-Qaeda's most powerful weapon is the ability to surprise. Despite multiple attacks in the decade leading up to 9/11, most Americans had never heard of Osama Bin Laden or Al-Qaeda. Americans never dreamed that a band of terrorists, financed with about $250,000, could do so much damage and cost so many lives. Now that we know such things can occur, follow-on attacks have lost some of their impact. For example, US markets barely flickered last week despite the bombings in Riyadh and Morocco, and reacted only slightly to the recent elevation of the national threat level to Orange. As the shock of the 9/11 attacks have worn off, as the Americans have been able to capture or kill about 1/3 of the top Al-Qaeda leaders, as the US has achieved military success in Afghanistan and Iraq, investors have adjusted their investment models and expectations to assume future attacks and assess the impact of those attacks at the same level as a hurricane, tornado or earthquake disasters.

Al-Qaeda's greatest weakness is public relations in the Islamic world. Bin Laden and al-Zawahiri have portrayed themselves as leaders of a great Jihad to throw out the Westerners. However, as a result of the 9/11 attack, the Muslim countries of Afghanistan and Iraq are now occupied by the United States. The United States recently announced plans to withdraw its troops from Saudi Arabia, not as a result of Al-Qaeda threats, but because these troops are no longer needed to support the "no fly"zones in Iraq. However, following the Riyadh and Morocco takes, which killed more Muslims than non-Muslims, the US may reconsider. Al-Qaeda can issue all the threatening audio tapes it wants (one was broadcast last week on Al Jazeera.) But if Al-Qaeda can't deliver 9/11 attacks, or even attacks as substantial as the ones launched by Islamic Jihad, Hezbollah and Hamas against the Israelis, it will fade into irrelevance.

Saudi Arabia - The House of Saud first came to control the Arabian Peninsula in 1744 by making a pact with the Wahabi sect of Sunni Islam. For the next 200 years, the Saudi's enriched themselves through piracy and shaking down pilgrims on the way to Mecca. Oil was discovered in Saudi Arabia in 1938. By 1980, Saudi Arabia was recognized as the world's largest source of oil, currently estimated at 25% of known reserves, and currently supplies 18% of the oil shipped to the United States. About $100 billion/year in oil revenues flows to Saudi Arabia. Despite this largesse, per capita income has fallen by 75% since 1981 as the birth rate has outstripped oil sales. Most critically for the House of Saud, there is the growing perception among the Wahabi faithful that the Saudi Princes have been corrupted by the West and should no longer serve as the protectors of Mecca.

Bin Laden, a Yemeni by heritage, is a member of a family grown rich on Saudi Arabian construction contracts. However, he turned against the Saudi royals 15 years ago and is now dedicated to their removal. It was not a coincidence that 15 of the 19 9/11 attackers were Saudi nationals - Bin Laden attempted to drive a wedge between US and Saudi Arabian interests. It is not a coincidence that last week's terrorist attacks against Westerners in Saudi Arabia was followed by additional attacks in Morocco. Al-Qaeda was sending a message to the Saudi royals that they could be attacked at home, and in Morocco, site of many Saudi vacation palaces. However, this attack may have back-fired. Until recently, Saudi Arabians directed tens if not hundreds of million of US dollars to "Islamic charities," often fronts for terrorist groups in Afghanistan, Palestine and Al-Qaeda, in an attempt to maintain legitimacy in the eyes of the Wahabis. This financial support may dry up as a result of the recent attacks, and the Saudi Arabians may be more willing to share intelligence with the US.

Iran - Iran was delighted to see Hussein deposed - the Iran-Iraq war caused at least 500,000 Iranian deaths. However, US forces now border Iran to the East (Afghanistan) and West (Iraq.) Iran, despite being awash with oil, is in the midst of developing "peaceful" nuclear power plants, pragmatically speaking with the sole purpose of obtaining weapons grade uranium. Some Al-Qaeda and Taliban forces appear to be domiciled in Iran at this time, and Iran has sent militant forces across the border to Iraq in an attempt to influence or destabilize the post-Hussein government. The cleric dominated Iranian government is corrupt and inefficient, and rapid population growth has created yet another pool of disaffected youth, only their hostility is directed against the mullahs, the only government they have ever known. Iran knows it cannot withstand the US militarily, hence the focus on nuclear weapons. Iran may be willing to trade intelligence in return for assurance of non-aggression.

Pakistan - On the one hand President Musharraf's government has been able to deliver quite a few Al-Qaeda operatives. On the the other hand, he controls only half of the country - the remainder provides support to terrorists striking against India in Kashmir, against the newly formed government in Afghanistan, and is probably shielding Bin Laden. Pakistan is the only Islamic country currently a nuclear power, and the US has to worry how secure those nuclear weapons might be, particularly if Musharraf is swept from power.

Israel/Palestine - the permanent thorn in US-Arab relations. The bottom line is that Israel wants territorial integrity, which in practice means pushing the Palestinians out of the West Bank and Gaza strip. The Palestinians want their land back. Unfortunately, the Palestinians are no more likely to get their land back than the Sioux Indians are likely to get back North Dakota, the Aborigines to get back Australia, or for that matter the Jews to get their land back in Europe. The Palestinians lost the moral high ground with the 1972 hostage taking at the Munich Olympics, and have squandered opportunity after opportunity to settle anything with the Israelis. Recent attempts to create a new road map to a Palestinian state, as proposed by the US, EU and Russia, are already foundering. Five fresh bomb attacks against Israel over the weekend were met with fresh lock downs by Israeli forces in the occupied territories.

Sharon and Arafat mouth platitudes about peace, but both are committed to achieving the territorial goals which can only be achieved by the defeat of the other. The only reason why the Israelis haven't captured, killed or exiled Arafat (who is clearly directing terrorists attacks from the rubble of his Ramallah compound) is because of pressure from the United States. If the US loses patience with Arafat for good, he's gone.

Syria - Syria is currently ruled by the relatively young, relatively inexperienced Bashar Al-Assad, second born son of Hafez Al-Assad, the previous ruler who died in 2000. Bashar was studying ophthalmology in London when his older brother Basil, the nominal heir, was killed in a car accident in 1994. Bashar returned to Syria and took over from his father at the age of 34. Syria and Iraq were both allies and rivals over the last 30 years. In the last decade, Syria derived about 20% of GDP by illegally transshipping Iraqi oil. The pipeline which provided this oil was promptly shut-down by US forces a few weeks ago, so now Syria has to deal with a major financial crisis. In addition, the US has been pressuring Syria to turn over members of the former Iraqi leadership (these leaders keep mysteriously turning up in Baghdad.) Syria has unfriendly relations with Turkey to the North, now faces US forces in Iraq to the East, the US fleet in the Mediterranean to the West and, below Lebanon (occupied by Syrian forces since 1975,) Israel. So Al-Assad has to walk very carefully to avoid US forces simply rolling over his country in about a week.

North Korea - North Korea may well be the most dangerous country in the world right now. Following the ascension of Kim Jong Il in 1994, North Korea has been wracked by economic crises leading to the deaths of 2 million people (out of 25 million) by famine in the mid 1990's. Most of North Korea's resources are directed to the support of a 1 million man army, currently lined up to attack South Korea. However, fuel oil is in such short supply that most of North Korea is blacked out at night, and should the Chinese sever a key oil pipeline, the army could maneuver for only two weeks before grinding to a halt (unfortunately, long enough to kill at least 1 million South Koreans.) Primary North Korean exports include missiles, counterfeit money, drugs and slave labor. North Korea may have traded missile technology for nuclear technology with Pakistan and claims to be currently nuclear capable (although North Korea has not actually detonated a nuclear test blast.) Given that North Korea is the same size as Mississippi, it's hard to imagine where such a weapon could be tested. The US is currently trying to bring pressure to bear on North Korea to repudiate its nuclear program in multi-lateral talks with South Korea and China. However, the US has also moved strategic and stealth bombers within easy striking distance of North Korea.

SARS - SARS is frightening because it's new and the transmission mechanism is not fully understood. In the worst effected regions, including parts of China, Taiwan and Hong Kong, a virtual shut-down of economic activity will cost $ billions. However, since SARS was first recognized in November 2002, about 6000 people have been infected worldwide and about 400 have perished. Over the last year, worldwide, about 250,000 people died of flu, 3.1 million died of AIDS, 2 million died of Tuberculosis and 1 million died of Hepatitis B (all statistics from WHO.) It would be ideal if the disease could be wiped out through quarantines before it become endemic. Since the disease appears to have crossed over from farm animals in China, this may not be possible. However, in time, as better treatment plans are derived and vaccines are developed, the overall mortality rate of this disease will drop off, and with it the hysteria.

Bottom line, events are happening beyond US shores which directly effect the investment picture in the US. Although there are dangers everywhere, for the time being the US has the initiative. The swift prosecution of the Iraq war has demonstrated that no country can hope to withstand US forces in a conventional war (hence, the scramble by Iran and North Korea to acquire nuclear weapons.) The US can now choose between military, diplomatic and economic tools as it negotiates to achieve its long term interests.

Fed Policy - The Fed has maintained short term rates at 1.25% since November 2002. Consumer Price inflation is currently running about 2% year over year. The money supply is expanding at a rapid rate. GDP is forecast at 2-2.5% for 2003, which is better than can be expected for the Euro zone or Japan, but still less than ideal (3.0-3.5%.) Bottom line: the Fed has an accommodative stance towards the economy.

Tax Policy - Economic theory says one-off tax cuts do little to stimulate the economy (because consumers don't build the windfall into their spending patterns) but permanent tax cuts do stimulate the economy. If this theory is valid, than the economic effect of consumers refinancing their mortgages over the last several years is huge compared to the proposed tax cut currently under consideration in Congress. Details of this tax cut are as follows:

With the exception of the child credit, which will result in checks of $400/child being mailed out starting in 6 weeks, most wage earners will see only a slight (couple of dollars) reduction of taxes paid in the weekly pay check. Tax savings from lower taxes on dividends and capital gains are real, but won't be apparent to investors until 2003 returns are calculated. Dividends in HCMI portfolios average 1.5%, so the reduction in the top rate from 38.5% to 15% is worth about 0.35% in extra return. What worries us is that, if a ballooning deficit causes interest rates to rise (for example, from 3.5% to 5.5% in the ten year), the S&P 500 will be revalued downward (a 1% rise in rates reduces the value of the stock market by about 10%.) Bottom line: we don't think the current legislation is good tax policy because tax payers will be baffled by how much benefit they'll receive and therefore won't increase economic activity, even though the deficit will increase. An ideal tax policy would be a flat tax of 15% on all income greater than $20K/year, regardless of source, no deductions for anything. Won't happen though.

Many Democrats are hoping that the re-election of Bush 43 plays out like the re-election of Bush 41 (won the war, lost the economy, lost the re-election.) However, there are plenty of reasons why history won't repeat. For starters, the recession which brought down Bush 41 began in the third year of his first term, while the most recent recession started in the last year of the Clinton Administration and was effectively over by 2002. The economy should continue to strengthen and unemployment drop as the election approaches. Bush 41 alienated key supporters by raising taxes ("read my lips, no new taxes) while Bush 43 has delivered two tax cuts in the first three years of his administration. Bush 41 faced a bruising primary against Pat Buchanan (unusual for the party in power to permit a primary challenge) and lost center right votes to Ross Perot, who ran as an independent. Bush 43 is much more adept at managing the political process; therefore, we expect no primary challenge and no center right third party candidates, leaving the Republicans to go after centrist voters having already secured their core voters.

After catching highlights of the first Democratic Debate (9 candidates) we realized that any party which has to take seriously a political jester like Al Sharpton is in serious trouble. According to the most recent (March 2003) Quinnipiac University Poll, the candidate most attractive to Democratic voters is Sen. Hillary Clinton 37%, followed by Congressman Richard Gephardt 13% and Sen. Joseph Lieberman 12%. Without Clinton in the the primary, Lieberman has a slight edge. To win the election, Democratic candidates must first swing left during the primary, then back to the center for the general election, giving plenty of avenues for Republican attack. The Democrats are most vulnerable on the issue of national defense - during the eight years of the previous Democratic administration, the Al-Qaeda menace grew unchecked. During the current Republican administration, Al-Qaeda has been thrown on the defensive.

Clinton was re-elected in 1996 with only 49% of the popular vote, but still obtained 70% of the electoral vote. Ronald Reagan, another polarizing Republican president, received 59% of the popular vote in his re-election campaign, but 98% of the electoral vote. Assuming that the United States holds off any terrorist attacks on US soil for the next year and a half, and that the economy continues to improves, Bush 43 could get 50-55% of the popular vote, 70-80% of the electoral vote.

Economic reports have to be divided into pre- and post-Iraq War. Prior to the commencement of the war, oil was hovering near $40/barrel, hiring and capital investment were at a standstill, and the economy looked like it might fall back into recession. Post-war, oil is at $28/barrel, and may well be below $25/barrel by the summer. Consumer confidence is up, inflation is down dramatically (because of the sharp reduction in energy prices.) We don't see any confirmation of pick-up in such reports as capacity utilization and manufacturing activity, but due to reporting delays, we're still looking at April data when managers. Anecdotal reports indicate that, now that CEO's and CFO's are no longer glued to CNN and have some sense of costs (e.g. the cost of energy) they're starting to introduce new products, roll out marketing campaigns, even hiring people and investing/upgrading facilities. The impact of this will be more apparent in June economic reports. So far, the consumer remains king, with sharply improved consumer confidence numbers and new home sales remaining strong thanks to generational lows in mortgage rates.

Earnings for the first quarter of 2003 were strong, gaining 11.6% with 95% of S&P 500 companies reporting. Estimate for the rest of 2003 are a gain of 5.9% for Q2, 12.4% for Q3, 21.0% for Q4. This gains represent actual growth but also the end of a period of substantial write-offs, which depressed earnings in 2002 (all numbers from First Call.) Given low interest rates and expectations of growth in S&P 500 earnings, the S&P 500 is undervalued by about 40%. We extracted 35 years of Fed Model data (from Economy.com) and prepared the following chart:

At the end of the "Nifty Fifty" bull market of the late 1960's, the stock market was overvalued by about 55%. At the end of the 1973-74 bear market, the S&P 500 was undervalued by 43%. Five years from the December 1974 low, the S&P 500 was 60% higher, and 144% higher ten years later.

In March 2000, the S&P 500 was overvalued 64% according to this model and is currently undervalued by 32%. If interest rates start backing up with increasing economic activity, it will reduce the discount on the S&P 500. Still, the model suggests that now is a relatively low risk time to invest in stocks.

Sentiment surveys still show most investors leery of stocks. In the first Quarter, AMG Data noted that $5.9 billion flows out of equity funds, and a record $45.3 billion flowed into bond funds. In other words, investors are selling low in equities, buying high in bonds. April saw inflows of $12.9 billion into equity funds, with an additional couple of billion flowing into equity funds in May. Meanwhile, investors hold $2 trillion in money market accounts. If that money ever flowed back into stocks, there would be quite a buyers' panic.

Volatility is decreasing, volume is increasing on both NYSE and NASDAQ. As long-term investors return to stocks, hedge funds are losing their ability to move the market. Key difference between now and last summer is that, last summer stocks would open higher, close lower as investors used any strength to raise cash. Now stocks, open lower, close higher as investors are putting money back into stocks and short-sellers are getting squeezed.

The one worrisome issue is the dollar, which has declined to 4 year lows against the Euro. Although a lower dollar increases the value of earnings from overseas operations for American companies, it also reduces the desire of non-Americans to hold US dollar denominated securities and also increases the costs of goods imported from overseas. Why the dollar keeps falling is somewhat mysterious. Non-Americans were loathe to hold the dollar heading into the war with Iraq, but that issue is now over. European real interest rates are higher than the US, but Japanese real interest rates are lower. Money generally flows to whichever currency offers the highest real returns, and also to those countries with the highest economic activity. Since German, French, Italian and Japanese economies are projected to grow at half the rate of the US economy over the next two years, the dollar should be rising.

It's doubtful that we'll get back to the "sky's the limit" style of investing we saw in the late 1990's. It is reassuring, however, to see that the companies which HCMI typically invests in posting substantial rallies, taking our clients' accounts to the best levels YTD and several points ahead of the S&P 500. Between now and June 30th, we will fully invest the portion of our clients' assets that should be in stocks. After a year of telling prospective clients to sit on their hands, we're waving in new accounts as well.

HCMI Client Letter - May 27th, 2003