The stock market rally, which began in April, ran out of steam in the last 10 days of September. Profit taking erased half the gains of the quarter and took September’s return into negative numbers. There was more noise than news over the last month, so let’s take this opportunity to review from the top down all the factors we’re tracking in our investment process.
Several solid reports recently in construction and housing activity, consumer income and spending, and manufacturing activity. Consumer confidence is on the wane, reflecting uncertainty about the situation in Iraq and continued weakness in the job market. Earnings look fine for the upcoming quarter. Overall rating: Neutral-Bullish
Fed funds holding steady at 1.00% for the near future, and money supply growth remains on the high side. After a run of dramatic bankruptcies in 2000-2002, bankers have been more discerning in lending credit and underwriting bonds, especially in the junk sector. Yields have fallen and credit is readily available. Perhaps too much credit, between mortgage refinancing and high interest rate credit cards, is available to consumers. Neither inflation nor deflation appear to be problems. Overall rating: Neutral
Oil priced below last spring’s war wary $35/barrel, but, at $29.50/barrel, a long way from the $25/barrel we expected this fall. Political problems in Venezuela and Nigeria, delays in getting Iraqi oil back to world markets mean tight inventories and OPEC’s announcement of production cuts last week mean higher prices for now. OPEC’s production cut matched the amount of oil expected to start shipping from Iraq in a month or so. Despite this announcement, widespread cheating among oil producers should lead to higher inventories and lower prices through the winter.
Gold is at a multi-year high after being a lousy investment for a decade. Although no longer a “flight to safety” investment, there’s solid demand for gold in jewelry and manufacturing applications. Gold is typically priced in dollars, so a falling dollar makes gold more attractive in other currencies. Central banks have suspended sales of stocks as well.
Other industrial commodities are flat to higher, agricultural commodities are flat to lower. Overall rating: Bearish-Neutral
A rising dollar is good for financial assets (attracts foreign investors) but harms US exporters. A falling dollar creates the opposite effect. Best situation is a stable currency. A sharp rally last week in the Euro and the Yen staggered the US stock market. Overall rating: Bearish-Neutral
Yields on the ten year slipped below 4%, which is good news for mortgage rates (and anyone who failed to refinance last spring.) Yields usually rise when the economy is doing better (investors sell bonds to buy stocks), or when the dollar is weak (foreign investors bail on bond holdings.) In the current environment, rapid money supply growth is overcoming both these factors. The Fed repos in, or in some cases outright buys, Treasury bonds from US banks. Each dollar injected into the banking system is worth about six dollars in additional lending. Buying pressure from the Fed lowers yields, which increases the valuation of the S&P 500 (currently about 33% undervalued.) Overall rating: Neutral-Bullish
The advance/decline line, new highs/new lows, trading index, daily volume, heavy cash flows into mutual funds all point to an improved technical situation, especially compared to July 2002. However, after rallying 29% from the February lows, it seems reasonable that the market takes a breather through year-end. The S&P 500 is still 9% below the levels of September 10th, 2001. Overall rating: Neutral
The California recall election will be over by Tuesday. Latest polls show 63% of Californians in favor, with Republican Schwarzenegger favored by 40% of voters, Democrat (and current lieutenant governor) Bustamente at 25%, Republican McClintock at 18%. Tradesports, which compiles bets on political outcomes as well as sporting events, give an 85% chance of the recall succeeding, with Schwarzenegger given an 81% chance of winning. Odds of the recall results ending up back in court: high. Whatever the outcome, it’s not healthy for the world’s 4th largest economy, still mired in the tech bust recession and reeling from bad energy policy, to be rudderless much longer.
In Washington, any pretense of bi-partisan dealing on the “War on Terror” has evaporated. Overall rating: Bearish-Neutral
The good news is that Al-Qaeda has not succeeded in follow-on attacks in the US in over two years. Attacks by Al-Qaeda in Indonesia (Bali) and Saudi Arabia (Riyadh) have jolted the governments of those countries into cooperating more with the US. Numerous senior Al-Qaeda leaders have been caught or killed. Bin Laden remains at large in the Pakistan border region. However, this week’s arrest of two US military, charged with aiding prisoners in Guantanamo, and the interception of a courier with $340,000 in cash at Logan airport reveals that the fight against Al-Qaeda is far from over. In October 2001, we wrote, “There are possibly 20-40,000 extremists worldwide who have both the will and the means to inflict surprise attacks on the American interests, either at home or abroad. Since it would be impossible to track them all down, we believe a "war of containment" similar to the "Cold War" will remain in place for a decade or two.” That analysis still appears valid.
Iraq is a mess, but then so was the American South for 12 years after the Civil war. As we commented some time ago, “Capturing Iraq is like hitting a hornet’s nest with a baseball bat – you can see the hornets better but you might also get stung.” The question remains whether the US forces in Iraq can overcome the organized resistance in the “Sunni triangle,” the Rhode Island sized territory east and north of Baghdad and Tikrit. Although nothing more than hints of biological, chemical or nuclear weapons have turned up so far, about 650,000 tons of conventional munitions remain unsecured and available to Iraqi guerillas.
If Hussein’s WMD program turns out to be a mirage, it would be spectacularly good news. No weapons, no chance of anthrax, Sarin, uranium etc. falling into the hands of terrorists.
“Carrot and Stick” diplomacy continues with the purpose of getting Iran and North Korea to give up their nuclear weapons programs – the outcome is unclear. North Korea claims to have one or more nuclear weapons. Pakistan remains on the edge – an ally of the US in the war against Al Qaeda, at least in the urban areas, but also a promoter of terror in Kashmir. Bin Laden would love to see Musharraf overthrown and an Islamic fundamentalist government installed to get access to Pakistan’s nuclear weapons. Overall Rating: Bearish-Neutral
The bear market of 2000-2003 appears to be over. Even so, don’t expect a return to the plus 20% returns of the late 1990’s. We think gains of 8%/year are achievable, provided that terrorism is kept at bay.
Our strategy is as follows:
We’re fully invested and taking on new clients. We continue to monitor international developments, US economic reports and investor sentiment. Two positive quarters this year, let’s see if we can make it a third.