HCMI Client Letter - May 19th, 2006

Dear Clients and Friends,

The modest correction of the past two weeks bears some comments.  On May 9^th, the major indices were at 6 year highs with the Dow 80 points from an all-time high and the S&P 500 13% from its all time high.  On May 10^th, the US Federal Reserve Bank raised the funds rate to 5.0%, the 16^th increase in 16 meetings.   The increase was universally expected, but investors hoped to hear that the Fed was done, or nearly done.  Those investors were disappointed.   Over the next 7 sessions, the S&P 500 gave up 4.8%, the Dow 4.4% and the NASDAQ fell 6.8% taking that index negative on the year and to the lowest level since November 7^th, 2005.

Is this a temporary pullback, or the start of a new bear market?  How can we tell the difference?

Federal Reserve Policy

To start with, why are investors so glum about Federal Reserve policy?   The job of the Fed is to promote stable, non-inflationary growth in the US economy through application of monetary policy.  The Fed has two tools to facilitate this policy – the first is the well known setting of the Funds rate.   Higher interest rates make certain projects that businesses might consider less attractive.  For example, a condo builder might be able to develop a property if the cost of borrowing is 6%, but at 8% the cost of borrowing might exceed the profits of the project, therefore the condo doesn’t get built.   It’s less known that the Fed also controls how much money is available for loans through open market operations.  If the Fed wants to reduce the amount of money in circulation, it will “sell” government securities to banks at attractive yields, with agreement to “buy” these securities back at a later date.  These contracts are called “repurchase agreements.”  If the Fed “repos” a high volume of treasuries out to the banks, that money is no longer available for lending. 

Since the 1970’s the Federal Reserve has gotten ever more sophisticated at using these tools to provide the right amount of liquidity (through rate setting and money supply) growth to the US economy to maximize non-inflationary growth.

This charts shows quarterly growth in US GDP since 1945.  Through the 1950’s and 1960’s, the US economy often grew rapidly, followed by sharp, painful recessions (the Chinese economy has these characteristics today.)  In 1973-74, there was a different kind of recession triggered by the first OPEC oil boycott (following the 1973 Arab-Israeli War.)  Inflation soared and the Fed acted aggressively to block inflation, leading to a recession and widespread unemployment in the US.  A second oil shock followed in 1979 after the overthrow of the Shah of Iran and subsequent boycott of world oil markets by Iran.  Interest rates soared to record levels by January 1980, with Fed Funds targeted at 19-20% and yields on the 2-10 year treasuries reaching 15%.   By 1984, inflation was suppressed (at the cost of a vicious recession) and a general restructuring of the US economy from manufacturing to services started two decades of stable growth.  There was a mild recession around the first Gulf War in 1990-1, and an even milder recession in 2001-2 around the bursting of the Internet bubble and the 9/11 terrorist attacks.

Not only has quarterly growth become more stable over time, but the length of time between expansion and recession has also increased.  Given that the last expansion lasted almost 10 years, we would be very surprised if the current expansion lasted only 3 ½ years.  But let’s consider the risk of recession in the current environment.  Looking backward, the US economy is in great shape.  The most recent GDP report, at 4.8% growth, is well about the 3.5% rate we consider to be the non-inflationary speed limit.  Growth will probably ease to the 3-3.5% rate by the end of 2006, which is fine.  Unemployment, at 4.7%, is approaching the lows of 3.8% seen at the end of the last expansion in 2000.

Employment rate

United States

The housing market is cooling, as we see in a drop-off in constructions permits and sales of existing home, but so far we see a soft landing where prices stabilize near current levels (prices fell 0.9% in Q1 2006, but are still up 7.8% year over year.)   Corporations are in robust shape, with record levels of cash on their balance sheets and fat operating margins.  The only major concern is the impact of energy prices.   Expensive oil no longer has the ability to drive the US economy into recession (as we saw in 1974 and 1979) but high energy prices are feeding modestly into higher inflation rates (CPI is currently running at a 3.6% annual rate and core CPI, which excludes energy and food, is running at a 3.0% rate.  As we see in this chart, overall inflation is at or below the average of the last 10 years, but the current trend shows inflation stepping higher,

which is very worrisome to the Fed.  The new chairman, Ben Bernanke, would like to establish his anti-inflation credentials early, thus two increases already.  Investors fear, that, like the brakes on an old car which fail to respond to light pressure, then grab suddenly as the pedal is further depressed, the 17^th or 18^th or even 19^th increase in Fed Funds might cause growth in US GDP growth to abruptly halt.  We think this concern is over-blown, but we’re in the minority, hence the sharp sell-off in stock prices over the last ten days. 

Corporate Earnings

Corporate earnings, reported in April for Q1 2006, once again exceeded expectations.  With 80% of companies reporting, earnings grew at a 13.9% year over year rate, the 16^th consecutive double digit growth rate.  Growth is expected to slow to 7.7% for Q2, but analysts have consistently underestimated stock market earnings growth in recent years (compliance with Sarbanes-Oxley has caused companies to “low-ball” earnings projections.)   Yet, despite stellar earnings growth since 2002, many companies are still trading far below the stock levels of 1999-2000

We pulled statistics for Citibank, Microsoft, Pfizer and Walmart (a range of large cap companies) for 1996-2005: