HCMI Client Letter - April 5th, 2007

Dear Clients and Friends,

Stock markets, US and international, were choppy in the first quarter.  Through February 20^th, the S&P 500 gained 2.9%.  Over the next two weeks, the S&P 500, fell 5.9%, recovering before quarter end to a net gain of 0.6%.  From the market low of last July, the S&P 500 remains up 16.0%, so hardly a disaster.  The trigger of the mid quarter fall was a 9% sell-off in the Chinese stock market, but investors remain leery of recession in the US caused by a contraction in the housing market.

Housing Market

We first discussed the implications of “a bursting of the current real estate bubble” in April 2005, but to recap:

·         Construction is one of the few remaining sources of high paying non-exportable manufacturing jobs.

·         Mortgage lending is a major source of fee income for certain banks.

·         Consumers became dependent in the last 7 years on borrowing against their home equity.

·         Naïve home-owners and inexperienced real estate investors took on more risk than they realized with adjustable mortgages.

The rate at which borrowers become delinquent and the rate of foreclosures are both up sharply, with inventories and time on market increasing in most markets.  Prices are still mostly up year over year, but there was a modest decrease in prices in Q4 2006.  So far, the bubble appears to be deflating gently, but we expect housing prices to remain flat to lower through year end, and flat subsequently.  Combined with poor results in the US automobile industry, we expect GDP growth to be a percent lower than in 2006, in the 2.5% range. 

Corporate Earnings

Standard & Poor’s projects a sharp decline in earnings growth for Q1 2007, only 3.6%, versus 10.6% in Q4 2006, and the first single digit rise in 14 quarters.  The distribution of earnings growth is highly variable, however.  Earnings at technology companies and in consumer staples are expected to grow 10%, financials up 7%, industrials, materials and utilities up 5%, healthcare up 2%, telecommunications down 1% and energy earnings down 3%. Consumer discretionary, which includes cars and housing, is expected to plummet 10%.  Financial service stocks were down in Q1 on fears of losses from “sub-prime lending.”  In fact, the damage is limited to a dozen or so companies which specialize in that area; companies in our portfolios such as Washington Mutual, MGIC (Mortgage Guarantee Insurance Company) and Federal National Mortgage have limited exposure to the poorest quality loans.  Meanwhile, our decision to position our clients out of energy and into technology last year appears due to pay off.

S& P 500 earnings projections for the rest of the year include: Q2 up 3.8%, Q3 up 6.7% and Q4 up 12.4%.  With earnings estimated at 9% over the next 12 months, and ten year bonds yielding 4.75%, the S&P 500 remains undervalued by 21%.

Energy Prices

In January, we wrote, “we expect oil to trade back into the $50’s through Spring 2007.”  By January 17^th, oil traded at $49.90/barrel, the lowest level since May 2005.  However, rising demand for gasoline, with consumers seemingly indifferent to prices near $3/gallon at the pump, lifted prices back to $60/barrel by the end of February.  Continued tensions in the Middle East culminating in the kidnapping of 15 British sailors and marines by Iran brought prices to over $65/barrel.  We now expect oil to trade between $55-65 through the summer.  These levels will be good for providers of alternative energy supplies, which are generally not competitive with oil below $60/barrel.

Fed Policy

In the Federal Reserve Bank’s March policy statement, the central bank indicated a neutral bias towards further increases (the Fed Funds rate has held steady at 5.25% since August 2006.)  Some investors have speculated that the Fed would move to cut rates as early as July 2007 to protect the housing market.  We don’t see this happening.  The US employment rate is at a 4.4% and wages are growing at 4% year over year.  Core inflation is growing at 2.7%, above the Fed’s target of 1-2.0%.  The Fed’s charter is not to protect asset prices (for example, houses) or promote full employment but to keep the value of money stable.  Not only is the Fed Funds rate higher than the entire Treasury Yield curve, but money supply growth in the US is sharply lower in the US – 5.6% annualized – compared to other industrialized economies (Britain 12.8%, Euro zone 10.0%, Canada 9.4%, Australia 14.3%).  Bottom line: we don’t see a change in the Fed Funds rate until core inflation is under 2% and the unemployment rate is over 5% (i.e. not in 2007.)

US Dollar

The dollar hit a two year low recently against the British pound and Euro.  Investors expect European economies to outperform the US economy in 2007, leading to higher interest rates in Europe.  For months, investors have speculated that the US dollar was losing its reserve currency status and that dollar reserves in China and the Middle East would be converted into other currencies, primarily the Euro.  Meanwhile, the Japanese yen has appreciated sharply YTD as speculators unwind the “carry trade.”  For the last several years, the cheapest source of financing has been to borrow in yen, convert the proceeds to US dollars and invest in higher yielding assets.  As the yen rises, currency translation costs offset the yield differential, so investors sell dollar assets, and convert the proceeds back into yen (which accelerates the yen’s rise.) 

The best situation for the US stock market is stable rates.  A falling dollar reduces the attractiveness of US investments to foreign investors, but it also increases the value of non-US earnings to US companies.  Over the next three months, we’ll see if the current exchange rates represent the bottom of a multi-year trading range, or a temporary pause on the way to new lows in the US dollar.

Politics

When we wrote in July 2005, that “Bush will spend his second term in ‘lame duck’ status,” we had no idea how lame things could get.  Bush has absolutely no traction in Social Security, immigration reform, tax policy, energy policy, or resolution of conflict in the Middle East.  What little energy remains in his administration is squandered on senseless controversies like the firing of eight district attorneys for blatantly political reasons.  The biggest mystery is how Deputy Chief of Staff Karl Rove maintains his “boy genius” status after delivering control of the House, Senate, majority of state Governorships and probably the 2008 Presidential election to the Democrats.  We’ll handicap the 2008 elections later this quarter.

Strategy

The US economy and US corporate earnings will grow at slower rates in 2007 compared to the previous 4 years.  The risk of actual recession (defined as two quarters of negative GDP growth) remains low, however.  We have little exposure to the sub-prime mortgage crisis, limited exposure to housing stocks, and no exposure to the troubled US automobile and airline industries.  We scaled back on our energy exposure last year.  The companies that remain in our portfolios have reasonable growth prospects for a slow growing economy.  We maintain our forecast for 8-10% gains in the S&P 500 for 2007.