HCMI Client Letter - October 1st, 2006

Dear Clients and Friends,

Once in a great while, a series of investment themes will come together in a very satisfying way. 

In previous letter, we had speculated about the investment of hedge funds in the energy market and whether that participation was driving oil prices artificially high.  In the last three months, two hedge funds hit the wall on bad bets in the natural gas market.  The second fund, with $9.2 billion dollars in assets reduced to $3.5 billion in a matter of weeks, was forced to sell off the rest of its energy portfolio at a discount, which caused the price of oil to fall from the low $70’s to the low $60’s in a week.  Oil briefly touched $59.50 last week before closing at $62.91 on Iranian saber rattling, compared to $61.04/barrel at the start of the year.  On the back of over-supply, gasoline prices are falling sharply compared to the summer, and natural gas prices are at the lowest levels since December 2002.  We have said that oil should trade in the mid-$50’s based on supply/demand conditions, and that range looks achievable by year end.

For over a year, we’ve underweighted energy stocks and overweighted tech.  That was completely the wrong position to hold right up until August when the oil stocks peaked and the technology stocks began to rally.

For the most part, our clients are trailing the market on the year, but the gap is closing rapidly as other investors roll out of energy and into growth stocks, primarily in technology.  Microsoft will release the Windows Vista operating system over the next 6 months, along with a new release of Office, which will drive revenue and earnings growth across PC oriented companies.  Meanwhile, earnings grow steadily in the Internet oriented sector.  Cisco, for example, has revenues 43% higher than in 2000, the height of the internet bubble.  Earnings are 108% higher, and Cisco’s current P/E is 26 versus over 100 in 2000, which represent a pretty good value given Cisco’s growth prospects.

For two and a half years, we’ve warned our clients to be very careful about real estate investments, and now that bubble appears to be bursting.  Sales volume is down dramatically, particularly in the most speculative markets such as Florida, Nevada and Arizona.  The year over year statistics indicate that prices fell 1.7% August to August, but anyone who is trying to sell a house these days would be thrilled to get last year’s price.  Robert Shiller of Yale University has compiled an index of house resale prices net of inflation over the last century, which was artfully rendered recently by the New York Times. 

Where have we seen this chart before? 

From 1998-2000, the US stock market soared to twice fair value, before collapsing.  Even 6 years later, the S&P 500 remains 25% undervalued.  We’re not expecting a similar wipeout in US housing, but as we have said, it wouldn’t surprise us if housing prices remained flat for the next 10 years.  The good news in housing is that, with the 10 year hovering around 4.75%, adjustable rate mortgages are resetting only modestly higher.  Our nightmare scenario was that a surge in 10 year yields (from which US mortgage rates are benchmarked) would cause a surge in monthly mortgage payments beyond borrowers ability to pay, forcing houses on the market at fire sale prices.  We haven’t owned any housing stocks in some time, but given the 40-50% decline in the stock prices of the publicly traded companies, we’ll start looking for purchase candidates over the next year.

Fed Policy

Seventeen straight increases in interest rates was like Chinese water torture to US stock investors, but thankfully the Fed is on hold for the foreseeable future.  GDP growth in the US moderated from 5.9% in Q1 to 2.6% in Q2, and will probably come in at 3.4% for the year, possibly slowing to 2.5% for the year in 2007.  Fed watchers and the treasury interest rate curve are already anticipating a cut in rates by February 2007, but that will depend on whether inflation, which has been running at a 3.3% rate for several quarters now, drops below 2.5% on a sustainable basis.  Lower energy prices will help, and businesses will be loathe to raise prices in the face of slackening consumer demand.  A flaw in the inflation calculation is that rent increases count as inflation while increases in house prices don’t count.  As buyers shy away from owning housing, rents are coming up, which may offset improvement in other components of the inflation gauge.

Middle East and the War on Terror

The eight week old ceasefire between Israel and Hezbollah is holding for now, and UN troops are moving reluctantly into a 20 mile buffer zone between the two combatants.  Hezbollah claims victory for lasting 5 weeks against the superior Israeli forces.  However, with a kill ratio 10:1 in favor of the Israelis, the death of 500 Hezbollah fighters, the destruction of Hezbollah’s medium and long range rocket launchers, and the ruination of Lebanon, this is like an amateur prize fighter claiming victory over Mike Tyson by surviving one round without being punched into a coma.  The United States, Iran and Saudi Arabia, the major power wielders in the region, continue circling for advantage.

Strategy

Earnings reports for Q3 2006 will start arriving in ten days.  The forecast is for growth of 9.0%, which, while the first single digit growth number in many quarters, is still respectable.  Within the S&P 500, we expect a sharp deceleration in the earnings growth among energy companies and a sharp acceleration among techs.  Oracle blew away its estimates in a recent report from the second quarter.

We also see money flowing to large cap growth stocks in general.  As we have noted in previous newsletters, stock prices in many well-run large caps like General Electric, Pfizer, Walmart and Citigroup have yet to exceed the highs seen in 2000 even though the Dow Jones Industrials are within 40 points of a record high and the S&P 500 is just 12.5% from its all time high.  Compared to September 10^th, 2001, the Dow and S&P 500 are 22% higher and the NASDAQ is 33% higher, which is not bad considering how many horrible things have happened since September 11^th, 2001.

In August, when the Israel/Hezbollah conflict looked ready to spin out of control and oil prices surged to $78.50/barrel, we wrote “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 malcontents.  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.”  Our strategy and patience was rewarded as US stocks achieved their best quarter since Q4 2004.  We anticipate another good quarter for US stocks and are remaining fully invested.