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Eye of the
hurricane!
Last month, we wondered whether the solid recovery from the March lows
was the calm after the storm, or the eye of the hurricane. June
answered that question with the worst one month return (down 8.6%) since
February 2002 and the worst return for the month of June since
1930. For the quarter, the S&P 500 declined 2.7%, which is not
so bad except that it's the third negative quarter in a row (the S&P
500 declined 3.3% in Q4 2007, and declined 9.4% in Q1 2008.)
As multi-quarter declines go, we've seen worse over the last 100 years
(stocks declined 6 straight quarters Q1 1969 through Q2 1970.)
Stocks declined three quarters in a row in 2000 and 2002 during the
particularly vicious bear market which started this century.
However, combine the stock market decline with a doubling of oil prices
and a 15% decline in housing prices over the last year, and you have
pretty much the perfect storm of economic misery.
Overall, the stock market returned to the low levels set March 10th-17th
as Bear Stearns was forced out of business, edging official bear market
territory with a decline of 20% from last October's record high.
Overall, three factors are keeping a lid on stock prices:
o Speculation that banks will announce larger than
expected credit losses for Q2 2008
o Inability of the dollar to rally from the all-time
lows set earlier this year
o Continued volatility and record prices in the energy
sector
Each factor ties into the other. The Federal Reserve will likely
keep rates at the current low 2% through year end to help the banks
recapitalize (banks borrow overnight at 2% or slightly higher, lend long
at 5% or more, profiting from the net interest margin. If short
rates rise, that margin and therefore profit is squeezed.) US rates
are low relative to European rates, which may well rise later this year,
so currency traders sell dollars to buy Euros. But pressure on the
dollar pushes the price of oil higher.
The price of oil popped to a record $144/barrel as rumors spread over the
weekend of a potential US or Israeli attack against Iranian nuclear
facilities in the next 6 months. Iran has threatened to close the
Straits of Hormuz if that occurred, and the US has threatened to attack
any Iranian warships which tried to enforce that closure (20% of world
oil deliveries pass through that waterway.) Whether either side can
afford that kind of conflict remains to be seen. Israel fought a
war with Iran's proxy Hezbollah in Lebanon as recently as July 2006;
world stock prices fell sharply, but then quickly recovered as the
conflict ended.
The sun'll come out tomorrow!
We have spent a lot of time in the last three months reassuring our
clients that the end of the world is not here. We've asked the
simple question, "Do you remember how crappy you felt on September
12th, 2001?" We're not being facetious. On September
12th, 3000 Americans were dead, killed by a gang of terrorists most
Americans had never heard of, even while the US economy was sharply
contracting in the aftermath of the burst Internet stock bubble.
Yet, by December, optimism returned even though the bear market didn't
end for another three quarters. From September 2002 until the
present, US GDP grew 17%, and stocks rallied 74.5%, which includes
reinvested dividends AND is net of the 20% decline since last October.
Some economic reports ticking higher
The Case Shiller housing index is back to the December 2004 level, which
means that anyone who bought property since then is showing a loss, and
anyone who bought property at the July 2006 peak has probably lost all
their equity (assuming a 20% initial equity relative to the national
average decline of 17.7%.) Even so, as new construction slowed
sharply over the last year, supply is coming in line with demand, prices
are starting to stabilize, and inventories of unsold houses are leveling
off. Auto sales plunged in June as consumers left trucks and SUV's
on the showroom lots but can't find high mileage cars such as the Prius
at any price.
Construction and automobile manufacture are a huge driver of economic
growth. Despite depressed conditions in those sectors, the final
revision showed that US GDP grew 1.0% in Q1 2008, exceeding economists'
expectations. GDP forecasts are: 2008 Q2 - 0.45%, 2008 Q3 - 1.65%,
2008 Q4 - 1.10%, 2009 Q1 - 1.70%. These forecasts are well below
the peak growth of 4.1% we saw in 2004 (average was 2.6% over the last 8
years) but the economy stays out of recession. Meanwhile, the US
exports are surging as the cheap dollar makes US goods exceptionally
competitive right now. Growth in export manufacturing jobs will
offset job losses in autos and construction; the average unemployment rate
for 2009 is forecast at 5.6%, an uptick compared to the current
unemployment rate of 5.5%.
Strategy
The stock market action of the last month hasn't changed our opinion that
the economic slow-down will be short lived. We are eagerly awaiting
July earnings reports for the banks, because we believe the current
speculation about further credit losses is just speculation. In
March, we had a raft of credit loss pre-annoucements; in June,
nothing. We continue to review and rebalance our clients accounts,
worried more about missing the next rally than fearing further losses.
Yours sincerely,
The Heron Capital Management client letter is published
immediately following month end and when market conditions require
comment. The views expressed in this letter represent HCMI opinion and
strategy as of the date published and can change at any time upon receipt
of new information. Data quoted in this letter are from sources deemed
reliable, but no guarantee of such data is implied.
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