Client Letter 01/01/2004

With 18 trading days remaining, the major US averages appear poised to turn in the best performance since 1999, showing gains of 21.5% in the S&P 500, 47.2% in the NASDAQ. Although these gains look dramatic, the S&P 500 is still 30% off the March 2000 peak, the NASDAQ 61% below its previous high. The NASDAQ is 16% over the level of September 10th, 2001, but the S&P 500 remains 2% below that level. In investment math, an index that loses half its value (down 50%) has to double (up 100%) to get back to the previous high water mark. On that basis, it could be several years before the S&P 500 makes a new high, perhaps a decade or more for the NASDAQ to make a new high.

Among our clients, portfolios are, on average, off about 10% from all-time highs within the range of -15% to +5%. Considering we've just come through the worst bear market since 1973-4, we're pretty happy with these results.

Preview of 2004

A large portion of 2003's stock market returns is attributable to heavily over-sold stocks rallying back to fair value. The S&P 500 in aggregate is still undervalued by 35%, but at one point in the last year was undervalued by over 50%. The gap between fair and actual value will shrink rapidly if interest rates rise as we expect in 2004. For example, if yield on the 10 year treasury rises from the current 4.4% to 5.5% next year, the gap shrinks to just 25%.

Earnings growth and economic growth in the most recent reports were just spectacular. The 9.2% growth rate recorded for 3rd quarter GDP was the highest rate in 20 years. Earnings growth in the Q3 averaged 21.5%, the best result since Q2 2000, and revenues grew 9.0%. Solid revenue growth is an important indicator of corporate health; earlier in the recovery, earnings growth was achieved by cost control (i.e. improving the bottom line) while sales remained flat. Earnings for full year 2003 are estimated at 18.3% vs. 0.1% in 2002 and a decline of 17.3% in 2001, and are expected to grow 12.3% in 2004.

Business spending is on the rise (replenishing lean inventories, increased capital spending). Consumer spending is slowing somewhat as the benefit of lower tax rates and mortgage refinancing is largely spent. Still, retailers are looking at one of the better holiday sales periods, especially as discounting is muted so far. The job situation is improving with a net gain of 328,000 since the cyclical low of 129,846,000 set in July, reversing nearly two years of losses. Today's jobs report, a gain of 57,000, disappointed compared to expectations of 150,000, but the unemployment rate fell from 6.0% to to 5.9%.

Bottom line, by this time next year, we expect the Feds Fund rate to be higher by 50bp (0.5%), 10 year treasury and mortgage rates to by higher by 100 bp (1.0%) and the S&P 500 to be at least 8% higher.

About 15 banks/mutual funds are under investigation for improper activities, primarily allowing favored investors to make "late trades" based on post close news. Jim Cramer, a market commentator and former hedge fund manager, analogizes this activity to allowing bets on horse races after the race is over. The money scalped from individual fund investors, while small on a percentage basis, amounts to outright theft. The money management business is relatively straightforward; do a decent job, collect a decent fee. Why a fund company would jeopardize this by dealing with some sleazy hedge fund for the sake of incremental revenue is beyond us. We call this the "killing the goose that lays the golden eggs" strategy.

We own positions in a number of companies under investigation including Alliance Capital, Bank of America, Bank One and Citigroup, and we have some money invested in the mutual funds of Janus Capital. We can't dump these companies or funds outright because to do so would incur capital gains charges for our clients. As in previous scandals (for example, JP Morgan/Chase accommodations to Enron), penalties will be paid, and the stock prices will suffer for a while, then resume their long-term upward track. So far, the scandal has not touched Fidelity Investments, the second largest mutual fund company and the custodian of our clients' assets.

2004 Presidential Election

With 11 months to go to the next presidential election, we're making projections about the likely outcome since a Democratic vs. Republican victory would require us to make changes among our current investments. The critical issues include:

With the Iowa Caucuses January 19th, followed by the New Hampshire Primary, January 27th, February primaries and March 2nd "Super Primary," the likely candidate on the Democrat side will be Howard Dean, representing the "Democratic wing of the Democratic party." Recent polls show Dean pulling away from John Kerry and Wesley Clark; Hillary Clinton will wait until 2008. Issue by issue, here's a (hopefully non-partisan) comparison of Bush vs. Dean.

The defining issue of the Bush presidency. Over two years have passed since the 9/11 attacks without a follow-on assault by Al-Qaeda in the US. We won't know for another 20 years whether Al Qaeda is biding its time, waiting for the right psychological moment for another US attack, or whether Al Qaeda no longer has the ability to mount such an attack. Although Al Qaeda has substantial financial resources remaining and a large supply of Jihadi volunteers, the network is geographically scattered through North Africa, Afghanistan/Pakistan and South East Asia (Bin Laden is rumored to be sheltering in Iran), Al Qaeda does not appear to have obtained the necessary components to launch a biological, chemical or nuclear attack yet (although we are concerned with what weapons might have been spirited out of Iraq during the last days of the Hussein regime.) A growing body of evidence points to ties between Al Qaeda and Hussein in recent years.

Al Qaeda may also have only a limited supply of Jihadis able to pass unnoticed through Western countries who also have the will to commit a suicide attack. Al Qaeda attacks of the past year have all been in countries such as Saudi Arabia, Morocco, Indonesia and Turkey, where Al Qaeda operatives can blend in with the local population. Jihadis also appear to be active in Iraq (coordinated suicide attacks against Western symbols such as the UN headquarters seem to be more the style of Al Qaeda, whereas "shoot and scoot" attacks against convoys, banks and police stations are more likely native Iraqi Baathists.)

The Democrats are still in denial about the seriousness of the War on Terror, which, while not as bloody as World War II, is as global in scope as the Cold War and could last as long. The Democrats operating assumption is that, by obtaining the goodwill of other countries and working within international organizations such as the United Nations, the United States can thwart Al Qaeda. The problem with this assumption is that many other countries are working at cross-purposes with the US in pursuit of their own interests (for example, France and Germany cheerfully selling contraband to Iraq over the last decade, Pakistan and Iran harboring Al Qaeda operatives, North Korea exporting nuclear and missile technology.) The United States is stretched already to cover the world's trouble spots with the 1.8 million men and women currently under arms, but few countries can contribute more than token support to military efforts. The UN is ill-equipped to deal with terrorists and has been effectively driven from Afghanistan and Iraq by terrorist action.

The Republican administration has had its own share of trouble defining strategy in the War on Terror. To take battle to the heart of the enemy, it was necessary to grab a good chunk of real estate. Iraq, which borders six countries in the Middle East and is a short plane flight to the rest, fit the bill perfectly. The US is constrained by world opinion regarding unilateral land grabs, however, so the invasion of Iraq was justified in terms of removing a tyrant who had flouted UN weapons resolutions. To the surprise and dismay of the Bush administration, only hints of weapons programs have been found to date. (For example, review of seized computer records show that, as recently as March 2003, Iraq was trying to buy an assembly system from North Korea for building long range missiles. The North Koreans failed to deliver, leaving the Iraqis attempting to get their deposit back.) Anti-US demonstrators have taken to the streets denouncing the "duplicity" of the Bush and Blair administrations. Next, we suppose they'll demand that the US apologize to Hussein and reinstate him.

Military planners in the Bush administration were surprised at the relative ease that the US took Iraq as Hussein, his courtiers and army ran away at the first sight of US tanks. This event lead to the assumption that the Iraqis, liberated from Hussein, were prepared to take up democracy and capitalism. As we see now, that was as realistic an assumption as expecting an illiterate to embrace Calculus. It was pre-mature for Bush to take a victory lap on the deck of the USS Lincoln; the "Mission Accomplished" sign will haunt him through the remainder of the presidential campaign. Between 5,000 and 50,000 "resistance fighters" (most Iraqi, but some "foreign" fighters) have mounted a campaign of harassment designed to whittle away the American army's will to remain in Iraq. Between 1 and 3 million tons (that's 2-6 billion pounds) of mines, artillery shells, ammunition and RPG's remain unsecured in Iraq, giving the guerillas plenty to work with.

Casualties among US and coalition forces in November mounted to nearly 200 (although in the same time frame, 1100 guerillas were killed or captured.) However, the coalition forces have gone back on the offensive in the last 4 weeks; groups of 2-5 guerrillas can make harassing raids against convoys, or more commonly, other Iraqis. Massed formations of 50 or more guerillas are easily smashed, as we saw in Samarra over the weekend. Can the Iraqi guerrillas succeed in the fashion of, for example, Vietnamese guerrillas in 1974? Without the support of "Great Powers" China and the Soviet Union during that conflict, the North Vietnamese army would have been pushed off the map.

Al Qaeda is reaching the point of "put up or shut up." In response to the Al Qaeda attack on the World Trade Center and Pentagon, the "sleeping giant" now owns Afghanistan and Iraq, and is poised to roll over Iran and Syria if those states make any threats against the US. Furthermore, US supported Israel continues to seize territory from the hapless Palestinians. Recent Al Qaeda attacks in Saudi Arabia and Turkey have resulted in casualties primarily to Muslims (in Riyadh the casualties were primarily Muslim women and children.) The Saudi Arabians, long time financial supporters of Al Qaeda, are now aggressively hunting Al Qaeda cells to ward off the threat to the Royal family (which looks as secure right now as the Shah of Iran in 1978.) To regain the initiative Al Qaeda needs a major hit on a US city, preferably timed for maximum embarrassment to the Bush Administration. We believe that the period of time remaining to the next US election is particularly dangerous (for example, an attack on New York City during the post Labor Day Republican convention.)

In a recent ABC/Washington Post poll, Bush rating for handling the campaign in Iraq was split between approval and disapproval. As the situation stabilizes further, the approval component should rise. Other polls show voters have a great deal more confidence in Republicans than Democrats regarding the issue of national defense

Advantage: Bush (provided no attacks in the United States between now and the election.)

An early campaign issue for the Democrats was the state of the economy. During the 8 years of the Clinton administration, 12 million jobs were created; during the first two years of the Bush administrations, 3 million jobs were lost. As we pointed out in previous commentaries, presidents have relatively little influence over the state of the economy. A more reasonable interpretation of the data is that, from the end of the last recession (1994) to the end of the recent recession (2002), a net 9 million jobs were created. Given the recent GDP report (best in 20 years,) exceptionally low interest rates, employment picking up, there's little for the Democrats to work with.

The Bush administration has pushed through two monster tax reductions in the last three years. Spending however has sharply increased for a number of programs in addition to extra spending for the War on Terror. As a result, the surplus of the Clinton administration is a distant memory, with projected deficits likely to swamp the previous levels set during the any previous administration. The question is, do these deficits matter to the average voter, or is that a problem for the average voter's children and grandchildren. In no year since the end of World War II has the Federal budget been smaller than the year before, so the only way for Democrats to address the deficit is to argue for higher taxes.

In the past week, one of the greatest entitlement programs of time, projected to cost $400 billion over the first decade, was voted upon in Congress, and will be signed into law by the president next week. This law has all the "talk radio" hosts fuming, as the future costs are estimated in the trillions of dollars. However, 1 out of 4 of next year's voters will be senior citizens, and they're pretty psyched about this bill. While planning and paying for healthcare will remain a huge problems for decades to come, the Republicans have effectively stolen this issue from the Democrats (similar to how the Democrats stole welfare reform from the Republicans during the Clinton administration.)

The most recent attempt at an energy policy (nicknamed the "leave no lobbyist behind" bill) withered and died before coming to vote earlier this fall. How about a simple 50 cents/gallon tax on retail gasoline sales? By our calculations, such a tax would increase the annual operating cost of a mid-size sedan from about $5400/year (including depreciation, insurance, gas, maintenance, registration fees and financing) to $5550/year - 3% cost increase (SUV from $8000/year to $8300/year - 4% cost increase.) Such a tax would generate $68 billion in additional taxes, and would also be a weekly reminder that a portion of every dollar sent to the Middle East comes back to us as a terrorist threat (we send the money to the Saudis, the Saudis send a percentage to the Islamic charities, the charities route a percentage to Al Qaeda.) Unfortunately, while Americans are willing to sacrifice many sons and daughters, fathers and mothers in defense of the United States, they're not willing to sacrifice gasoline at $1.75/gallon.

The Bush administration is cheerfully rolling back 2 generations of progress on cleaner air, water etc. Unfortunately for the Democrats, voters don't seem to care.

The 2004 election will set records for funds spent. The Bush campaign alone will raise $200 million. Howard Dean, assuming he's the Democratic candidate, has already announced that he's foregoing public financing, which would limit his campaign to spending $45 million The Democrats will have the support of unions (particularly union phone banks), college and university students, and Hollywood. The Republicans will have the support of the "true believers", talk radio fans and religious conservatives. The Democratic candidate, post the primary process, will be in the position of a marathon runner who, having just crossed the finish line of one marathon, faces another marathon against a fresh opponent.

We dug out a map of the electoral vote in the last election. The network news shows painted a stark contrast between the Democratic "blue" coasts and industrial heartland, versus the Republican "red" fly-over states. A map colored on the basis of the popular vote shows a mostly purple country, slightly redder in the middle, slightly bluer on the coasts, with some states won or lost by under a thousand votes. We think it's likely that Bush retains all of the states won in the last election (50.5% of the electoral vote, easily picks up Oregon, Iowa, New Mexico and Wisconsin where the margin of Democratic victory was 1% or less (net 58.3% of the electoral vote) and has a chance at picking up Washington state, Minnesota, Michigan, and Pennsylvania where the margin of Democratic victory was 2-5% (net 64.4% of the electoral vote.) This result would be worse than 1996 Clinton (70.6%) v. Dole, 1984 Reagan (97.8%) v. Mondale, Nixon (96.8%) v. McGovern, and Eisenhower (86.3%) v. Stevenson. However, the election is not a lock for Bush yet. Ford, Carter and Bush 41 all lost second terms because voters perceived that the sitting president lacked the ability to deal forcefully with the issues of the day. Bush 43 is determined not to fall into that category.

Crosschecking our analysis against the political betting website www.TradeSports.com, Dean is showing a 60% probability of being the Democratic candidate, Bush is showing a 65% probability of winning the election.

We’re fully invested and taking on new clients. We know we can't dump stocks in the event of a terrorist attack, but we have removed companies such as airlines and hotels that would be affected worse and are bulking up on healthcare companies which would be relatively unaffected. We continue to monitor the world political and economic events.

HCMI Client Letter - December 5th, 2003

Preview of 2004

2004 Presidential Election