HCMI Client Letter - January 1st, 2006

Dear Clients and Friends,

The S&P 500 gained 1.9% in the 4^th quarter and gained 4.2% for the year.  Nearly all the return for 2006 came from November 1^st through the second week of December, with the S&P 500 peaking for the year on December 14^th, but sliding 2% by year end.  In October, we wrote:

“Investors won't step up to buy stocks until

·                     energy prices stabilize or go lower

·                     the Federal Reserve finishes raising rates (probably another 0.75% over the next three meetings)

·                     the US makes some progress in extricating itself from Iraq.”

Three months later, each of these factors has made modest improvements, but not enough to bring investors back to stocks in a big way.  So our start of year target of an 8% gain in the S&P 500 was not achieved, even though earnings growth exceeded our expectations while interest rates remained lower than our expectations.  Eventually, investors will recognize that the stock market remains undervalued.

Oil

Our expectation at the start of the year was that crude oil would trade in a range of $40-48/barrel.  In fact, the range was $55-71, with a September peak coinciding with hurricanes Katrina and Rita, which closed down about half of the Gulf Coast production and refining capacity.  About 28% of production and two refineries totaling 300,000 barrels/day are still offline 3 months later.  However, inventories of crude are 9.3% higher than year end 2004, and 19.2% higher than year end 2003.  Economics 101 says higher supply results in lower price, so why has oil doubled since

October 2003 and quintupled since December 1998?  Worldwide demand is growing faster than the average 2% increase in demand in the US.  There is still about a $5-8 “terror premium” built into the price against interruption of supply.  OPEC countries, especially Saudi Arabia, are at the limit of current production capacity, so there is less “cheating” among OPEC members.  Two bad hurricane seasons have disrupted US production two years in a row.  Finally, there are a lot of “trend followers” among hedge funds who have piled into the oil markets the last year or two. 

We believe that if the hedge funds piled out of the oil trade, the price would fall precipitously below $50.  But perhaps we’re wrong.  Perhaps $50/barrel or better is the new oil price.  If prices haven’t come back down below $50 by June 2006, we would buy companies that produce energy without relying on conventional oil (solar, tar sands, methanol, nuclear) and other companies that increase the efficiency of using oil (companies that make components that go into hybrid cars, for example.)  If oil should fall back below $40, none of these companies are economically viable, so we have to be careful.

Federal Reserve Policy and Interest Rates

The Fed raised rates another 25BP to 4.25%, and will probably raise rates a total of 0.50% through March.  At the start of the year, we had thought that the Fed would stop at 4.0%, but the inflationary pressure of higher energy prices caused the Fed to tighten more aggressively.  Unexpectedly, long term rates have not followed short term rates higher – at 4.4%, the 10 year treasury yield is barely higher than last year’s 4.2%, while Fed Funds are 2.25% higher.  Last week, yield on the 2 year treasury exceeded that of the ten year, the “yield curve inversion” that is a traditional harbinger of recession.  In fact, we think the probability of recession next year is pretty low.  In the past the yield curve has inverted as rates at the long end fell, not, as in the current situation, because short term rates were rising. 

For nearly two years now, we’ve said that the yield on the ten year should be at 5% or more, and for two years, the ten year yield has been stuck in the 3.9-4.6% range.  Historically, banks would be selling the ten year in a rising short term rate environment (which would raise the yield on the ten year) because the “carry trade” becomes too risky and unprofitable.  In the “carry trade,” banks borrow money in the overnight market and use the funds to buy long dated bonds, profiting from the spread between the two rates.  Banks have stopped borrowing short term funds in Dollars, but have replaced that borrowing with Yen and Euros at low rates (0.02% and 2.5% respectively) and made additional profits from the appreciation of the Dollar against most currencies this year.  Add in outright purchases of treasury bonds from China, and the yield on the ten year remains depressed.  If Euro and Yen overnight rates rise, or if the dollar starts falling against those currencies, we’d expect the “carry trade” to unwind and yields on the ten year to rise sharply.  We expect the ten year to be (finally) over 5% by the end of 2006.

We’ve commented often in the past year about the riskiness of the housing market.  The Federal Reserve has also expressed concern and has spoken out against the promotion of risky mortgages such as interest only, reverse amortization (where the principal value, and therefore the monthly payments, grow over time) and no money down mortgages.  So far, no collapse, but statistics drawn from new and existing sales show an increase in the length of time houses remain on the market, and a reduction in year over year appreciation, indicating a “soft landing” in house prices.  Our nightmare scenario is a repeat of the 1989-91 market where prices fell 40% in many markets and up to 60% in certain markets.  We don’t expect a repeat of that market, which coincided with the collapse of the traditional mortgage lenders in the “savings and loan” or “thrift” industries.  We remain cautious about housing and own no housing stocks.

Iraq and Al Qaeda

An impressive 70% of registered Iraqi voters turned out for the December 15^th parliamentary elections.  Of 275 seats up for election, the largest share was captured by the United Iraqi Alliance, a sectarian Shia party with ties to Iran.  Following the election, a number of Sunni winners were disqualified for ties to the Baathist administration of Saddam Hussein, which complicates the process of compromise among the different segments of the Iraqi people.  Over the next 6 months, the Iraqis have to form a permanent government and permanent constitution.  Meanwhile, insurgents, both foreign and Sunni, continue to attack other Iraqis and occupation forces. 

It would be ironic if Iraq formed an Islamic state along the model of Iran, with a puppet legislature and true power in the hands of unelected mullahs.  Although Iraq is an exceptionally unfortunate country, this outcome appears unlikely.  The most aggressive Islamist, Muqtada al-Sadr has been subsumed into the United Iraqi Alliance, which has the endorsement of Grand Ayatollah Ali al-Sistani.  Al-Sadr is no Ayatollah Khomeini (the Iranian cleric who presided over the ouster of the Shah of Iran), while al-Sistani considers clerical involvement in politics to be unseemly.  Therefore, there will be no “Guardian Council” of clerics with veto power over the elected parliament as in Iran.  The UIA does not command an absolute majority in parliament, and therefore has to horse trade with the more secular parties, the Kurds and the Sunnis.  When the dust settles a year from now, Iraq may be only the third Middle Eastern country (the other two are Israel and Turkey) with representative governments.

The Iraqi branch of al-Qaeda is in good health, with dozens of attacks weekly against Iraqi police, governmental institutions and occupation forces.  Abu Musab al-Zarqawi is a particularly vicious and successful terrorist leader, and it will be interesting to see if he can maintain his pace of operations if the Sunni tribal leaders, who currently protect him, decide to enter into politics with the Shia and Kurds. 

The rest of al-Qaeda is a question mark.  In the 4 years since the 9/11 attacks, there have been nearly 100 attacks attributable to al-Qaeda affiliates in Turkey, Jordan, Saudi Arabia, Egypt, Morocco, Algeria, Indonesia, Pakistan, Kashmir, Spain and London, but each subsequent attack has delivered a smaller body count and commanded less media attention.  Some observers have questioned whether Bin Laden is still alive, since Bin Laden has no been heard on audio tape since December 2004, and not seen on video tape since October 2004.  The United States, its embassies and warships, have not been attacked in 4 years, breaking the cycle of once every two years which prevailed through the 1990’s.  There’s much to criticize in the Bush administration’s management of the “War on Terror,” but it’s possible, just possible, that the US government is getting the job done.  As the situation in Iraq appears to be stabilizing, raising the possibility of US troop withdrawals, President Bush’s approval ratings are also rising.  Whatever one’s opinion about Bush, a crippled Presidency is not in the best interests of the United States.  While the Clinton administration was crippled by the investigation into Lewinsky-gate and the subsequent impeachment proceedings, Al-Qaeda grew unchecked.

Economic Reports

Our forecast for US GDP growth in 2005 was 3.5%, and, with one quarter remaining to be reported, 3.5% looks to be the correct estimate.  GDP in the third quarter grew at 4.1%, which is well above the 3% rate considered to be the non-inflationary speed limit and included the impact of hurricanes Katrina and Rita.  Inflation including the cost of energy grew at 3.5% year over year through November, but excluding energy, grew at only 2.1%.  The unemployment rate is at 5.0% while a record 134 million Americans are employed.

Even thought the economic news is mostly good, there is a substantial disconnect between how Americans feel about the economy and how it actually is.  Americans were very optimistic through 2000, but since 2000, worries about al-Qaeda, the war on terror, job outsourcing, the safety of 401K plans and pensions, and the safety of the housing market have made Americans fairly pessimistic.  As a result, they don’t want to invest in stocks.

Stock Market Valuation

Since the S&P 500 peaked in March 2000, S&P 500 dividends have grown 41.8% and S&P 500 earnings have grown 42.7%.  In the same time frame, the P/E ratio (the price investors are willing to pay for those earnings) compressed from 27.8 to 17.0, which is why, even after this substantial growth in dividends and earnings, the S&P 500 remains 18% below its all-time high.  Among companies with market caps of at least $100 billion, household names such as Cisco Systems, Pfizer, American International Group, General Electric, Intel, Wal-Mart Stores, and IBM have flat or negative 5 year returns.  Only the energy group has done well over the last 5 years.  That sector now accounts for about 9% of the S&P 500, compared to 4% in 2000, and accounts for nearly all the gain in the S&P 500 this year.

We often refer the “Fed” model which looks at forward P/E ratios in relation to forward interest rates.  In an environment of low interest rates (i.e. 10 year under 6 percent) P/E ratios can expand and still leave the market undervalued.  That’s because E in P/E refers to the earnings stream which is discounted back to a present value using some interest rate, usually the ten year treasury yield.  When the 10 year yield rose into the teens back in the late 70’s early 80’s, it was no surprise that P/E ratios in the S&P 500 fell to single digits.  However, it was unreasonable in the late 90’s for P/E ratios to expand to near 40, when the discount model said that 30 was about fair value given interest rates in the 3.5-4.0% range.

At present, the Fed model suggests that the S&P 500 should be about 1540 versus the current

1248.  In the late 1990’s the stock market was 90% overvalued, ultimately collapsing 55% through 2002.  From 2002 through 2004, earnings grew rapidly while interest rates fell, so the fair valuation rose rapidly.  In 2005, earnings are still rising, but so are interest rates, hence the decline in fair value.  However, even if the 10 year gets to 5% and even if earnings grow only 10% next year, the S&P 500 would still be undervalued by 20%. 

Strategy

Oil, drillers and housing stocks fell sharply in the 4^th quarter, so we were glad we had scaled back on oil companies and avoided the housing stocks.  Our largest investments in technology, healthcare and financial services hardly budged in 2005, despite good earnings.  We’re watching how energy prices move during the peak heating season, and we look forward to the end of the Fed tightening cycle.  The equity component of our clients’ accounts remains fully invested, and we’re keeping the duration of our clients’ fixed income component relatively short as we expect long term rates to go higher.