HCMI Client Letter - November 1st, 2005

Dear Clients and Friends,

The S&P 500 lost 1.5% in the 3rd quarter and is up just 0.8% for the year.  Energy prices, the bugaboo of 2005, have improved in the last 4 weeks, with oil dropping to $59/barrel from the post-Katrina high of $70.40, and gas at the pump dropping from a nationwide average of $3.05/gallon to $2.49.  With two thirds of companies reporting, Thomson Financial estimates that Q3 earnings grew an average of 16.1%.  The most recent GDP report for the quarter ending September 30^th was, at 3.8%, the 11^th straight quarter of plus 3% growth in the economy (the full impact of the three hurricanes won’t be felt until Q4, and even then growth should exceed 2.5%.)  The Federal Reserve increased overnight rates to 4.00% (a 0.25% rise well expected and the 12^th consecutive rate increase) and yields in the 10 years treasury rose to 4.6%.  Even so the US stock market remains under valued by 20% (assuming the rate of corporate earnings growth drops to 10% while 10 year yields rise to 5%.)

Despite good news on the economic side, investors continued to sell stocks, taking the averages to 5 months lows.  Part of the problem is investor uncertainty about the Administration of President Bush, who recently hit new lows in his overall approval ratings.  The bungled nomination of Harriet Miers to the Supreme Court, the indictment of Lewis Libby (chief of staff to Vice President Cheney) on perjury charges over “Plame Gate,” the 2000^th death of American military personnel in Iraq, and the complete collapse of fiscal responsibility in the latest Energy and Transportation bills have even conservatives fuming.  Good news, such as the ratification of a constitution in Iraq, the appointment of Ben Bernanke to succeed Alan Greenspan as Federal Reserve Chairman, and the relatively smooth confirmation of John Roberts to Chief Justice of the Supreme Court, is lost in the turmoil.  Investors are also uncertain over how many more times the Fed will raise rates, whether the housing bubble is flattening gently or is about to burst, and whether high gas and fuel prices will crush consumer spending.

After the nice rally off the July 2002 lows, stock market averages have fluctuated on either side of unchanged since December 2004.  What will it take to get stocks moving again?

Energy Prices

We wrote through the spring and over the summer that we expected energy prices to moderate in the fall, but Hurricanes Katrina, Rita and Wilma knocked that conclusion for a loop.  All but three Gulf Coast refineries are now back on line, but over a hundred oil and gas production platforms were sunk or damaged in the storms.  It could take over a year to restore that lost capacity.  The shortfall is being covered by higher imports from European refiners, but at higher cost.  According to the weekly EIA Oil and Gas Inventory reports, supplies remain above long term averages for this time of the year.  One interesting development is that demand is averaging 2-3% below year ago levels.  It seems that gas at $2.00/gallon, or even at $2.50 had little impact on consumer behavior, but gas at $3.00/gallon reached a tipping point; consumers are now driving less and choosing more efficient cars.  Whether this is a temporary or permanent phenomenon depends on whether gas stays in the $2.50-$3.00 range, or drops back towards $2.00. 

It will take over a year to restore the platform capacity lost in the Gulf, so we expect oil prices to settle into a $50-$60 range, versus our previous prediction of below $50.  If we are truly convinced that oil will remain priced at $50 or higher, we will start buying companies which produce energy using alternative methods than hydrocarbon extraction (tar sands, solar, nuclear) and which allow consumers to increase their energy efficiency (components for hybrid cars.)  Meanwhile, we’re glad we scaled back on our oil stocks in recent months.  The Oil Index (XOI) peaked at the end of September

and fell sharply thereafter.  A number of our clients have asked us recently why we haven’t been loading up on energy stocks.  We reminded them that we bought energy stocks back in the late 1990’s, when oil got as low as $11/barrel, and subsequently doubled or tripled our initial investments.  Oil stocks aren’t as attractive to us now with demand falling and supplies increasing.

Fed Policy

In last month’s newsletter, we opined that the Fed would raise rates at least three more times (0.25%/raise to 4.50%.)  Where did this estimate come from?  The Federal Reserve sets interest policy in relation to inflation rates, adjusted from accommodative (+1% to less than inflation) to neutral (1-3% over inflation) to restrictive (3% or more).  In 2001-2003, the Fed dropped rates substantially below the rate of inflation to boost the economy after the 9/11 Terror attacks, and as the economy fell into recession after the late 1990’s boom.  The Fed held rates at a 40 year low of 0.75% long after the economy recovered out of fear of “disinflation.”  Exceptionally cheap money on the short end allowed long rates to fall also to a 40 year low, which, passing through to cheap mortgage rates, triggered a real estate bubble.  How do we know that there is a real estate bubble?  Prices in most markets doubled or more from 2001 to 2005 while rents barely budged.  The price/rent ratio is as significant to real estate investing as the price/earnings ratio is to stock investing.  When the ratio doubles in stocks, as we saw in 1995-2000, watch out below.  The same applies to real estate, which is why for over a year we’ve been very leery of real estate investments.

If the Fed decides to move to Neutral stance, to which of several inflation measures does the Fed refer?  In the most recent report, CPI hit a cyclical high of 4.7%, implying Neutral Fed Funds Rate in the range of 5.7-7.7%.  Fortunately, the Fed is more interested in “Core” CPI, since food and energy are so volatile (in the September report, gasoline prices rose 18%, but probably fell as much for the upcoming October report.)  Core CPI in the most recent report was 2.0%, implying Neutral Fed Funds rate in the range of 3-5%.  Perhaps the best inflation gauge is the GDP Implicit Price Deflator, which rose 3.1% in Q3 2005, and implies Fed Funds at 4.1-6.1%.  Given that energy costs are coming down, it is reasonable to conclude that the Fed is done at 4.5-4.75%, or two-three more increases.

On a side note, stock markets rallied sharply two weeks ago on the nomination of Ben Bernanke to Chair of the Federal Reserve.  Bernanke is widely regarded as inflation hawk, but, of course, does not yet command the reverence accorded to outgoing Chair Alan Greenspan.  Few today remember that Greenspan had been Chair for less than two months when the October 1987 stock market crash occurred.  It took time for his halo to be fitted.

Delphi and General Motors

Investors were “surprised” when Delphi went into bankruptcy last month over, among other things, under funded pension liabilities.  This event is another chapter in the long decline of the American car industry, which even now accounts for 4.3% of GDP, with annualized sales currently averaging around 17 million units, and record dollar sales.  Despite this benign environment for car sales, General Motors lost $1.6 billion in the most recent report, so imagine how GM will perform in the next recession?  Some years ago, GM spun off Delphi, its parts division, as a separate company in an effort to reduce costs by shifting workers to another company (presumably at lower wages.)  However, Delphi is not cost competitive compared to Asian manufactures and went bankrupt, which means that the pension liabilities that GM thought were shifted away are now back.  Given world wide over-capacity in autos, the high cost producers which include GM and Ford will not survive.  We don’t own auto stocks and don’t expect to own auto stocks, but the debt downgrade of GM in light of Delphi’s difficulties puts shivers through the corporate bond market, so we continue to monitor the situation.

Hurricanes

Of the top ten strongest hurricanes of the last century, three occurred this past summer (Katrina #3, Rita #1, Wilma #6.)  Combined damage exceeded $150 billion and took the lives of 1300 across the Gulf states, Texas and Florida.  The summer of 2005 saw a record number of tropical storms of which a record 13 became hurricanes.  The question: is global warming responsible for this increased hurricane activity?  The answer, unfortunately, is not yet clear, with evidence on both sides.  One intriguing study noted that global ocean temperatures (as opposed to global air temperatures) are averaging 1-2 degrees higher than a century ago.  Since hurricanes form over water at a temperature of at least 80 F^o, could this extra heat account for the extra punch?  Well no, because the ocean temperature rise in concentrated in polar rather than equatorial regions. 

Post Katrina, we added bought into several property casualty companies.  Investors tend to sell off these companies after natural disasters although in fact, losses tend to fall hardest on the uninsured, and in any case the insurance companies are well reserved. 

Politics

The Harriet Miers nomination represented the moment that the Bush Administration lost credibility with its own conservative supporters.  We discussed in July how the Bush Administration was prematurely achieving “lame duck” status, and the situation has only gotten worse.  Disaster relief after Katrina demonstrated the hollowness of the Federal Emergency Response (and persistent cronyism in political appointees).  The budget process is broken, and only record Federal tax receipts have prevented the deficit from getting worse.  Social Security reform is dead on arrival.  Tax reform, as represented by this week’s report from the President's Advisory Panel on Federal Tax Reform,  is even more critical the Social Security reform, yet is likely to receive the same fate.  

It will require a major staff reorganization in the White House for Bush to regain the initiative.  With Libby out, but Rove apparently surviving “Plame Gate,” such a house cleaning does not appear to be in the cards.  During the Clinton years, paralysis in Washington was an acceptable state of affairs.  Post 9/11, paralysis in Washington allows al Qaeda to regroup and regain the initiative.

Hedge Funds

In recent newsletters, we’ve expressed some concerns about hedge fund activities.  Compared to traditional Registered Investment Advisors, hedge funds use concentrated rather than diversified strategies, often use leverage (borrow money to increase returns), and often invest in illiquid securities.  Hedge funds also charge performance fees in addition to management fees, which encourage the hedge fund managers to stretch for returns.  Net, hedge funds can deliver much higher returns than traditional RIA’s but can also deliver substantial or even total losses as well.  Our background concern is that a large hedge fund failure (such as Long Term Capital in August 1998) takes out the rest of the financial system.  In the last six weeks, Bayou folded as its principals admitted defrauding investors of $350 million.  Outright theft is not the same, however, as a failed trading strategy.  In Chicago, the largest futures clearing broker, REFCO, collapsed following the revelation that up to $430 million in bad debts had been hidden from REFCO auditors and investors.  Fraud again, but with implications for the many hedge funds which cleared through REFCO and now can’t get back their collateral to meet client liquidations.  Many hedge funds in addition sustained substantial losses in October as leveraged bets on the energy and housing markets turned sour, and also in debt instruments as spreads widened following the GM downgrade.  So far, no event severe enough to shock the financial system.

Strategy

With the market unchanged on the year as of November 1^st, it would take an 8% rally in stocks in two months to achieve our 2005 projection of 8% returns in the S&P 500.  It’s unlikely although not impossible that this rally will occur.  Economic fundamentals remain excellent and the S&P 500 remains cheap.  We have seen 4 substantial rallies of at least 1% in a day in the last two weeks and clearly a bottom is in place.  However, investors need a catalyst of some kind for the rallies to last more than 1 trading day.  We don’t know what that catalyst will be (most likely, a Fed pause on further rate increases,) but we remain fully invested in anticipation.