HCMI Client Letter - July 1st, 2006

Dear Clients and Friends,

Stocks looked pretty healthy right up until May 10^th when the Federal Reserve Bank raised rates for the 16^th time to 5.0%.  The increase was widely anticipated, but investors read the attached commentary and noted with alarm that the Fed feared core inflation was on the rise as higher energy and commodity prices finally percolated into the general economy.  The conclusion was that the Fed would continue raising rates indefinitely.  Over the next month, the S&P 500 fell 7.5%, the NASDAQ 10.7%.  Damage in US markets was limited compared to certain indexes such as the gold index, down 28.8% and the oil index down 13.6%.  The decline was more dramatic in emerging markets – for example, India declined 34.3%, including a 14% decline in a single day.  Commodity, energy and emerging markets have been the hot plays of the last 18 months.  In a no or slow growth environment, these sectors would do poorly.  It seems that investors reached the same conclusion and all tried to exit those investments simultaneously.

At the June 29^th meeting, the Fed raised rates yet again, to 5.25%, but this time the attached commentary suggested that economic growth was easing, with the implication that the Fed might raise one more time at the next meeting and pause after that.  US markets soared, retrieving half the losses of the previous 5 weeks,

Pushing back from the day to day activity, what’s really going on here?  We’ve made some comments in the past about the trading of hedge funds exaggerating price moves in the markets, and we did some research recently to try to quantify the size of the effects.  First off, what is a hedge fund?  In principal, a hedge fund eliminates the contribution of overall market moves to a portfolio’s return (beta) while providing an overall absolute return (alpha).  In theory, this strategy should provide more stable, yet on average lower, returns compared to simply buying an index fund.  In practice, hedge funds have become highly leveraged long/short trading vehicles pursuing any number of strategies.  Their returns can be sharply higher compared to a conventional strategy, but losses can be total.  Because of the leverage component (hedge funds borrow against assets to enhance returns), hedge funds can be forced to liquidate positions if a market goes against them and make things worse by selling into a falling market.  Over the last 5 years, hedge funds have soared from 1,000 to 8,000 firms, and assets under management have grown to $1.5 trillion, compared to $8.4 trillion invested with traditional money mangers.

By one statistic, hedge funds account for 25% of all trading on the New York Stock Exchange.  Another statistic, “program trades” as a percent of overall trading, is even more telling.  Hedge funds, and banks/dealers copying hedge fund strategies, often send baskets of trades amounting to at least $1 million principal value of at least 15 stocks, to the NYSE for execution.  The percentage of program trades recently hit a record 76.3%, versus an average of 55.1% for the previous 12 months, an average of 40% in 2003, and an average of 20% in 2000.  We conclude, therefore, that the ever more volatile daily returns are being driven by a handful of frantic traders.  More traditional investors including registered investment advisors like HCMI, mutual funds and the average retail investor are sitting on the sidelines scratching our heads.  The only defense against such swings is to not get oneself in a leveraged situation where you have to sell into downturns, and simply ride them out.

Other than the sharp sell-off and recovery, not much else happened in the second quarter.  Earnings growth was fine, averaging 15.3% for Q1 and expected to grown 9-12% for Q2.  The final GDP report showed growth of 5.6% for Q1, and growth is expected to slow to 2.75% for Q2.  Inflation is running a little hot at 3.1%, employment is at a record, unemployment is at a cyclical low of 4.6%.  The housing market is clearing cooling.  Prices haven’t fallen year over year yet, but average time on market is up 50% in many markets, and nationwide there’s a 37% increase in the number of home for sale.  So far, we don’t see signs of collapse in real estate but we continue to monitor that situation closely.  In Iraq, there was some good news on the death of Abu Musab al-Zarqawi, but the US administration has learned not to get too hopeful that the situation there will be resolved any time soon.

The “5th inning”

Last quarter, we made that comment that “the current economic expansion is only in the 5^th inning.”  Our analogy refers to the fact that economic expansions have a cycle of rapid expansion coming out of recession (let’s call those innings 1-4), followed by more moderate expansion (innings 5-8) as capacity constraints such as the inability to find qualified people or enough factory space assert themselves.

Typically the Fed cuts rates to start the expansion, sits tight as the economy picks up speed, raises rates to a “neutral” level once the economy gets back on its feet, only raising rates aggressively to contain growth if the economy appears to expanding too fast (the 9^th inning.)  Compared to the previous cycle, the Fed raised rates to neutral in 1994, made modest adjustments over the next five years and raised rates aggressively only in 2000, which prompted a small recession made worse by the 9/11 attacks.  If the two cycles were exactly the same, then there would be 5 more years of expansion ahead.  Economic cycles, of course, are never exactly the same, which is why we like our baseball analogy.  No two baseball games are exactly the same length either. 

Strategy

For the last 3 years, the energy sector has outperformed all other sectors of the stock market, and this year is up 12.8% versus 2.7% in the S&P 500.  The technology group last outperformed the stock market in 2003, gaining 46.5% that year versus 26.4% in the overall market.  So far this year, technology is down 6.2%, the worst performing sector in the S&P 500.  We started selling our energy position and increasing our technology positions a year ago, which means we’ve underperformed the stock market on average for about 18 months.  However, the fundamentals look too good for technology and too worrisome for energy for us to change allocations now, and we expect to be rewarded eventually. 

The stock market overall remains cheap.  Even if US GDP growth slows to 3% later this year, world GDP growth is projected to grow faster than 4.5% for the next two years.  US corporate earnings, 40% of which are derived from non US operations, can continue to grow at a brisk pace.  Thus, we remain fully invested.