The S&P 500 gained 1.2% in the second quarter, while the NASDAQ gained 2.9%.  YTD through June 30th, the S&P 500 is down 1.1%, the Nasdaq down 5.5%.  Over the last two weeks, however the S&P 500 has rallied 3.5%, the Nasdaq 4.6%.  The comments below are slightly dated - we held off publishing them in the aftermath of the London terror bombing and have added a section commenting on the London bombing.  Our thesis remains that stocks are undervalued and investors should be buying them.  After the impressive rally of the last 6 days, with the S&P 500 making a high for the year today and breaking a high set 4 years ago, it seems that others are thinking the same way.

Al Qaeda and Iraq

Al Qaeda affiliates struck the London Underground system on July 7th, killing 51, wounding 700, and killing the 4 bombers.  Within 12 hours, British police had identified one bomber, within 72 hours, three more and were rapidly tracing the network, leading already to the arrest of one "person of interest" in Egypt.  While a moment of unspeakable horror and tragedy for the victims and their families, the global significance of the attack is up there with a medium sized plane crash.  As experts had predicted, the United Kingdom was a likely target (8 other plots have been foiled in the last two years) due to a large and disaffected Muslim population and because of Britain's support of the US in the Iraq war.  So the mood in England was resignation rather than surprise. 

Meanwhile, the nature of this attack tells much about Al Qaeda remaining capability.  Prior to 9/11, Al Qaeda made progressively larger and more dramatic attacks against major financial, governmental or military targets (the first WTC attack, African embassies, USS Cole), culminating in the 9/11 attack which was a simultaneous assault on financial (WTC), military (the Pentagon) and political (either the White House or the Capitol) targets.  Subsequent attacks have been primarily against civilian targets (Tunisian synagogue, Bali resort, Madrid commuter trains, London Underground) with a progressively declining body count and progressively shorter attention in the news (within 48 hours of the Underground bombing, the lead story in the United States was Hurricane Dennis.)  If these attacks are the best Al Qaeda can do in the West, Western security forces are doing a pretty good job.

In Iraq, suicide attacks continue at a reduced pace, with Iraqi civilians and military taking the brunt of the casualties.  There appears to be two entities fighting US and coalition forces in Iraq: disgruntled Sunnis and foreign Jihadis.  The Jihadis appear to be less concerned about spilling Iraqi blood.  Last week, a car drove into a crowd of children receiving candy from two US soldiers and detonated.  The explosion killed 1 soldier, and 25 Iraqi children.  Episodes like this make Iraqis more likely to turn in the Jihadis.  Two weeks ago, the kidnapped Egyptian ambassador was executed by Jihadis; 1 week ago, his captors were identified by locals and captured.  The Sunni insurgents are less blood thirsty, and also more likely to be co-opted by the political process.  If these trends continue, it's quite likely that US forces will withdraw to a series of 14 bases currently being prepared in Iraq, drawdown troop strength by half, and leave the bulk of fighting insurgents to the Iraqi military, all by mid to late 2006. 

As we've said before, the conflict between the Islamic and Western worlds began centuries ago and will last at least another generation.  However, as long as the West can keep nuclear, biological and chemical weapons at bay, the ability of the Jihadis to damage the Western economies is limited.  It was not surprising therefore, that European and American stock markets shrugged off the latest attack within 24 hours.

(Original comments written July 5th) 

Stocks rallied back to break even on the year by June 1^st, meandered on both sides of unchanged for the rest of the quarter, before declining slightly at quarter end.  Earnings for the first quarter were solid- up 13.1% versus forecasts of 7.8% in March.  The current forecast for Q2 earnings is 7.8%, but we expect actual earnings to exceed forecasts once again. 

The yield on the 10 year slipped from 4.45% last quarter to 4.05% this quarter, which leaves the S&P 500 undervalued by 35% according to the Fed Model.  The most recent GDP clocked in at an impressive 3.7%, corporate profits are at an all-time high, personal income and disposable income are at all-time highs, personal bankruptcies declined by 10% over the last year (many commentators have worried that the US consumer is over-laden with debt), consumer confidence is high, housing sales and starts continue at record levels, inflation remains low despite oil hitting a record $61/barrel last week, interest rates are hovering near generational lows, employment is up, the unemployment rate is down, yet no one will buy stocks – why?

Efficient Market Theory vs. Caribou Theory

Academic observers theorize that because information about US corporations is widely and rapidly disseminated, no investor or portfolio manager should be able to derive “excess profits” in the stock market because no one has an edge in information gathering.  However, a small percentage of investors consistently out-perform the market.  While these portfolio managers vary in investment style, they share a contrarian streak and move in counter-trend to most investors. 

We have developed the “Caribou Theory” to explain this phenomenon.  10,000 years ago, hunter gatherers learned to follow the tracks of the Caribou herds, which would lead them to food.  Hunters who went in a different direction generally starved to death.  Over time, natural selection programmed trend following into the human brain.

Unfortunately, financial markets don’t act like Caribou herds.  If all the “hunters” buy in to the same idea, who will they sell to when the market turns?  Often times, investors will disregard information on, for example, relative valuation if they see that other investors are making money (there will always be a “greater fool” to sell out to.)  Time and again, we see a “ballistic curve” as the higher a market goes, the faster it rises (until the inevitable sharp reversal and crash.)  We’ve seen this in the US stock market in 2000, 1987, 1964 and 1929, in the Japanese stock market in 1989, in the gold and silver markets of the early 1980’s, in the US real estate in 1989-91.

Today’s hunter-gatherers seem to be following two herds: average citizens are rushing into real estate, especially certain coastal regions and the second home market, because who can deny 30% gains in a quarter? (especially compared to stock market returns, which are at breakeven over the last 5 years.)  Meanwhile, hedge fund traders, who have had a sub-par year so far, appear to be piling into the energy markets (driving oil from $45 Jan 1, to $57 April 1, to $49 in early June, to $61 June 29^th) regardless of the underlying inventories (above average) and demand (about 2% year over year growth.)  We have taken a counter-trend position on both, advising our clients to be exceptionally cautious on real estate, and have scaled back our energy positions in the face of $60/barrel oil (we aggressively added to our energy position some years ago when oil slumped to $11/barrel. 

Last fall, hunters followed a different herd, the declining dollar (much commentary about how the US dollar would lose its “reserve currency” status.)  We advised our international clients not to worry too much about this trend, which reduced the purchasing power of their US dollar investments.   The dollar bottomed against the Euro in December and made a 13 month high against the Euro this week.

Politics

Bush may have “earned political capital” in the 2004 US elections but appears to have squandered that capital through an ill-advised foray into revising the Social Security system and from an inability to bring the Iraq war to a conclusion.  The unexpected retirement of Supreme Court justice Sandra Day O’Connor will set off a firestorm of partisanship for the next three months, and then political system will grind to a halt as the US House of Representatives gears up for the 2006 re-election.  Bottom line: Bush will spend his second term in “lame duck” status, as did Bill Clinton in his second term.

Names at the top of the list for the 2008 Presidential election include: Republicans-Senators John McCain and Bill Frist, former mayor Rudolph Giuliani, Democrats: Senator Hillary Clinton way out in front, followed by Senators John Kerry and Joe Biden.  Polls and Tradesports.com show Democratic and Republican candidates pretty much tied at this point in time; the Republicans have exhausted their appeal, but the Democrats have failed to come up with compelling alternatives.  Just 1,222 days until the next election.

Strategy

For 6 months, we have said stocks should be higher, and for 6 months, stocks have gone nowhere.  Cash accumulated during Q2, but we invested all of it by mid-June.  The yield on the 10 year continues to baffle us (it hovers near 4% when we believe it should be 5% or more.)  However, such low yields support the housing market even at dizzying levels, and more importantly enable corporations to fund projects at generation lows, which supports corporate growth, corporate profits and higher stock market valuations.  Oil might be high, but other commodity prices have settled back, so inflation remains low.  High oil prices appear to exert much less influence on the economy than during the oil shocks of the 1970’s (when oil peaked 50% higher than current levels, adjusted for inflation.

Our target of 8% growth in the S&P 500 remains unchanged from the start of the year, which means 9% gains from current levels.  Stocks rarely move much in the third quarter as investors head to the beach, so we may get all of our gains in the 4^th quarter, as we saw last year.  We’ll be reading the next round of earnings reports starting next week, and we’ll be investing new accounts as they come in.