HCMI Client Letter - August 9th, 2004

Stocks have fallen 7 of the last 8 weeks and are now trading below the "hard floor" of 10,000 on the Dow, 1100 on the S&P 500 and 1900 on the NASDAQ  we described last month.  With 80% of S&P 500 companies reporting, earnings grew 25.9% in Q2, a touch behind the 27% rate of Q1 and well ahead of the of the 20.8% rate estimated.  Historically, earnings surprise to the downside, but this is the 4th straight quarter of upside earnings surprise, and the 4th straight quarter of plus 20% growth (compared to the historic average of 8% growth.)  Stock prices should be flying, but investors are on a "buyers strike."  Why?

Uncertainty trumps earnings

The probability of George Bush being re-elected slid from 80% in January to 53.7% of late, and dipped below 50% at the start of the Democratic National Convention last week, according to TradeSports.com, which lets individuals buy futures on political outcomes as well as sporting events.  We keep an eye on this service as well as the state and national polls, because TradeSports correctly called last fall's California gubernatorial election, the nomination of John Kerry as Democratic candidate, and John Edwards as vice-presidential candidate, and generally has been a more predictor than opinion polls.  Critical issue in November is the breakdown of the electoral vote.  6 months ago, we opined that Bush would retain all the states won in the 2000 election, and might pick up 4-6 additional states.  At this point in time, Bush looks unlikely to gain any additional states, and if he loses either Florida or Ohio, states currently polling about 50/50 for the two candidates, he loses the election.  Investors generally speaking would prefer a Bush second term, but at this point would take Kerry just to know where they stand. 

The price of oil traded up to $45/barrel last week, and is still hovering in the $44 dollar range.  For the most part, OPEC is at full pumping capacity, while disruptions threaten other sources of supply.  Terrorists in Iraq manage to blow a hole in a pipeline capable of delivering 1.2 million barrels/day about once a week.  The Russian Oil company Yukos, which may well be taken over by the Russian government, could be forced to shut down later this week, taking another 1.2 million barrels/day offline.  Venezuela's capacity is falling due to political problems in that country, which is causing problems in the US, the largest purchaser of oil from that country.  Meanwhile, demand remains high as worldwide economic growth remains strong.  Oil might not fall back below $40/barrel until the distribution problems are solved, or unless high oil prices reduce worldwide economic growth.  In the US, it takes half as much energy to produce a unit of GDP as a generation ago, but energy consumption is at an all-time high.

Terrorism warnings continue to unsettle markets and worry consumers.  The Democratic Convention passed by without incident, but the Olympics and the Republican convention remain.  The situation in Iraq remains grim, with the possibility of civil war breaking out between the new interim Iraqi government and the armed militia of cleric Muqtada al-Sadr, and terrorist Abu Musab Zarqawi continues to launch suicide bombers against Iraqi civilian infrastructure.  Several mid and high level Al-Qaeda operatives were arrested recently in Pakistan and in Europe, but the arrests only serve to remind people that the Al-Qaeda threat is still out there.

Good news overlooked

Over the eight weeks, the yield on the ten year treasury has fallen from 4.85% to 4.2%.  This is the key rate for establishing both corporate borrowing and mortgage lending, so good news for business and consumers.  With inflation tame, and GDP growth slowing from plus 5% to plus 3%, investors expect the Federal Reserve to raise the short term Fed Funds rate 0.25% this afternoon, then leave rates alone for the rest of the year.  As we noted above, earnings growth have been over 20%/quarter the last 4 quarters (previous record was 3 plus-20% quarter in 1973.)  For the Q3, earnings are expected to grow about 15% (all numbers from First Call.)  A month ago, the Fed Model showed the S&P 500 about 35% undervalued, now about 48% undervalued.  In other words, the stock market would have to double from current levels to be at fair value.  Since investors rarely consult the Fed Model, and mostly respond to their emotions, the stock market can diverge from fair value for quite some time, but the odds are in our favor.

Strategy

We’re fully invested in stocks according to clients’ individual risk tolerances.   Many of our growth stocks fell in price QTD despite beating earnings estimates, but our energy stocks are doing well as are our interest rate sensitive stocks like REIT's, and we gained in our fixed income investments.   We expect the stock market to tread water through Labor Day, and we still expect the stock market to close out the year up 8% regardless of whether Bush or Kerry wins the Presidency.