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Oil down,
Dollar up, Financials stabilizing
Some months ago, with oil pushing over $140/barrel, we observed that the
chart of the commodity looked a lot like the chart of the NASDAQ through
2000 - new highs on ever
 
Oil -
2006-present
NASDAQ 1996-2000
increasing volume. We call these movements 'ballistic charts"
since a rocket shows a similar gain in height and speed (right before the
fuel cuts off, at which point the rocket makes a rapid descent to
earth.) We never can predict exactly what will halt the rise, only
that it will occur. For the last year, we've been underweight
energy, overweight other sectors. Until mid July, we were
dramatically underperforming our benchmarks as energy stocks were the one
sector up in 2008. Over the last 8 weeks, however, we've
dramatically outperformed. We use mutual funds in certain of our
clients' accounts, and we surprised to see many showing negative returns
this quarter, even though the S&P 500 is up 1.4%. In reviewing their
asset allocations, we see that many top performing funds of the last 5
years are still overweight energy and materials (e.g. gold, steel)
stocks. So we expect continued pressure on those sectors as fund
managers reallocate. Thus, oil has settled for the time being at
the $115 level (despite another Katrina like storm bearing down on the
gulf.) We expect another down leg in oil this fall.
The 22% decline in oil, 17% decline in the commodity index, expands
manufacturers' margins, allowing them to make profits without passing
through price increases. Consumers, airlines and car companies all
get some breathing room. With reduced inflationary pressure, the
Fed can hold rates unchanged through the fall. It would be
unfortunate if the US stopped pursuing energy alternatives. Easily
extractable oil will run out in the next couple of decades, and prices
will go higher.
Since we're on the subject of "ballistic charts," here are two
more:
 
Euro
vs Dollar
2005-present
Case-Shiller Home Prices 1993-Present
We've been talking for a while how the dollar was grossly undervalued
against the Euro, GBP and other major currencies. The abrupt spike
in the Euro starting last August was related to the US dropping interest
rates sharply to deal with the credit crisis, while the European Central
Bank maintained and even raised rates. However, growth rates in
Europe have slowed sharply though growth rates in the US have remained
surprisingly. While US interest rates are still lower, foreign
investors are moving cash to the US to take advantage of better growth
opportunities. The dollar would have to rise at least 25% to
achieve purchasing power parity.
Housing prices are now down 19.1% from the July 2006 peak. Although
the rate of decline has slowed in recent months, we expect housing to
fall another 10% through 2009. That decline will place continued
pressure on banks and anyone else holding mortgage based
securities. There's perhaps a 10% chance that Fannie Mae and
Freddie Mac end up taken over by the US Government, wiping out
shareholders. As a result, the stock prices, already down 95% over
the last year, kite around like options, hitting 20 year lows in late
August. We retain small positions in both. For the most part,
while banks remain under pressure, financial stock prices have risen as
the absolute worst scenarios (total bankruptcy of the banking system)
recede in probability. Perhaps 100-200 banks will fail over the
next year, but in 1989-1991 nearly 1000 banks failed.
US Economy
Despite construction and the automobile industries flat on their backs,
with airlines once again fluctuating with bankruptcy, and with the
financial sector experiencing the worst turmoil since 1989-1991, US GDP
still grew 3.3% in Q2 2008, revised up from an initial reading of 1.9% as
exports surged. Expectations are that US growth moderates in the
second half of 2008 as tight credit conditions (the banks are unwilling
or unable to lend) depress business activity and frightened US consumers
cut spending. Some analysts believe that the "recession"
such as it is, started in Q4 2008 and is already over.
This chart from Moody's summarizes dozens of economic
indicators, showing that the risk of recession peaked in February 2008,
and has fallen ever since.
Politics
There remain but 64 days until the US Presidential Election.
Senator Barack Obama has been anointed the next president by the media
and has already taken a victory lap through Europe. However, the
election is not over. After two years and over a billion dollars
spent on the primaries, the most charitable thing we can say about the
candidates is that both parties have fielded their freshman squads.
Obama's selection of Washington insider and 6 term senator Joe Biden
contradicted his "Change" message. McCain's surprise pick
of Alaska governor Sarah Palin prompted one commentator to write,
"Palin's age, inexperience rival Obama's," which is alarming
considering McCain's age and ill health. An obvious question: can
Palin keep up with McCain, Obama and Biden, all of whom are seasoned
veterans of permanent campaigning.
As we commented long ago, "it all boils down to electoral college
math." Coming into this election, with Republicans in disgrace
over failed policy after failed policy, all the Democrats had to do to
win was retain the states that Kerry won in 2004, and pick up one or two
additional states. So far, the Democrats seem to be holding those
states. Of the 10
states where the polls are still close, Virginia and Ohio
could easily shift to Obama (in which case he wins) or if he picks up any
two of Colorado, Nevada and New Mexico. We had thought that Obama
might pick Governor Tim Kaine of Virginia as a running mate, tilting
Virginia to the Democrats and slamming the door shut on the Republicans.
We considered that McCain might go for Massachusetts Governor Mitt
Romney, a popular Republican in a generally Democratic state, and with a
long record of accomplishment as a businessman and as the organizer who
saved the Salt Lake City Winter Olympics. Also, Romney's father was
a popular governor of Michigan, which voted Democratic in 2004 but is a
toss-up state in 2008. Personally, however, the two men do not get
along.
The selection of Sarah Palin is a bit of a gamble. The knee jerk
reaction is that the selection of a woman VP will pull over disaffected
Hillary Clinton supporters. However, as pro-life, pro-creationism,
pro-gun former beauty contestant, Palin couldn't be further opposite from
Clinton. Her selection is directed at the tiny percentage of the
electorate that is yet undecided living in these 10 remaining toss up
states. As polls stand now (post convention polls won't be out for
another 10 days) Obama has the lead both at the national and at the
electoral college level. However, if McCain can hold Virginia,
Ohio, Colorado and New Mexico, he wins the election, though probably not
with a majority of votes at the national level. We conclude that Obama
has the advantage now, but a turnaround for McCain between now and
November 4th is totally possible.
Strategy
Stocks are just a few percent off the lows of mid July, with
financials down 41% from 2007,
and showing a negative return for the last 5 years.
Consumer discretionary, healthcare and information technology stocks
averaged low single digit returns over the last 5 years. Energy
stocks were the best performer of the last 5 years, more than tripling,
followed by utilities and materials stocks, which doubled. Generally,
out-performance is followed up under-performance and vice-versa.
We're overweight financials, healthcare and technology, underweight
energy and materials and continuing to move cash into the market.
Yours sincerely,
David Edwards
President
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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