HCMI Client Letter - July 1st, 2007

Dear Clients and Friends,

US Stock Market
The S&P 500 gained 6.2% in the second quarter and is up 6.9% for the year.  Coming in to the April earnings reports, stock analysts were universally pessimistic about US corporate earnings growth, expecting only 3.9%.  The actual growth rate came in at 7.9%, reflecting strong overseas sales for US corporations despite a domestic slow-down.  Earnings growth for Q2 is expected at 5.7%, Q3 at 2.4%, but accelerating into Q4 at 13.3%.  The largest drags on the US economy right now are: a sharp reduction in new home construction, a sharp drop in large (and more profitable) car and truck sales, and the high cost of energy.

The bond market, anticipating higher economic growth later this year, drove the 10 year treasury rate from 4.5% at the start of the year to nearly 5.2% - the highest level since 2002.  This in turn drove up mortgage rates. Combined with tighter credit standards, mortgage applications have plunged since the peak of the housing market in 2003.  Existing home sales are down 10% year over year, prices are down about 2.4% year over year, and inventories continue to build even as home-builders reduce production.

However, the rest of the US economy is doing fine, as reflected in an unemployment rate remaining at 4.5%.  Aside from a brief period in 1998-2000, the last time the unemployment rate was consistently below 4.75% was the 1960’s into 1970.  The US economy, growing at a $13.6 trillion annual rate through Q1 2007, is 43% larger today than at the end of the giddy 1990’s.

Fed Policy
Many observers expected the Fed to cut rates this spring to prop up the housing market.  We thought otherwise.  The Fed’s mandate is to promote steady economic growth with little or no inflation.  It is not the Fed’s job to prevent asset bubbles from bursting, whether stocks as we saw in 2000-2002 or the more recent housing bubble.  The Fed held rates unusually low through 2004 to help the US economy recover from the post 9/11 recession.  In hindsight, rates were held too low for too long.  The Fed’s focus right now is energy driven inflation.  Oil rallied from a low of $25/barrel April 2003 (following the downfall of Saddam Hussein) to a recent high near $70/barrel.  While energy prices are a smaller component of the US economy compared to the 1970’s, all commodities are at high prices, reflecting world-wide demand.  We don’t see the Fed raising rates for the rest of the year as the economy remains weak, but we also don’t see the Fed cutting rates as the risk of an increase in the inflation rate remains high.

Energy
Political turmoil in energy producing parts of the world, combined with strong demand, drove energy prices back towards the highs of last summer.  In the US, gasoline is likely to remain over $3/gallon through the summer.  Despite record prices, consumption of gasoline is up 2% year over year.  In analyzing retail sales, we see that US consumers will cut back on clothing purchases and eating out before they’ll cut back on gasoline (perhaps given commuting requirements, they don’t have a choice.)

We have given up on our expectation that oil would fall back below $50/barrel (this may happen, but only in the context of a world-wide recession.)  We’re increasing our exposure to exploration companies and equipment providers, but are avoiding the major oil producers such as BP and Exxon.  These companies are sitting on diminishing reserves.  We’re also increasing our interest in alternative energy companies, whether solar, tidal, wind, or ethanol producers.  The companies in this space are all extremely speculative, so our exposure remains low but is increasing.

Iraq/Al Qaeda
The “surge” of US troops into Iraq appears to have delivered modest benefits at best.  Increasing US troops by 20,000 on top of the 160,000 already in country amounts to an increase of barely 13% (for a country the size of California).  In 1991, the US sent 500,000 troops to Kuwait, a country slightly larger than Connecticut.  In 2007, personnel in the US armed services total 1.4 million (plus 1.3 million reserves) versus 2.6 million during the Gulf War.  One of the unremarked legacies of the Clinton Administration was a “hollowing out” of the US armed services, which was not reversed by the Bush Administration.  As a result, there simply are no more soldiers to send.

Wide scale sectarian violence now claims 100-200 Iraqis per day, while 10% of the population has fled to neighboring countries.  Iran is taking advantage of the chaos to bring in advisors to the Shia militias and weapons, particularly armor piercing explosive devices.  For the US to simply pull out would enable the deaths of a million or more Iraqis in full on civil war, and would allow Iran to extend its sphere of influence to the borders of Saudi Arabia.  To remain in Iraq means accepting the deaths of a hundred or more US troops per month.  There is no obvious solution.

The only good news is that it’s been two years since Al Qaeda wannabes killed 52 commuters in the 2005 London Underground attack.  A number of follow-on plots have been foiled, either by police vigilance or, as we have seen in the last 72 hours with three failed car bomb attempts in London and Glasgow, UK, the incompetence of the plotters.  Al Qaeda prime, by no means down and out, has none-the-less suffered setbacks in Iraq and Somalia.  The senior leadership remains in hiding along the Afghanistan/Pakistan border.

2008 US Presidential Election
With 16 months to go to the US Presidential Election, it’s time to start placing bets on the outcome.  On the Republican side the leaders are Rudy Giuliani, John McCain, Mitt Romney and, surging from a late entry, Fred Thompson.  Giuliani generally tops most polls, but 61% of respondents would like “more choices.”  To win the nomination, Giuliani has to swing way to the right and take positions on abortion rights, gay rights, and gun control that he obviously doesn’t believe, then swing back to the center for the general election.

On the Democratic side, the leaders are Hilary Clinton well in front, followed by Barack Obama, John Edwards and as yet undeclared candidate Al Gore.  Only 35% of respondents want more choices among Democratic nominees.  Clinton can afford to ignore the left wing of her party.  Obama is advantaged there with his 2002 vote against the Iraq War resolution but is otherwise disadvantaged by relative inexperience. 

Michael Bloomberg, the Democratic turned Republican turned Independent mayor of New York City, could mix things up with a late candidacy of his own.

Our forecast is that Hillary Clinton will win both the Democratic nomination and the Presidency in 2008.  Our forecast is based on a pragmatic analysis of Electoral College math.  The 2000 and 2004 elections were among the closest in US History.  In 2004, Bush won 50.7% of the popular vote and 53.2% of the electoral votes.  However, a swing of 65,000 votes in Ohio would have delivered the election to Kerry.  In 2000, Bush won 47.9% of the popular vote and 50.5% of the electoral vote.  The vote in Florida was a statistical tie, with only 537 votes separating the candidates in the official tally.  It’s usually forgotten that if Gore had won either his home state of Tennessee or Clinton’s home state of Arkansas, he would have won despite losing Florida. 

So Clinton’s campaign strategy is very simple: retain all the states won by Kerry and Gore in the previous two elections, plus one or two more states.  For residents of solidly Republican states such as Texas, or such solidly Democratic states such as California and New York, the election will be mostly invisible.  The battleground states will be Florida, Ohio, Pennsylvania, Wisconsin, Iowa, Nevada and New Mexico.  Since Illinois is solidly Democratic, it’s unlikely that Clinton would pick Obama as her Vice-President.  A more likely VP is Governor Bill Richardson of New Mexico who would draw voters across the Western states that would otherwise vote Republican, which might be enough to put Clinton over the top.  Meanwhile Democratic voters hunger to complete the sweep of American politics, having taken in the last 4 years the majority of state governorships, and the US House and Senate.

As we get closer to the election, we’ll continue to refine this analysis.  Michael Bloomberg’s entrance into the race could dramatically mix things up.  He’s more of a centrist than either Giuliani or Clinton, and could draw votes from both camps.  The independent candidate with the highest ever percentage of the popular vote was Theodore Roosevelt (27.4% in 1912, running as an independent after serving as a Republican president 1901-1909.)  In more recent times H Ross Perot received 18.9% of the popular vote in the 1992 election and 8.4% in the 1996 election.  Bloomberg could bring his own substantial resources to bear on the campaign (spending between $500 million-$1 billion.)  Compared to the other candidates, he’s a “grown-up,” one of a handful of Americans that would be on the short list to run General Electric or Harvard University. 

Strategy
Our forecast for stock market gains in 2007 remains at 8-10%.  With the S&P 500 up 6.9% YTD, that doesn’t leave much room for further gains this year.  However, we’re already focusing on 2008, when we expect earnings to increase relative to 2007.  As a result we’re investing cash as it comes in, focusing on mid and small cap companies, which have relatively more scope to increase earnings.  If, as we predict, the 2008 Presidential winner is a Democrat, we would expect the current Republican tax laws regarding estates, and tax rates on capital gains and dividends to expire in 2011 rather than be renewed.  We would expect that outcome to have a bearish impact on stocks as investors rush to realize gains at the current low rates.