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:

These companies were stellar price performers in the 1990’s, but with the exception of Citibank, have shown little appreciation since the end of the 2000-2 bear market despite turning in respectable growth in revenues and earning per share growth.

Like the rest of the stock market, these companies experienced “P/E compression” over the last 5 years.  At the end of 2000, the P/E on the S& 500 was 36.6, now 17.3, a compression of 53%.  The phenomenon of P/E compression means that companies can grow revenues and earnings quite healthily and still see their stock price stay flat or even decline.  So the net effect is that stocks over the last 5 years have “digested” the excesses of the late 1990’s. 

Historically, the actual value of the S&P 500 hugged its estimated fair value.  Actual value soared 90% higher than fair value by the end of 1999, collapsed through year end 2002, and even now remains 30% below fair value.  So we’re sticking to our guns and remaining fully invested.

Commodity Prices

Oil touched an all-time high of $75.50 two weeks ago on the news of Iranian defiance over nuclear inspections; political unrest in Venezuela and Nigeria also kept prices high.  Inventories of crude oil are an eight year, high, and not that far from a 15 year high.

Gasoline inventories are also building as high retail prices are encouraging consumers to be more thoughtful about their driving.  In the last week, some moderation in Iranian rhetoric, combined with recognition that oil supplies are plentiful, caused prices to moderate: crude oil last quoted at $68.53, a 7% decline from the high.

More interesting, sharp declines this week in precious metals (gold at $656.70 after hitting $730.40 last week, a10.1% decline), and also in industrial commodities including copper down 13.7% from its recent high and aluminum down 9.9%.  Either investors have decided that the entire world economy is about to go into recession, or speculators, who have made big profits on ramping commodities prices over the last two years, are rushing to take profits.  Given the uniformity and severity of declines on commodity prices, we’re betting on the later case.  If the decline is sustained, we will see a substantial drop in next month Producer and Consumer Price Indices, which in turn will give the Fed some room to pause the current Fed Funds increases.

Strategy and the Client Grumble Index

In the thirteen years we’ve been running this firm, one thing we’ve noticed is that when our clients start asking us to deviate from our core strategy, we’re usually due for a rally.  This has nothing to do with our clients’ intelligence and everything to do with the contrary nature of investing, where success is based on buying what everyone else is selling, and selling what everyone else is buying.  In the last 18 months, our client’s returns have averaged in the single digits as we have pared our energy holdings and added to our technology positions, while commodities markets and emerging stock markets have soared.  In recent weeks, our clients have asked us to buy gold or gold stocks, wondered about investing in Asia or Latin America, and wondered also about alternative energy stocks.  We’ve been leery about gold and, at least in the last two weeks, justified.  We’re equally leery about emerging markets.  The MSCI Emerging Market index gained 24% YTD through May 10^th, fell 14% since then. 

We are intrigued by alternative energy companies.  We believe that 10 years from now we’ll all be driving hybrid cars and we’ve made some small investments in companies that produce solar panels, extract oil from tar sands, or make components and batteries for hybrid cars.  However, we expect oil to fall back below $60/barrel by year end, which would hurt the stock prices of alternative energy companies, so we’re keeping our exposure limited for now.  Meanwhile, we’re feeling bullish about our unloved technology stocks as we see chip sales setting records sales, exceeding the previous boom in 2000

and are anticipating the next technology upgrade cycle which coincides with Microsoft’s Windows Vista rollout.  Stocks rallied into this afternoon’s close, which we believe marks the bottom of this particular pull back.  Most likely we’ll be investing recent client deposits on Monday.