Eleven weeks into the new year, US stocks are lower, with the S&P 500 down 1.8% on the year, and the NASDAQ down 7.3%.  We had expected last year's rally to continue through month end of January.  However, stocks have moved in inverse reaction to gains in the price of oil, which set a record intra-day high today of $57.60 before closing at $56.40, a couple of pennies below yesterday's record close.  Our forecast was that oil would trade in a range of $42-48 through the spring, but colder than expected weather in the Northeast, compounded by hedge funds piling into the oil trade, has pushed the price of oil far above what either current inventories or growth in demand would imply.  Oil traded on January 1st at $43/barrel, and demand if anything is starting to ease (Chinese economy slowing somewhat, SUV sales in US down 20-30% in January-February.)  So we don't agree that certain forecasts of oil over $65 are reasonable or sustainable.  We expect the price of oil to ease this spring, allowing stocks to rally.

Annual rebalancing

We typically take profits in the first quarter in companies that have done well the previous year.  In 2004, energy stocks, HMO stocks, some healthcare stocks, and REITS did very well for us.  We don't own any home-building stocks, but that sector did well also.  Many of our clients will have received confirms for transactions where we sold part, but not all, of a position such as United Healthcare which had grown to an outsized position in an account.  We typically hold individual positions to about 2-3% of an account, so that, if something terrible happens to an individual company, it does not destroy the portfolio.  For example, Biogen is a company we have held for a long time in about 2/3's of our clients' portfolios.  On February 28th, Biogen announced that one person had died during a clinical trial of a new drug involving 5000 participants.  Sadly, we live in such a litigious society that, even though the drug may hold benefits for many people, it is unlikely to ever receive marketing approval.  Thus, Biogen's stock price was cut in half on the opening trade.

We also check how much a client's portfolio is allocated to certain sectors.  Our strategy includes putting 25% of our clients' assets into each of three sectors: technology, healthcare and financial services.  These are the three fastest growing components of the S&P 500, but also the most volatile (although the swings among these sectors tend to cancel each other out.)  The remaining 25% of portfolios are invested in sectors such as energy, consumer staples, REITS and other stocks with high dividends and low correlation to the overall S&P 500.  This last allocation further reduces risk in the portfolios, yet we usually outperform the averages by a couple of points a year.  This year, our clients are underweight technology and overweight healthcare, so we have adjusted portfolios accordingly.

As a result of these trades, many of our clients have realized large capital gains (taxable and non-taxable gains are always summarized at the bottom of your HCMI investment report.)  We will take as many offsetting capital losses through year end as practical, but clients should alert their accountants now if their gains are substantial (check your April 1st client report.)

Last minute tax issues

Be sure your accountant has a copy of your January 1st client report, which summarizes gains or losses we took in 2004.  Some accountants have asked about the tax basis of a small distribution associated with Advanced PCS stock.  This distribution is a residual balance associated with the merger of of Advanced PCS with CareMark last March.  Because the distribution is a small percentage of the overall deal, we are advising our clients' accountants to treat this as return of capital with no gain associated with it and have adjusted lower the cost basis of the resulting CareMark position.

Lastly, don't forget that investment advisory fees are tax-deductible.  Give your accountant copies of the invoices we send out quarterly, or contact us for a summary of 2004 fees.

Investment Climate

Since January 1st, oil prices rose further than we expected, but the dollar continues to recover from its December lows, interest rates continue to rise toward the 5% we expect by year end, corporate earnings continue to increase, the jobs situation continues to improve, economic reports look good, and inflation remains tolerable.  Investors, however, have no appetite for stocks because they fear that the inflationary impact of higher oil prices will cause the Fed to step up the pace of rate increases, and because they fear that growth in earnings and revenues is about to decelerate rapidly.  We're not convinced that these fears are reasonable.  While it's painful to pay more than $2/gallon for gas or $600 to fill one's heating fuel tank, energy is a significantly smaller cost to the present day economy than in 1974 during the "energy crisis."  Inflation still remains in the acceptable 2% range.  The Fed will continue to raise overnight rates (next meeting is March 22, an increase of 0.25% is expected), which will drive long rates (e.g. the 10 year bond) higher as well.  Higher long term rates draw in overseas capital (good for the dollar) and should also take some out of the froth in the real estate markets.  It's not healthy for the economy when home prices in many markets have doubled in the last 4 years.  While home-owners are "richer" on paper, new buyers are either shut out or spend too much of their income on housing.  Also, should prices fall sharply, people could find their equity wiped out, a more catastrophic economic event than the 2000-2002 stock bear market.

The earnings picture is very intriguing.  As a result of Sarbanes Oxley, we believe that corporations have become excessively cautious in making growth projections and are substantially low-balling their earnings guidance.  In 5 of the last 6 quarters, analysts underestimated overall S&P 500 earnings growth by at least 4%.  In Q4 2004, analysts had estimated 15.2% growth in earnings, but the actual number was 19.5%, with revenues up 12.9%.  So we expect that the current estimate for Q1 2005 of 7.6% to be way low.  Even if the earnings growth for Q1 comes in on target, by at least two measures the stock market is substantially undervalued.  By the Fed Model, assuming earnings growth of 10% in 2005, and the ten year treasury bond at 5.0% by year end, the S&P 500 is 18% undervalued. 

The other model compares the earnings yield of the stock market to the ten year bond yield.  The stock market's current P/E is 18.7 and forward P/E is 16.2.  To get the earnings yield, you invert the P/E ratio, so current earnings yield is 5.4% and forward earnings yield is 6.2% - both are higher than the current yield on the 10 year bond of 4.47%.  James Altucher at Formula Capital has published research which shows that, on the previous 5 times since 1980 that the earnings yield has been higher than the yield on the 10 year, the stock market has shown gains averaging 27% over the following year, 63% over the following three years, and 121% over the following five years.  There's no guarantee that history will repeat a 6th time.  If nothing else, the period of 1980-present was a period of generally declining interest rates, while we expect rates to rise over the next five years.  Still, we believe this model indicates a strong buy signal.

Investment Strategy

Over the last 4 weeks, we've fully invested  the cash raised from rebalancing sales and from client deposits.  We are avoiding the home-building stocks, which we believe will get slammed later this year after a powerful three year rally.  We're scaling back our energy exposure.  We're scaling back our REIT exposure, although we have take advantage of Fannie Mae's regulatory woes to build up positions in that company.  In financial services, we're putting money in companies that will not be adversely impacted by higher borrowing costs (i.e.. service providers over lenders.)  Although we've been burned by sell-offs in Merck, Pfizer and Biogen in the last 6 months, we're putting some money into Biogen, a lot more money into healthcare stocks such as HMO's that have less litigation exposure and also into medical supply companies. 

We're putting a lot of money into technology companies, which no investor seem to like right now.  A company like Cisco, which carried a 220 P/E during the Internet bubble, now is priced at a P/E of 23.  The companies that we're focusing however, are in the mid-cap to small-cap range, because it's a lot easier to double the sales of a $1 billion revenues company, than double the revenues of a large cap company.  For example, Cisco has revenues of $27 billion,  Microsoft revenues of $40 billion, Walmart has revenues of $79 billion,  and General Electric has revenues of $166 billion (estimates for 2005.)  A summary of the 21 new companies we're adding to our portfolios can be found here.