HCMI Client Letter - August 10th, 2006

Dear Clients and Friends,

Eight months into the year, the S&P 500 is up 2.37% and the NASDAQ is down 6.58%.  From January 2005, which marked the end of the last decent rally, the S&P 500 has gained 7.4%, which is about the same return as an investment in bank CD’s over the same time frame.  Earnings for the S&P 500, however, have once again surprised to the upside.  The forecast in June was that earnings would drop below 10% for the first time in 16 quarters at 9.1%.  With 86% of S&P 500 companies reporting, earnings growth has averaged 13.4%.  What will it take to get stocks moving again?

Fed Policy

For the past two years, much of our commentary has focused on Federal Reserve Bank policy.  Stocks don’t do well when the Fed is raising interest rates, because investors apply a higher discount factor to future earnings.  At the height of the dot.com madness, the P/E ration on the S&P 500 was 44.  In 2003, the ratio fell to 20.3, 17.9 in 2004, 16.3 in 2005, and is projected at 14.8 for the full year 2006, which is a level not seen since 1991.

On Tuesday, the Fed announced no rate change after 17 consecutive 25BP increases from 1% to 5.25%, citing a slowing housing market, and the adverse effects of higher energy costs and interest rates on consumer spending.  However, the Fed indicated that future increases might be needed if labor and commodity costs continue to rise.  This is the worst of all worlds from the stock market perspective – growth will slow, and may slow more.  Economists immediately lowered GDP projections over the next year from 3% to 2.5%.  Still, with world economic growth bubbling along in the plus 3% range, and with S&P 500 earnings expected to grow 9% over the next year, yield on the 10 year treasury hovering around 5%, the US stock market remains undervalued by 31%.

Energy Prices

Oil prices fluctuated in the mid $70’s/barrel over the last month.  Supplies in the US remain plentiful, but speculators worry about the Israeli/Hezbollah conflict spreading to Syria and Iran and disrupting deliveries of Middle East crude.  Meanwhile 8% of US production went off line earlier this week as BP announced widespread corrosion in a pipeline processing Alaskan oil.  US demand is slack now as refineries switch from gasoline to heating oil production.  However, another hurricane like Katrina hitting the Gulf Coast refinery region would push oil over $80 for sure.  Interestingly, plus $3.00 gasoline seems to have little or no effect on consumption, which is 2% higher than last summer.

Natural gas prices fluctuated widely over the last month.  Natural gas is used for both heating and electricity production.  Prices spiked on demand for extra electricity to power air conditioners across the US in July, but have since eased back with cooler temperatures.

Ethanol production continues to attract investor attention.  Companies operating in this industry are still speculative from an investors point of view, but Walmart recently announced plans to roll out sales of E85, which is 85% ethanol and 15% gasoline, at select Wal-Mart’s and Sam’s Clubs over the next several years.  Broader availability would increase consumers’ confidence in this alternative.

Israel/Hezbollah, Iraq/Afghanistan and terrorism in general

We have described the conflict between the Muslim world and the Western world as World War IV (the Cold War being World War III) and in recent months that conflict has heated up.  The Al Qaeda leadership is bottled up in Northern Pakistan, but the Taliban is resurgent in Afghanistan, the Sunni/Shiite civil war grows in Iraq, and Iran is simultaneously seeking nuclear weapons and attacking Israel through its proxies in Syria and Hezbollah.   We commented some years ago that this conflict would last a generation and events of the last 6 months point further in that direction. 

One way to evaluate this conflict is to try to figure out, “what does the Muslim world want?”  To begin the analysis, start in 1095 AD when the Islamic Caliphate stretched from the Middle East through Central Asia, north through modern Turkey, west across North Africa, across the Straits of Gibraltar to Spain, and Sicily as well.  The Caliphate had trade, culture, architecture, poetry, science and mathematics (we use the Arab numeral system today.)  The Christian Westerners were just emerging from the Dark Ages and were as much barbarians as the Visigoths who sacked Rome in 410.  In 1096, after several false starts, an army of Franks set off for Jerusalem, arriving in Syria in 1097 in the “First Crusade.”  Although nominally a campaign to recapture the “Holy Lands,” the Crusaders were not averse to picking up a little booty on the way.  Thus began a series of military conflicts which, over the next several centuries, resulted in the destruction of the Caliphate by 1268.  The Islamic world entered its own “Dark Ages.”

Roll forward to the 20^th century, the Middle East was dominated by the Western powers, which arbitrarily created countries to suit their own geopolitical needs.  Peoples of different tribal, sectarian and ethnic derivation were lumped together by map makers back in London and Paris.  In the latter 20^th century, countries such as Iran, Iraq and Saudi Arabia threw out their Western governors but remained divided internally along tribal and religious lines.  The primary sectarian split (dating from 632) is between Sunni and Shiite Muslims, which can be best described to Westerners as analogous to the split between Protestants and Catholics in 15^th century Europe.  In either case, to an outsider the distinction is arbitrary, but both sides are willing to spill blood and treasure over it.

The final outrage to the Muslim world was the establishment of a Jewish “home” in British administered Palestine in 1917, which was in incorporated as the state of Israel by 1947.  Muslims regard the territory of “Palestine” as theirs since the conquest of Jerusalem by Muslims in 638 AD.  In the second half of the 20^th century, Israel fought off successive attacks from its surrounding neighbors, in the process expanding the territory of Israel to its present size, about the same size as the US State of Connecticut.  Though Israel occupies 0.2% of the former Caliphate, the Muslim world remains obsessed by this tiny enclave. 

After the European powers withdrew from the region at the end of World War II, the United States and the Soviet Union influenced the region for their own purposes.  The Soviet Union aligned with Abdul Nasser of Egypt and earlier Iraq, while the US aligned with the Saudi Royal family, the Shah of Iran, and, later, Saddam Hussein of Iraq.  Following the downfall of the Shah of Iran in 1978, Iraq, with the support and armaments of the United States, began a 9 year war which, ending in a stalemate, caused the lives of 500,000-1,000,000 Iraqis and Iranians, 2.5 million injured, and the impoverishment of both countries.  More recently, the US interceded against Hussein after the invasion of Kuwait, and deposed him for good in 2003. 

Iran, which is the strongest Shiite country in the region and Persian rather than Arab in ethnology, has attempted since 1980 to export its revolution through Sunni Syria and the covert operations of Hezbollah.  The major Sunni powers, which include Saudi Arabia and Pakistan have attempted to rein in the Iranians while pursuing their own agendas.

The greatest strength that the Western powers in confronting the Muslim world is that, for the most part, Westerners have broken the bonds of tribalism, sectarianism and “the land.”  Americans, for example, get along reasonably well despite have the most diverse population of any modern country.  Americans move constantly, have no allegiance to any particular piece of property, and organize their affiliations by career and education.  Iraqis, to give one example, divide themselves among three major religions, tribal alignments within those religions and then to territory.  In the present civil war, Shia and Sunnis are trying to “ethnically cleanse” their particular neighborhoods of “the other” even though Iraqis themselves can scarcely tell the difference.

The greatest weakness of Westerners in confronting the Muslim world is a lack of a sense of history.  In the Muslim world, the Crusades are “current events;” American can barely remember the 9/11 attacks, let alone remember the damage inflicted on Iran by the US’s support of Iraq.

So what does the Muslim world want?  It wants the Caliphate restored, the Muslim civilization lifted out of its current subordinate role and the Jews out of Palestine.  Within the Middle East, Iran wants to dominate the “Islamic revolution”, and expand Shia influence through Iraq.  The Sunni states, particularly, Saudi Arabia, wants to contain the Shia states and promote its own version of Islam. 

So net, the current war between Israel and Lebanon, which looks horrible on television, is a relatively low grade conflict in the history of the region.  It’s hard to believe that in modern countries of the 21^st century, civilians, women and children can be targeted by rockets or killed in collateral strikes, but there it is.  However, attracting no outrage from the rest of the world, the daily body count in Iraq during this civil war is a multiple of the deaths in Israel/Lebanon.  Israel fights as a proxy for the United States, and Hezbollah fights as a proxy for Iran.  As neither the United States nor Iran dares go after the other country directly, fighting in Lebanon could go on for some time.  This conflict is clearly a humanitarian disaster, but the economic impact is limited to Lebanon (15 years of infrastructure wiped out) and Israel.

Strategy

So where does all this leave us in stocks?  To go by broadcast media, the world is already at the Apocalypse.  Earlier today, flights from the UK to the US were suspended, and 21 alleged terrorists arrested,  after a plot to bomb trans-Atlantic flights with bombs assembled in flight from liquid components, was discovered.  In July 2005, terrorists killed 50 Londoners, and destroyed 3 subway (Underground) cars and a bus.  Within months, ridership levels returned to normal.  Air travel dipped after the Pan-Am Lockerbie bombing in 1988, but is many times greater today.  But meanwhile, in a planet of 6 billion people, economic activity continues, products are manufactured, services are delivered, people go on vacation.  In other words, economic value creation does not stop because of the actions of Islamic mal-contents.  To participate in this value creation, we have to stay invested in stocks.  In light of the Fed rate pause, stable bond yields, and deeply discounted stocks, we remain fully invested.