HCMI Client Letter - May 2nd, 2005

Dear Clients and Friends,

 

On April 18th, we outlined our reasons why stocks should rise.  Stocks rallied sharply on the 19th, fell to a low for 2005 on the 20th, and have since worked their way higher.  The S&P 500 is down 4.0% on the year, and the NASDAQ down 11.5% YTD.
 
Since mid-April, oil rallied briefly to $55/barrel, but is now at $49.40/barrel as inventories of both crude and distillates accumulate.  A mix of economic reports show a slowing but hardly moribund economy.  Chief among them, the 1st quarter GDP report showed growth at 3.1%, down from 3.8% in Q4 2004, and below the estimate of 3.5%.  We don't have a problem with this lower report because, as we have often commented, growth in the 3.0-3.5% range is the healthy, long-term, non-inflationary growth rate for the economy.  The Federal Reserve Bank is widely expected to raise overnight rates by 25BP to 3.0% on Tuesday.  We expect two more 0.25% increases later this year, but we believe the imperative for the Fed to keep raising rates is diminishing with the slackening in economic activity.  The Fed has an eye on inflation, which is running at about 3.1% year over year, up from 1.9% a year ago,  largely on a 12.3% increase in energy prices.  If energy prices decline through the spring, as we expect, and economic growth remains moderate, inflation will take care of itself.
 
With 75% of S&P 500 companies reporting through April month end, earnings growth for Q1 is coming in at 13.6%, well over the 8% estimated coming into the reporting period.  We have repeatedly commented that companies are low-balling their earnings guidance in light of Sarbanes-Oxley requirements, and that's exactly what we're seeing again this quarter, with results exceeding expectations by 5.1%.  Certain companies like IBM and General Motors grabbed headlines with worse than expected reports, but we don't own those companies.  Our growth oriented companies are doing just fine by expanding the top line while controlling costs to boost the bottom line.  Growth estimates are around 7% for Q2, low teens for the second half of the year (all numbers from Thomson First Call.)  Given earnings growth of at least 10% over the next year, and a ten year currently at 4.25%, the stock market is undervalued by 38% according to the Fed Model.  Even if the 10 year rises to 5%, as we have expected in vain for the last year, the stock market still remains undervalued by 26%.
 
Bottom line
We're staying fully invested and putting new money to work on the dips.

 


Yours sincerely,
David Edwards, President
Heron Capital Management, Inc.
(800) 99-HERON
http://www.HeronCapital.com

The Heron Capital Management client letter is published immediately following quarter end and 1 or 2 additional times per quarter. The views expressed in this letter represent HCMI opinion and strategy as of the date published and can change at any time upon receipt of new information. Data quoted in this letter are from sources deemed reliable, but no guarantee of such data is implied.