HCMI Client Letter - January 1st, 2004

After three years of negative returns, US stocks finished a solid 2003 with solid 4^th quarter results.  The Dow Industrials, S&P 500 and NASDAQ are at the highest levels in over two years and now exceed the levels set September 10^th, 2001.  However, the averages remain well below the record levels set in Q1 2000 – the S&P 500 is off 27%, the NASDAQ off 60%, their respective high water marks.

The stock market’s performance this year is attributable to three factors:

1. A sharp increase in economic production in an environment of low interest rates and little or no inflation, leading to a huge increase in corporate earnings.
2. A perception that the threat from Al Qaeda, while ever present, is at least contained to non-US targets
3. A technical bounce off extremely over-sold conditions in 2002.

Can US markets repeat gains in 2004?  We project gains of 8% in the S&P 500, attributable to the following factors:

1.                  Earnings growth for S&P 500 companies of about 12% for 2004, slowing somewhat from 2003’s expected 16% growth rate (from FirstCall.)

2.                  Interest rates at both the short end (Fed Funds rate) and long end (10 Year Treasury yield) should be higher by next December.  We think Fed Funds will be 50bp higher at 1.25%, 10 year yield to be over 5% (versus the current 4.26%.)

3.                  Projecting 12% earnings growth and a 10 year yield of 5.25% still leaves the S&P 500 28% undervalued according to the Fed Model.

4.                  The US dollar remains flat to lower, which reduces demand for US dollar denominated investments from non-US investors.

5.                  Oil prices remain higher than the $25/barrel we had projected earlier this fall (currently oil is around $31/barrel.)  Demand for energy remains solid in the US and is increasing in rapidly industrializing countries such as China and India.  Meanwhile, supply remains constrained both because of political problems in Nigeria and Venezuela and because of production cuts engineered by OPEC.

6.                  The “easy money” has already been made, particularly in technology stocks which in many cases doubled in 2003 (technology was our sector of choice this time last year.) 

Risk

Without Al Qaeda’s threat, we would comfortably increase our stock market allocations and reduce our fixed income allocations in anticipation of the earnings growth which comes with a new economic cycle (the recession of 2000-1 is now well in the rear view mirror.)  Since Al Qaeda still functions, albeit without the territory and anonymity which supported the terror organization through the 1990’s, we have to be much more thoughtful. 

Al Qaeda is very much in “put up or shut up” mode.  In response to Al Qaeda’s attack against the World Trade Center and Pentagon, in 2001, the United States now “owns” Afghanistan and Iraq (try explaining that at the Jihadi annual meeting.)  Although Al Qaeda has struck numerous targets in Indonesia, Turkey, Saudi Arabia, Morocco and Iraq in the last two years, the primary casualties have been other Muslims.  To maintain credibility, Al Qaeda must accomplish a major hit on the US in 2004.  Between now and the November presidential election is the period of greatest risk.  The US recently increased the terrorist threat level to “High” amidst a flurry of threats against international plane flights.  Al Qaeda appears desperate to assassinate President Musharraf of Pakistan (two attempts in two weeks) in the hopes of reversing his support of US objectives against Al Qaeda and Taliban remnants, and also to gain access to Pakistan’s nuclear arsenal.  Al Qaeda’s increased activity in Saudi Arabia has finally convinced that government to get serious about anti-terror efforts (although the Saudi Arabian royal family looks as secure as the Shah of Iran in 1978.)

We wrote in our January 2003 client letter, “Securing Iraq achieves several objectives 1.) eliminates the threat of the unpredictable Iraqi leader, 2.) allows the US to establish an anti-terrorist base right in the heart of the Arab world, 3.) dispels Al-Qaeda assumptions that the US is unwilling to project force and sustain losses to achieve security, 4.) gives the US access to the second largest reserve of oil, thereby the leverage to control world oil prices.” 

Although mopping up operations continue in Iraq, the US has already reaped dividends in the form of admissions by both Iran and Libya that these states were illegally pursuing nuclear weapons.  This in turn has blown the cover off Pakistan’s export of nuclear technology, which in turn puts pressure on North Korea (which had swapped missile technology for cash and nuclear technology.  UN inspectors in Libya have found, so far, centrifuges for extracting enriched uranium at 4 sites.  Follow-up question: where did these centrifuges come from?  It was rumored, but not yet proven, that Hussein had transferred scientists, machinery and materials to Syria and Libya prior to the March invasion.

Coalition casualties in Iraq in December, following Hussein’s capture, fell to 38 killed from November’s record 83.  The number of attacks dropped off sharply and is limited primarily to suicide car attacks and road side bombs.  In any instance of guerrillas forming up groups larger than three (including one example where the attack was signaled by releasing pigeons,) coalition forces have slaughtered them.  Biggest problem remaining is how to dispose of 1-2 million tons of munitions scattered around Iraq – far too much to guard and far too susceptible to theft for use against coalition troops and Iraqi citizens.

Strategy

After misreading how badly stocks would fair in 2002 (we didn’t expect investors to dump their life savings at fire-sale prices for no good reason) we did a better job in 2003 getting our clients fully invested in stocks by April to reap the benefit of the post Iraq rally.  Our big worry in 2004 is Al Qaeda; another hit on the scale of the 9/11 attack would strip 5-10% off stock values, although we have seen over the last two years, and in other times of crisis, that the stock market always recovers. 

We’ve pushed up fixed income allocations in our balanced accounts.  In our equity accounts, we’ll be reviewing in January those accounts that are over-exposed to technology (more than 25% of assets) as a result of the rally in that sector over the last year.  We will put the proceeds primarily in healthcare stocks to take advantage of low valuations in that sector and because that is the group least vulnerable to a terrorist strike.

The Heron Capital Management client letter is published immediately following quarter end and 1 or 2 additional times per quarter. The views expressed in this letter represent HCMI opinion and strategy as of the date published and can change at any time upon receipt of new information. Data quoted in this letter are from sources deemed reliable, but no guarantee of such data is implied.