Dear Clients and Friends,
US stocks put in a decent return for Q1 2006 even as oil prices settled in at
the highs for the quarter, the Federal Reserve continued to raise short term
rates, the situation in Iraq improved only modestly, housing prices settled
back on falling sales, the 10 year yield moved substantially towards 5%, and President
Bush’s approval ratings hit the lows for his presidency.
Despite this less than stellar economic environment, S&P
500 earnings gained 14.4% for the 4th quarter and 13.5% for
2005. Growth for Q1 2006 is projected at 11.3%, which would be the 16th
consecutive quarter of double digit growth. Standard and Poors expects
that streak to end in Q2, but overall expects growth of 10.8% for 2006.
As we have often pointed out, because 40% of S&P revenues come from
overseas operations, the key driver of S&P earnings growth is the state of
the overall world economy, which is in pretty good shape right now even if the
US economy is taking a bit of a breather after a dozen quarters of above trend
growth. Projecting 10% earnings growth in 2006, with the ten year at 5%,
still leaves the S&P 500 undervalued by 15%.
The current bull market dates from August 2002. From
those lows, the S&P 500 gained 67% (though still 15% below the all time
highs of March 2000), and the NASDAQ gained 111% (though still 54% below its
all time highs.) In recent months, some market observers have expressed
concern that the bull market is aging (3 ½ years!) and that the market is due
for a pullback. As we see below in this chart of the S&P 500
since 1970, a bear market (defined as a pull back of at least 20%, occurs, on
average, once every 5 years. However, since 1974, the average has gained
10%/year (before dividends, about 12%/year including dividends.) 1974 was
a pivotal year. Not only did it include the shock triggered by the 1973
OPEC oil boycott, but that year marked the completion of the transition of the
as services companies replaced manufacturing companies in the composition of
the index. As there is no similar transition occurring now, there’s
no reason why stocks should plateau for half a generation (as we saw more
recently in the Japanese stock market as that economy transitioned from
industry to services.
Interest rates
The Federal Reserve raised rates by 0.25% to 4.75%, the 15th
consecutive increase since June 2004 when rates were just 0.75%. Comments
from the Fed indicated that further tightening should be expected, so we have
increased our expectations of the final increase from 5% to 5.25%. Long
term rates grudgingly moved higher, ranging from 4.82% at the short (2 year)
end to 4.89% at the long (30 year) end. Money markets funds are now
yielding over 4%, up from 0.50% two years ago. The ten year treasury,
which is the key indicator for mortgage and corporate lending, is now at 4.85%,
up from 4.40% at the start of the year, and we expect that rate to exceed 5% by
mid-summer (we have been expecting 5% rates for two years now.)
Fed policy is predicated on an analysis of whether the
economy is expanding too fast, and whether inflation is getting out of control.
The most recent GDP reports (Q4 2005) showed that the economy grew at only a
1.7% rate, down sharply from the 4.1% growth fate of Q3 2005, and also below
plus 3% rates seen for the previous 10 quarters. Growth is expected to
rebound in Q1 2006, but moderate for rest of 2006. Adding to growth,
increased spending for Katrina rebuilding and defense spending; subtracting
from growth, higher energy prices, lower consumer spending as the housing
market cools.
Inflation, unfortunately, is picking up as higher energy
prices percolate through the economy, but also because there’s little
slack in the employment markets. Corporate profits, however, are at an
all time high, operating margins are high, productivity remains strong, and
corporations for the most part have strong balance sheets and plenty of
cash. The Fed therefore, will continue to seek the “sweet
spot” in interest rates where inflation is tamed, yet growth continues.
Energy
For two and half years we’ve forecast lower energy
prices and for two and half years we’ve been wrong. Oil closed the
quarter at $66.63, ranging through the quarter from $58-68/barrel, even as
stocks rose to the highest levels in five years.
Normally, a supply surplus leads to lower prices, but traders have built in a
”supply disruption premium” over political concerns in Nigeria,
Venezuela, Iran, Iraq, Saudi Arabia and Russia. It’s rarely
mentioned, however, that the
The price of natural gas over the last 6 months is
illustrative of how quickly commodity prices can go in the opposite
direction. Natural gas is produced in most states west of the
Strategy
The sporadic inversion of the yield curve has led some
analysts to forecast a recession. This event has predictive value when
the yield curve inverts because the long end is falling, not because the short
end is rising, so we disregard this signal. In our opinion, the current
economic expansion is only in the 5th inning. We’re
fully invested and concentrating on mid-cap companies with strong market niches
and room to grow, paring back on large-cap companies with fully developed
markets.
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.