The S&P 500 rallied
26.4% in 2003, but 4 months through 2004, the S&P 500 is virtually
at break-even, up 0.2% YTD. Earnings for the first quarter were
spectacular (more below), economic reports are solid and the jobs situation is
improving, so why isn't the stock market doing better? This chart shows
the S&P 500 in a tight trading range since New
Year's:
Joy over the improving
economic picture is balanced by fears about Iraq and the War on Terror, higher
energy and interest rates, and uncertainty about the November Presidential
election. Joy and Fear are equally balanced right now, leading
to a 5.6% trading range in the S&P 500, an 11.9% trading range in the
NASDAQ. Day to day volatility has been high, with half of trading days
year to date up or down 0.5% or more, but no actual progress has been
made. What will break the deadlock, leading to either higher or lower
stock prices?
Earnings
We're at the tail end of
the first quarter earnings reports, and the numbers have dramatically exceeded
expectations. With 82% of S&P 500 companies reporting, earnings grew
25.8% year over year (double the estimate at the start of the quarter,) and
revenues jumped 11.7%. In the last quarter, earnings grew 28.3% and
revenues 10.7%. With each passing quarter, comparisons become
progressively tougher, but overall, earnings should grow in the low teens
through the rest of 2004 (all numbers from First Call.)
77% of companies
reporting have beaten estimates versus 66% in the previous quarter.
As we commented previously, the application of the Sarbanes-Oxley
regulations has incentivized corporate management to low-ball estimates, and
also to avoid the accounting gimmicks that tripped up management at WorldCom,
Enron, Tyco and Adelphia. The quality of earnings reported is higher than
a few years ago.
Economic
Reports
GDP slowed from Q3's blistering
8.2%, maintaining a more sustainable 4.2% rate in Q4 and Q1. As we see in
this chart, the mild recession which began in the last year of the Clinton
administration and prevailed through the 9/11 attack, is now well in the rear
view mirror.
In the manufacturing sector, we
see higher orders, higher productivity, and higher output, generally
outstripping estimates. In the consumer sector, we see high housing starts
and resales, higher retail spending and high consumer confidence. Personal
income is drifting higher, and employment remains below the peak level set in
2000. However last month's outsize 308,000 (revised upward today to up
337,000) jump in payrolls was followed by today's 288,000 jump in
jobs, so the unemployment rate (latest 5.6%) should continue to fall through
2004, despite higher productivity and despite "outsourcing."
Overall, these reports point to
higher stock prices, although today's initial reaction was negative on concerns
that the Fed will start raising rates.
Interest
Rates
In April, long term
interest rates jumped dramatically higher, with yields on the 10 year treasury
rising from 3.68% in early
March, to the current 4.60%. The Fed Reserve did not change
rates at the most recent meeting, but indicated rates would go higher (so watch
the June and August meetings carefully.) Mortgage rates move in
tandem with the 10 year treasury
so the
cost of servicing a mortgage jumped about 10% in a little over 6 weeks (each 1%
rise in rates increases the monthly payment by about 10%.) This could
bring a screeching halt to the current housing boom and prick the real estate
bubble blown up by the 40 year low in mortgage rates. Particularly at risk
are people who bought the biggest house they could afford on an adjustable rate
mortgage. Still rates have backed up only to the level last seen in June
2002, so no need to panic yet, especially as higher long term rates, combined
with lowered money supply growth, reduces the pressure on the Fed to raise short
term rates. Our target for year end 2004 is still 5.25% in the 10 year
treasury.
Investors
typically worry about the impact of higher interest rates on the stock market so
here's an update on the Fed model, which determines whether the S&P 500 is
under or over valued given current interest rates and forward earnings growth
projections.
We coded this chart so that
when the S&P 500 Actual Value is greater than the Fair Value, it shows as
Red, Green otherwise. This is not a chart you can day-trade off of because
the data points are computed quarterly. Still, what we see is that, until
1998, the Fair and Actual Value held reasonably close together (even on a
logarithmic scale, the 1987 bubble and crash is tiny compared to the late '90's
bull and bear market.) Only in 1999 did a huge gap (bubble) open up with
Actual Value rising even as Fair Value was falling. The S&P 500 went
to the opposite extreme from mid 2002 till mid 2003, an excellent time to buy
stocks. Even now, with interest rates higher and the S&P 500 up 46%
from the October 2002 low, the model estimates that the S&P 500 is
undervalued by 40-45%. So in a rising rate environment, we have to be a
little cautious about certain industry groups like REITS, building stocks, and
brokerage firms, which are particularly sensitive to rising rates, but in
general we should be buying, not selling
stocks.
Energy
Prices
Spot prices for a barrel of oil
hit $39.57 this week; given high demand and constriction in supply, oil should
be over $40/barrel shortly, and gas at the pump over $2.00/gallon for the
summer. However, since energy as in input into the economy is only half
the level of a generation ago, we see a slight uptick in inflation, but no major
drag on the economy. As we calculated recently, given the cost of
depreciation, insurance, and maintenance for the average vehicle, gas prices
could double from current levels without causing a major shift in American
driving habits.
It is interesting to speculate
on the nature of energy markets 50 years from now. Oil production in the
Middle East is peaking now, and may be dramatically lower 50 years from
now. However, this will not mean the end of the world economy, which uses
oil not only for energy production, but also as a feedstock for producing
plastics and other industrial commodities. As energy prices continue to
rise, we expect nuclear energy to be revisited, (nuclear currently provides 75%
of the electricity of France.) We also expect continued research into wind
power and tidal power (neither is without environmental impact) and in producing
oil products from biomass conversion (e.g. ethanol from corn production,
composting of garbage.) We'll see some interesting investment
opportunities in the years to come.
Presidential
Election
At the national level, the race
between Bush and Kerry is a statistical tie. At the state level, it looks
like Bush will retain all of the states from the 2000 election, possibly pick up
a few more, and will win in the electoral college. Still the race is a lot
tighter than 6 months ago, and investors don't like the uncertainty.
Iraq - War on
Terror
Two months ago, the situation
in Iraq looked calm and stable. A month ago, Iraq looked like it would
spin completely out of control. A measure of stability has been achieved
in the last few days, but only at the cost of 140 troops in April and 26 so far
in May (vs. 52 in March and 20 in February.) One year after the fall of
Baghdad, what has the US learned in the Middle
East?
In Iraq, no chemical,
biological or nuclear weapons have been found, or programs related to their
production. We know these weapons existed when UN inspectors exited the
country in 1998, but we don't know whether the WMD were destroyed as Saddam
claimed, or were transshipped to Syria and other countries. About
3,000,000 tons of conventional weapons (that's 300 pounds for every man, woman
and child in Iraq) are in the process of being destroyed, but much has fallen
into the hands of insurgents. Also learned, when it comes to "nation
building," no good deed goes unpunished.
Libya was operating an active
nuclear and chemical weapons program in Libya (it was long rumored that Iraq had
shipped scientists, money and technology to Libya.) In return for giving
up these programs, sanctions against Libya are being
reduced.
Iran was much closer to
obtaining nuclear weapons than previously thought, in violation of Iran's
signature on the non-proliferation treaty. Iran is still frantically
trying to complete this program.
Pakistan was bartering nuclear
technology all over the Middle East and to North Korea, with "Father of the
Pakistan bomb" Abdul Kahn as chief salesman. Pakistan is at best a
diffident ally in the effort to round up Osama bin Laden and other Al Qaeda
leaders along the Pakistan/Afghanistan border.
UN officials, including the son
of Secretary-General Kofi Annan, facilitated the theft of $5-10 billion
from Iraq's "Food for Oil" program. Over 200 primarily French,
German, Russian companies, politicians and terrorist organizations benefited
from skimming the program.
Neither the UN nor allies such
as Spain have any stomach for dealing with terrorist attacks. The UN
evacuated its office last summer following a car bomb attack against its offices
in Iraq; Spain withdrew its troops from Iraq following the Madrid terror
attack. It doesn't really matter whether the US has the rest of world's
goodwill; with the stalwart exception of Great Britain, the US is in the War on
Terror by itself.
Lastly, the US has learned that
its intelligence agencies are woefully inadequate in navigating the seedier
parts of the planet. The 9/11 commission, partisan as it is, revealed that
both the Clinton and Bush administrations failed time and again to adequately
understand and take action against the Al Qaeda threat. Even now, the
failure of Al Qaeda to launch a follow-on attack in the US has been more a
matter of luck than skill.
Strategy
Companies that are relatively
insensitive to interest rates (no debt, don't depend on customer financing)
should do well in the current expanding economy. Interest rate sensitive
stocks, (for example, REIT's which are down 15% QTD) might become interesting
when rates stabilize at higher levels. We're also keeping the maturity of
fixed investments on the short side. Our forecast remains 8% rise in the
S&P 500 for 2004, so that's a gain of 7.8% from now till year end.
We continue to monitor the world geo-political situation. The
Olympic games and the US presidential nominating conventions look particularly
at risk for terrorist action.
Yours sincerely,
David Edwards, President
Heron Capital Management, Inc.
(800) 99-HERON http://www.HeronCapital.com
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.
