The S&P 500 lost 2.2 %  in the first quarter of 2005, while the NASDAQ declined 8.1%.   It was a tough quarter for growth companies, which account for about 75% our stock investments.  Earnings grew 19.5% in Q4 2004, but are projected to grow only 7.8% for Q1 2005, and 10.3% for all of 2005.  Companies continue to grow both top and bottom line, but the comparisons are now versus the robust numbers of 2004, rather than the sickly numbers of 2003. 

When investors see growth decelerating, they’re willing to pay less for future earnings, resulting in the phenomenon of “P/E compression” where stock prices fall even as earnings rise.  This compression can be overdone.  From the height of the Internet bubble in 2000, when the Price/Earnings ratio on the S&P 500 was 39, the P/E ratio has fallen to the current 16.2.  However, the fair value P/E ratio implied by the Fed Model is 22 (given the current 4.45% yield on the 10 year treasury,) which implies that the S&P 500 is undervalued by 30%.  Even if the 10 year yields 5% (our year end target,) the S&P 500 is undervalued by 20%.  Given the general undervaluation of stocks right now, we took our clients fully invested in the last couple of weeks, and are now waiting for the next round of earnings reports, which starts in the second week of April.

Oil

Our January forecast was for oil to trade in a $42-48 range through the spring, but actual prices blasted through that range, touching a record $57.70 on April 1^st, a year-to-date gain of 37% and a year-over-year gain of 68%.  However, year-over-year demand for oil products is up only 2%, and crude oil stocks are at the highest level in three years, with rising imports outstripping consumption.  How can oil be at its current record levels?  Checking the statistics at the NYMEX, we see record open interest in the Crude Oil contracts, up 30% from a year ago and 67% from two years ago.  The high level of open interest reflects some desperation by large users of oil such as airlines to lock down supplies, and we suspect also speculators such as hedge funds have entered this market in a big way for the first time.  However, the major oil companies are not undertaking any major new exploration programs, indicating that they think prices will fall.  Bottom line: the price of oil is not trading on fundamentals.  A few more weekly reports of above average inventories and we would expect to see oil back in our $42-48 target range, which would be very supportive of the stock market.

Housing Market

Far more disruptive to the economy would be a bursting of the current real estate bubble.  Prices are at record levels in many markets, soaring 22% in the past quarter in just the New York City market.  The explanation is that buyers are rushing to buy while mortgage rates are still low, which implies that most buyers don’t understand the risks they are taking.  For example, if a homeowner buys a $1 million dollar house, 20% down, 80% financed at 5%, the monthly mortgage payment is $4,300.  If rates rise to 7%, the same loan would cost $5,300/month.  To match monthly payments, a new buyer could only borrow $650,000 with $200,000 down, which implies that the $1 million house is now worth only $850,000, a decline of $150,000, which wipes out 75% of the home-owners $200,000 in equity.  Given that US homeowners have far more wealth tied up in housing than in the stock market, a 2% rise in mortgage rates could be disastrous.  Luckily, houses aren’t marked to market daily as are stocks, so most homeowners won’t be aware of the loss in value until they have to sell.  The hoped-for outcome is that housing prices level off after doubling over the last three years.

US Dollar

In fits and starts, the US Dollar continues to rise versus the Euro and Yen.  The trade deficit seems to matter less than relative interest rates, and, as the Fed continues to raise rates a quarter point with each meeting, money continues to flow into the US currency.  The weak jobs report of April 1^st knocked the dollar back somewhat (low jobs growth implies that the Fed will raise rates at a slower pace, which keeps the relative yield differential low), but the manufacturing and service sector reports released later that day implied that the economy is growing just fine. 

The jobs report has two components, “jobs created” which is calculated by surveying companies, and the “unemployment rate,” which came down to 5.2% from 5.4% and is calculated by surveying households (and is deemed less reliable than the company survey.)  It seems that companies are being extremely vigilant about taking on new hires, but job seekers have become very clever at finding jobs (self-employment, for example) that are not counted in the company survey.  According to the company survey, 110,000 jobs were added, but, estimated by the household survey, 350,000 jobs were added.  The “truth” lies somewhere between these two estimates, but net, we believe that the economy is stronger than the jobs report would imply, we believe rates are going up by at least ½ percent across the yield curve by year end, and we conclude that the dollar will continue to strengthen, which is good news for the stock market, even if higher interest rates are not.

Al Qaeda/War in Iraq

Both Al Qaeda and the insurgency in Iraq have fallen off the headlines recently, with no terrorist attacks against Western Targets since the Madrid train bombing in March 2004, and with insurgency attacks in Iraq directed more against Iraqis than coalition forces.  Al Qaeda’s representative in Iraq, Abu Musab al-Zarqawi and the Jihadi or international insurgents appear to running out of maneuvering room as the Sunni, or nationalist insurgents appear to be joining the political process in Iraq.  Bin Laden appears to be in the tribal areas of northern Pakistan.  The recent sale of F-16 to that country (banned after Pakistan tested a nuclear weapon some years ago) seems to indicate that Pakistan will now allow US special forces to go after Bin Laden in that region. 

This is not to say that the capture of Bin Laden is imminent – Atlanta Olympics bomber Eric Rudolph eluded the FBI for five years in the North Carolina woods with far fewer resources.  Also, it’s still possible for Al Qaeda or one of its many affiliated organizations to strike again, and the nightmare scenario remains that one of these groups obtains a functioning nuclear weapon.  However, radical Islam appears to have lost momentum for the time being in the Arab World, from the Muslim Council of Spain recently issuing to a Fatwa against Bin Laden, to the succession of free elections in Afghanistan, Iraq, and now potentially in Lebanon and and perhaps eventually in Egypt. 

Strategy

The declines of 2.2 % in the S&P 500, 8.1% in the NASDAQ of the first quarter have taken stocks to very cheap levels, given an economy growing at 3.5%/year with earnings forecast to grow 10.3%.  However, higher interest rates are tough on the financial service sector, and any sector such as housing which relies on cheap credit.  Normally, our healthcare stocks, which grow independently of the interest rate cycle (because people need drugs and care regardless of the state of the economy,) would be shining right now.  However, several well-publicized problems (Merck last year with Vioxx, Biogen more recently with Tysabri) have cut the stock prices of many of these companies in half.  We’ve had better success with healthcare technology companies such as Arrhythmia Technology, maker of heart monitors, up 29% since we began adding it to our clients’ portfolios a month ago.  We have upped our exposure to some large, many mid-sized technology companies, which we believe have good opportunity for growth.  We pared back our energy and REIT exposure.  We maintain our 8% target for the S&P 500 for 2005, which is 10.5% above current values.

Correction

Last month's newsletter linked to last year's mid-cap stock recommendations.  The current recommendations are here.