HCMI Client Letter - September 14th, 2004

Stocks fell steadily from the third week of June through mid August, but since mid August have rallied back steadily.  The S&P 500 is now 2.2% off the high set late March, while the NASDAQ remains 10.3% off the high set in late January.  The advance appears to be driven primarily by short-covering rather than any fundamental change in news.  At a certain point new investors will be drawn in to invest a portion of the $7-8 trillion currently residing in money market accounts and uninvested in mutual funds, which would finally take US stocks to the plus 8% gains for 2004 we have discussed all year.  The major indexes are back above the "hard floor" of 10,000 on the Dow, 1100 on the S&P 500 and 1900 on the NASDAQ  we described in July as the likely lows for 2004.  According to the Fed Model (data from Economy.com), the S&P 500 remains undervalued by 28-36%.  At this point, the S&P 500 is up only 1.5% on the year, so still further upside between now and December 31st.

Bush and the stock market

For the last 6 months, the stock market has moved in lockstep with the probability of George Bush being re-elected.  Correlation doesn't necessarily imply causation.  However, as we commented before, the investor class generally prefers the loose regulation and deficit spending of the Bush administration to the likely tighter regulation and tax increases of a Kerry administration.  As the Iraqi situation destabilized last winter, and as the Democrats challenged Bush, the probability of his re-election dropped from 75% to a low of 49% right before the Democratic National Convention.  We keep checking in with TradeSports because this gambling site correctly picked Schwarzenegger for California Governor, Kerry for Democratic presidential candidate, and Edwards for Vice-presidential candidate, which is a better track record than most polls. 

TradeSports.com - % probability of Bush reelection - last 61%

Generally speaking, if a sitting President does a relatively good job of promoting his accomplishments, the second election is just a formality (for example, Ronald Reagan won in 1984 with 58.8% of the popular vote and 97.6% of the electoral vote.)  Bush, however, has done a particularly poor job of promoting his administration, and so finds himself in a very close race.  To understand how Bush could win re-election, despite a good chance of again losing the popular vote, we examined the state by state electoral count with data provided by Rasmussen Reports.

Since the last election, changes in US population have resulted in the addition of 1 electoral vote, and a net shift of 6 votes from Democratic to Republican states.  So if Bush wins the exact same states as won in 2000, he actually increases his lead over the Democratic challenger by 13 votes.  Among a number of states where the outcome is in doubt, New Hampshire, Wisconsin and Ohio are most likely to switch sides.  New Hampshire, the one traditionally Republican state in New England, may vote for the (relatively) local guy, John Kerry, who not only is the Massachusetts junior Senator but also a former Deputy Governor of Massachusetts.  Even shifting 4 votes still leaves Bush in the lead.  It is also possible that Wisconsin, reflecting a population shift away from the traditionally union/Democrat South to the more rural/Republican north, votes Republican, which shifts 20 votes to Bush. 

The ultimate battleground state is Ohio, which, with 20 electoral votes, shifts 40 away from Bush if it goes Democratic, and costs him the election.  Bush and Kerry, Cheney and Edwards, have made multiple visits to Ohio in the last three months.  According to a CNN/USA Today/Gallup poll published September 9th, Bush leads Kerry by 9 points, reversing the trend of just a month ago.  The lead could be reversed again if Bush does particularly badly in the upcoming Presidential debates, or if a terrorist attack in the US convinces the electorate that Bush is not capable of protecting the homeland.  Our portfolios are currently configured to assume Bush wins re-election, so we'll see in just 50 days if we made the right call.

Oil weighs on stocks

Raw demand for oil suggests a price of $30-35 barrel; risk of oil flow disruption in Nigeria, Venezuela, Saudi Arabia and particularly Iraq adds about an $8 dollar "uncertainty premium"; hedge funds piling into the oil market add another $5, leading to a record $49.50/barrel a few weeks ago (adjusted for inflation, the real record was set at over $66/barrel during an OPEC boycott in 1981.)  Recently, oil has traded around $42-44/barrel as some of the speculators got washed out.  Surprisingly, high energy prices seem to have caused little change in US consumers behavior (perhaps because, as we calculated some time ago, net of depreciation, financing charges, insurance and maintenance, fuel accounts for only 5-10% of the operating cost of a US car.)  Walmart, which caters to the most price-sensitive part of the US population, noted that same store sales came in at the low end of expectations (indicating perhaps that consumers had less disposable income,) but Walmart also sells gasoline through its Sam's Club subsidiaries, so the effect should have been a wash.  Since energy consumption has fallen by half for a unit of GDP over the last 30 years, high energy costs don't seem to hurt the economy as badly as during the energy shocks of the mid-70's and early 80's.  None the less, each spike in oil towards $50 took a corresponding whack out of the stock market this summer.

Iraq and Al-Qaeda

Anyone who doubts that the "war on terror" exists need only look at Russia, which, over a ten day period, saw two airliners and a subway station bombed, and experienced the most horrific attack yet - at least 350 (possibly as many as 700) civilians killed, half children in a school in Belslan, Russia.  The terrorists responsible appear to be primarily Chechens, although is seems that there were a number of Arab, particularly Sunni Muslim, "consultants" in the massacre.  The declared aim of the attack was to stir up war across the Caucuses.  US and European markets scarcely gave notice to the these attacks, or to last week's latest scary videotape from Ayman al-Zawahiri, Al Qaeda's chief ideologue and Bin Laden's second-in-command.  But just three years ago, the 9/11 attack cost the US economy $75 billion and put the US airline industry on life support (US Air today declared bankruptcy for the second time in two years.)

In effect, the Western World, primarily the US, Britain, Australia and Russia, is engaged in a World War with the 1% of the Muslim world that supports Al Qaeda and its affiliates.  The United States, through its sponsorship of repressive Arab governments since the 1950's, its arming of the Afghan Mujahidin to repel the Soviet invasion of Afghanistan in the 1980's, its purchase of Arab oil, which sends billions of dollars to the region which in turn is diverted to the terrorist networks, and its invention of the Internet, which allows efficient, anonymous communication among Al Qaeda cells, has created a Hydra; as fast as one terrorist cell is mopped up, three more take its place.  Meanwhile, Bin Laden and Zawahiri in Pakistan/Afghanistan, Moqtada Sadr and Abu Musab Zarqawi in Iraq, Yasser Arrafat in the West Bank, take on mythical status in the Arab world for simply surviving.  Like the Cold War, the US and its few reliable allies will be fighting this war for at least a generation. 

It is actually remarkable that there has not been a follow-on attack in the US since 9/11.  The DNC and RNC passed without incident (although Bostonians and New Yorkers mostly evacuated their cities while the conventioneers were in town).  The Olympics also passed without incident, although tourists stayed away in drove (when cameras panned the venues, at least 75% of seats were vacant.)  So the terrorists succeeded in damaging the economies of Boston, Athens and New York simply by creating a climate of fear.  It's also possible that the terrorist extract maximum advantage from doing the unexpected (e.g. the Belslan school attack.)  Or it's possible that US security procedures, while still rudimentary, are more effective than we realize. 

Earnings, Interest Rates and Economic Reports

The primary drivers of stock market value get scarce attention these days.   Earnings growth for Q3 is estimated at 14.8%, well above the historic average of 7%, but a slow-down compared to the last 5 quarters of plus 20% growth.  The 10 year bond, which is the key rate for both corporation borrowing and mortgage lending

continues its drift back towards 4%, offering another opportunity to refinance one's mortgage at a compelling rate.  Economic reports have eased in recent months; the unemployment rate fell to 5.4%, the lowest rate since the 9/11 attacks.  Jobs growth has been anemic, but even so a record 139.7 million Americans are unemployed.  Bottom line, we have an economy not too hot and not too cold.

Strategy

We have some new cash that we're investing by month end; other than that, we're waiting to see the outcome of the US Presidential election before making any big asset allocation moves.