With three weeks remaining in the 3rd quarter, the S&P 500 is up 4.0% QTD, the NASDAQ up 12.3%. For the year, the S&P 500 is up 15.2%, the NASDAQ up 36.5%. The S&P 500 is at the highest level since June 2002, the NASDAQ the highest level since March 2002, so it seems, after a tough three year bear market, that a new bull market has been established. Perversely, there's more risk in the stock market now than 6 months, when world events looked a lot more grim and stock prices were a lot lower. However, the S&P 500 remains 34%, the NASDAQ 64%, off their respective all time highs. The Fed Model, even with a 1% gain in interest rates still shows the S&P 500 undervalued by 36%. So it's not too late to get back into stocks, just that the easy gains have already been made.
With the exception of the labor market, economic reports continue to surprise to the upside. The second estimate of 2nd quarter was revised upwards to 3.1% from 2.4% - 3.5% is generally considered to be the non-inflationary speed limit for economic growth. Inflation remains low at a 2.1% annual rate, the housing market has stabilized despite a sharp increase in mortgage rates. Consumer spending, as seen in retail sales, remains strong. Industrial production remains on the weak side, and capacity utilization, at 75%, remains below the 85% level signifying full production.
Why is the labor market struggling? As the economy heads into recession, employers are loathe to lay-off employees because there are high costs associated (unemployment benefits, loss of trained personnel.) As the economy recovers, employers are loathe to take on new staff because of the costs of hiring and training, and the fear that a "double dip" will require layoffs of the newly hired. So new job growth lags while employers require current workers to put in more overtime. At the tail end of the 1994 recession, job growth was flat heading into the recovery. In 2003, job loss continues as employers have discovered how easy it is to export not only manufacturing jobs, but service jobs as well. How many times recently has a call to a "Help Desk" obtained a customer support person in India?
As we have described in previous client letters, the excesses created in the the late 1990's capital spending boom are being worked off. For example, increasing demand for bandwidth means that the fiber optic cable, laid at the cost of billions of dollars by companies that later went bankrupt, is actually being used at rates greater than 1%. We focused our investments in the last three years on companies which had cash in the bank and positive cash flow (for example, Cisco) survived and are now thriving. Weaker companies, or companies without a rock solid product line, are struggling or out of business. For example, we recently sold our entire position in Sun Microsystems. This flagship company, with over 20 years of history developing leading edge server and operating systems, is being squeezed out between high servers from IBM, low-end servers from Dell, and the free Linux operating system, which competes directly with the Sun Solaris system.
Another proof that the late 1990's excesses are dissipating is seen in the solid revenue and earnings growth of the last year. S&P 500 revenues were flat to lower in 2001, and earnings fell 17.3%. In 2002, revenues were flat to slightly higher; earnings were flat. Revenue gains are running around 8% for 2003, and earnings growth looks to be about 16%. Earnings grew 9.6% in Q2 2003, about 3% ahead of expectations. For Q3, earnings growth is estimated at 14.7%, and 21.4% for Q4.
War on Terror
The wild card in our stock market forecasting is the potential of another terrorist attack on the scale of 9/11. Prior to 9/11/2001, in an economic environment as attractive as we see now, with valuations as realistic as we see now, we would have been waving in new clients and investing their cash as quickly as possible. Now, every company we invest in has to be evaluated in terms of its exposure to future terror attacks. For example, we have no exposure to airline stocks. Aside from the general ill health of the industry, the exposure of these companies to another week long shut down of the air industry is just too high. Property insurance companies are also high risk. Other companies such as healthcare and consumer non-durables have less exposure because people will buy these products no matter terror attacks we face.
After the 9/11 attack, the S&P 500 fell 12% in the first week, recovered most of the losses by year end 2001, but slumped through 2002, with investors liquidating their life savings at fire sale prices in July and October 2002. Investors are better prepared, mentally, for future attacks because we now can speculate about a variety of bad situations and prepare for them. The August blackout in the Northeastern United States showed how much better prepared civil defense is since 2001, certainly since the 1977 blackout during which New York City police were unable to prevent widespread looting, fires and mayhem. These days the stock market falls off with each reminder of terrorist activities (for example, this summer's attacks in Riyadh and Morocco or Wednesday's release of a Bin Laden videotape) but recovers quickly. Indeed, if the best Al Qaeda can do is release threatening videotapes, then we're better off than we think.
Despite the continued attacks on US troops in Iraq, with combat deaths averaging 1 every 3 days (grim, but better than the 1 death every 2 days which prevailed through the summer,) the US's occupation of Iraq is a net gain for US security. We said some time ago, "Capturing Iraq is like hitting a hornet's nest with a baseball bat; while it's possible to get stung, it's a lot easier to kill the hornets as they fly out of their nest." From all over the Middle East, Jihadists are flooding into Iraq to kill Americans, but movement and activity makes it easier for US troops to kill the Jihadists, and for counter-intelligence groups to identify risks. The situation in Iraq is unusually complex because different groups, including Sunnis and Baathists associated with the Hussein regime, Shiites Islamists associated with Iran, and free-lance terrorists associated with Al Qaeda, are able to take advantage of the complete collapse of security in Iraq to attack US formations at will. Over the next 6 months, however, we expect US forces to adapt to the situation and take control. As we discussed in detail in our May client letter, fighting Al Qaeda is not just a question of capturing or killing Bin Laden, but of changing the psychology of a generation of would-be terrorists who, beneath the radar of most Americans, spend morning, noon and night plotting to kill us.
George Bush's prosecution of the War on Terror has polarized political opinion in the US. Supporters, primarily Republican and conservative, point to successes in preventing follow-on attacks on US soil, successful military campaigns in Afghanistan and Iraq, capture or killing of many senior Al Qaeda operatives. Detractors, primarily Democratic and liberal, declaim against the Patriot Act, continued instability and deaths of US soldiers in Afghanistan and Iraq, failure to capture Bin Laden or Saddam Hussein. The reality lies somewhere in between. The US is responding aggressively since September 2001 to a war that began as early as 1993 (with Al Qaeda attacks in Mogadishu against US troops, and in bombing attacks on US embassies in Kenya.) Prior to 9/11, the US shrugged off attacks (including the 1993 WTC bombing, attack on the US Cole, etc.) as an elephant shrugs off mosquito bites. The 9/11 attack, like a shotgun blast to the elephant, has provoked an aggressive response by the victim which Al Qaeda did not anticipate. There are now over 200,000 US troops dotted across 20 military bases throughout the Middle East, and an equal number of these troops will probably be there 50 years from now.
As we saw with the Unabomber or with Eric Rudolph, it's very hard to find a single intelligent person who wants to avoid capture and who has assistance. It's relatively easy, given the unchallenged military supremacy of the United States, to capture territory from which to project force. It was widely predicted that the Middle East would convulse with anti-Americanism following a US invasion of Iraq. Instead, "the Arab street" has been very quiet, while the governments of Pakistan, Saudi Arabia, Syria and Iran, while not exactly cooperative, have become less resistant to helping US anti-terror efforts. Machiavelli, who wrote, "Since love and fear can hardly exist together, if we must choose between them, it is far safer to be feared than loved," would approve.
Since 9/11, the US has had both successes and failures, but most importantly has succeeded in preventing another large scale or even small scale attack in the US. Opposition forces, whether Al Qaeda, Taliban or Iraqi, are destroyed in short order in massed formations. Dispersed, they cannot threaten US interests, but the US cannot let down its guard either. A stalemate prevails for now. However, Democrats who think that military stalemate in the War on Terror combined with lack of jobs growth is the key to ousting the Republicans may well be disappointed in 2004. In 1972, a sitting Republican president faced soaring unemployment and inflation, combined with an unpopular and bloody war in Vietnam. None the less, Richard Nixon defeated George McGovern 61% to 38% in the popular vote on the way to obtaining 97% of the electoral vote.
Israeli-Palestinian conflict
As we expected, the US brokered cease-fire between Israelis and Palestinians broke down in under 100 days. The US would prefer resolution of this conflict since US support of Israel inflames Muslim antipathy, but the bottom line is that this tribal conflict will be resolved eventually by the Israelis pushing the Palestinians out of the West Bank and Gaza for good; think of it as "ethnic cleansing" in slow motion. In May we wrote, "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." After the recent bombings in Israel, it seems that the US has indeed lost patience, because Israeli special forces have surrounded Arafat's Ramallah compound again, and the Israeli cabinet voted Thursday to expel him from Gaza.
Our strategy is as follows:
We’re fully invested in current accounts and are sitting on cash in new accounts until the end of pre-announcement season (late September). As we had expected, fixed income yields have gone higher, so we were wise to avoid government and municipal bonds through the spring. If the 10 year treasury hit 5% (currently 4.3%), we'd be more comfortable putting money in that sector. However, our allocation to corporate bonds worked out pretty well over the last year, with gains exceeding 25%. This rally is attributable to a general recovery in the corporate bond market as investors became convinced that corporations could indeed service their debt, which caused spreads to narrow sharply. We continue to monitor international developments, US economic reports and investor sentiment.
Yours sincerely,
David Edwards, President
Heron Capital Management, Inc.
(800) 99-HERON
http://www.HeronCapital.com