HCMI Client Letter - April 5th, 2004

US stocks peaked in late January/early February (S&P 500 up 4.1%,) slumped in March (S&P 500 down 1.9%) on profit-taking and a renewal of terrorism fears following the detonation of bombs among 4 Madrid commuter trains (with 190 killed, over 1300 wounded,) closed the quarter up 0.9%.  Our forecast for the S&P 500 remains gains of 8% in 2004, so this quarter’s action represents a garden variety correction following the previous 9 months strong gains.  We used the March dip to move some new accounts into the market, left invested accounts alone.

In our March 11^th client letter we highlighted two issues: jobs and terrorism.  Regarding jobs, we commented, “A recent uptick in jobs classified advertising implies that a limit has been reached in the output of current hires, and that more hiring is on the way.  Another reason for optimism: initial jobless claims are currently averaging 350,000/week, down from a year ago average of 450,000/week and peak of 550,000/week in 2001.”  In Friday’s jobs report, 308,000 jobs were added for the month of March, and 513,000 for the quarter (compared to 200,000 for the previous quarter.)  The unemployment rate ticked up from 5.6% to 5.7%, representing more people encouraged to look for rate.  The jobs report was the best in 4 years and caused US stocks to soar while US bonds got pummeled.  Yields on the ten year leapt from 3.65% in mid-March to close the quarter at 4.12%

On terrorism, we commented that, as it had been over 2 ½ years since an Al Qaeda attack on a Western target, there was perhaps the hope that Al Qaeda was diminished to the point where such attacks could not be launched.  Hardly had those words left the keyboard when news came of the horrific attack in Madrid.  Blamed initially on Spain’s domestic terrorists, the simultaneous detonation of 10 bombs on four trains has been traced to a network of Moroccan and Tunisian Jihadis.  15 suspects have been captured following that attack, 5 suspects including the alleged ringleader blew themselves up yesterday rather than surrender. 

It’s not clear that the bombing was directed by senior al Qaeda leaders (currently hiding out between Afghanistan and Pakistan) but the communiqué which followed the attack referenced familiar al Qaeda themes.  The message claimed retribution on Spain not only for its contribution of 1300 soldiers to coalition forces in Iraq, but also revenge for Spain’s expulsion of the Caliphate in the 15^th century (Jihadis apparently have long memories.) 

The attack contributed to the defeat of Spain’s conservative party (which had supported the Iraq war).  The incoming Socialist party intends to remove Spain’s troops by June.  A follow-on communiqué from the terrorist said they would not commit further attacks in Europe if Spain withdrew its troops.  However, a bomb made of the same materials as in the previous attacks was removed from one of Spain’s high-speed tracks last week, and a high speed train in Germany ran over metal bars this weekend, apparently an attempt to derail the train.

Another terror front, occupied Iraq, which appeared to be settling down a few weeks ago, has heated up again, with US and coalition forces suffering casualties at rates similar to last November.  Al Qaeda militants appear to be making common cause with remains of the Hussein regime in disrupting the turnover of political control to the Iraqi provisional government June 30^th.  Shia clerics, anxious to assert political control of the Shia majority after decades of oppression under Hussein, contribute to the chaos.

So bottom line, we’re back to our 30 year estimate of fighting al Qaeda and related terrorists. 

Earnings

Earnings reports come fast and furious the week after next.  Estimates are for a robust 16.7% for Q1, 14.9% for Q2, 11.8% for Q3.  These numbers aren’t the home runs seen in the second half of last year(21.3% in Q3 2003, 27.8% in Q4 2003), but those quarters were in comparison to the disastrous numbers of 2002.  Some interesting trends: normally earnings estimates fall the closer to the reporting period, but in recent quarters we’ve seen the opposite trend.  We attribute this to aggressive clean-up of accounting practices following the implementation of Sarbanes-Oxley (and more usefully, the sight of corporate executives in handcuffs) and a tendency by corporate management to “low-ball” their guidance.  The net effect: the S&P 500 remains 30-40% undervalued, even with last week’s spike in interest rates.

Strategy

We’re fully invested in stocks according to clients’ individual risk tolerances.  We’re investing new accounts in anticipation of solid Q1 earnings reports.  We continue to monitor the world’s terrorism situation and have excluded those companies most sensitive to terrorism (e.g. airlines, hotels) from our portfolios.

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.