HCMI Client Letter - October 4th, 2004

Stocks failed to move higher in Q3, leaving the S&P 500 just over break-even on the year, with the Dow Industrials down 3.4% on the year, the NASDAQ down 7.4% on the year.  We’ve projected 8% gains for the S&P 500 for the full year, so how can stocks rally 8% in just 3 months?  As we saw on the first day of this quarter, the S&P 500 gained 1.5%, the NASDAQ gained 2.4% and the NASDAQ 100 gained 2.8%, taking stocks to the best levels since early July. The only way to catch these rallies is to stay fully invested, and so we are. 

With 10 year interest rates hovering around 4.25%, and growth in corporate earnings estimated at 14-17% for Q3, 16% for Q4, the S&P 500 remains undervalued by 35-45%.  However, analysts are projecting a sharp deceleration in earnings growth for 2005, from 18.0% in 2003, to 19.5% in 2004 to just 10.1% in 2005.  Companies continue to grow both top and bottom lines at much higher than historic averages, but the comparables get harder with each passing year.  Still, stocks should be higher – what’s holding them back?

Oil

Oil set a new all-time high last week just over $50/barrel.  The same factors that have pushed prices higher all summer – high global demand, political and terrorist disruptions in multiple oil producing countries – were exacerbated by 4 hurricanes which shut down US off-shore production in the Gulf of Mexico, removing 1.5 million barrels/day from US domestic production (500,000/BPD remains off-line.)  At a time of the year when US refineries should be running flat out producing heating oil, inventories are at a 20 year low.  Additional supply can’t get here fast enough from the Middle East, so oil prices remain high.  Gasoline prices, however, peaked in July and remain off the highs, which implies that when the supply issues get sorted out later this fall, prices will moderate  Gasoline for sale today was refined months ago, therefore supplies of end-products are plentiful; it’s the supply of processing stock that’s the problem right now.

A high oil price has had less impact on the world economy than would be expected.  Oil is a much smaller component of GDP than 20 years ago.  Europeans, whose gasoline prices average $6-7/gallon, have shown that consumers can adapt to higher prices.  Meanwhile, we always have a couple of energy stocks in every portfolio, and have benefited from gains ranging from 18-30% in Exxon/Mobil, Haliburton, Schlumberger and Ensco.

Terrorism & Iraq

Last week, al Qaeda’s number two al-Zawahiri issued an audio-tape statement.  A year ago, such statements caused markets to swoon, but the latest was ignored by markets, partly because investors have programmed terror attacks into their investment models, partly because al Qaeda prime (as opposed to the many off-shoot organizations responsible for, for example, attacks in Iraq and in Madrid last spring) appears to be on the defensive in Pakistan, unable to mount a direct attack in the United States, and frustrated by the unwillingness of most Muslims, and nearly all Muslim governments, to take up the cause of Jihad.  The United States appears to have obtained the support of President Musharraf in going after al Qaeda targets in the Pakistani tribal areas; this support includes purging pro-al Qaeda and pro-Taliban elements from the Pakistan intelligence services.

In Iraq, US and Iraqi forces battle 20-30,000 insurgents, many affiliated with cleric Moqtada Sadr, and foreign fighters affiliated with Jordanian Abu Musab al-Zarqawi.  Six major battles have been fought in the Sunni triangle and in Baghdad’s Sadr City since April 2004, but in most cases US forces held back from delivering the coup de grâce to rebel forces to limit civilian casualties and avoid damaging religious monuments.  However, over the weekend, US and Iraqi forces routed insurgents from Samarra, regaining control of that town and cutting the road (and therefore supply route) to Fallujah (the center of Sunni resistance, controlled by rebels since April.)  Ahead of Iraqi elections in January, the US appears determined to suppress the insurgency, regardless of collateral damage.

US Presidential Election

John Kerry pulled out a badly needed win over George Bush in the first of three debates, erasing Bush’s lead in the national polls of 3-8 points and taking the race back to 49-49 according to the latest CNN/USA Today/Gallup poll. As we’ve said before, it’s the electoral vote that counts.  According to Rasmussen Reports, Bush has a lock on 213 electoral votes, versus Kerry with 169 and 156 up for grabs (defined as states with less than a 4% gap between the candidates.)  Including the electoral votes of the toss-up states according to the most recent state polls, Bush would shift Iowa, Michigan, New Mexico, and Wisconsin to the Republican column, losing only New Hampshire to Kerry, and winning the election 313-225 (270 needed to win.)  The problem with this analysis is that nearly all the state polls pre-date last week’s debate, so once again we don’t know where we stand on the election.

Strategy

We’re fully invested in stocks according to clients’ individual risk tolerances.  Just over four weeks remain until we get closure on the US Presidential election.  We continue to monitor events in the Middle East, cost of energy at home.  Economic growth remains solid, interest rates and inflation remain stable.  In all, a benign environment for stocks and we’re overdue to be rewarded.