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:: April 2005| Page 1 of 1
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Dear Clients and Friends,
By most measures the U.S. economy appears healthy. Despite
rising prices for gasoline, fewer mortgage refinancing cash-outs,
no new tax cuts and mounting health care costs, retail sales
are up 7.7% over the past year. The Conference Board's measure
of consumer confidence finally recovered to pre-September
11 levels and surveys of Chief Executives are the most positive
in years. The optimism of business leaders is bolstered by
record profit margins, free cash flow and liquid balance sheets.
Corporate cash is available for investment in the business
with new equipment and software. It may also be returned to
shareholders in the form of higher dividends or share buybacks,
while mergers or acquisitions represent another use for the
funds. In fact, all these uses of corporate cash are in progress,
a significant positive factor for the stock market over time.
Most observers expect solid GDP growth this year, close to
the long-term trend around 3.5%. Earnings for the S&P
500 this year are expected to be up about 10%, a reduction
from higher rates of growth in the recent past, but still
solid.
One might ask why the stock market has been generally unrewarding
this year given the positive economic background? There are
two primary answers: Inflation and Interest Rates. Inflationary
forces have been building as prices for raw materials rose
11% over the last twelve months. Wholesale prices as measured
by the Producer Price Index were up 4.7% over the previous
year in February, and the Consumer Price Index at the end
of the chain was up 3% (2.4% excluding energy and food). Crude
oil futures closed out 2004 around $43 per barrel and recently
peaked above $57, up over 33% on top of a 34% rise last year.
Economists report that energy price increases impact the broad
economy with a one-year lag that could begin showing up over
the coming months. Moreover, the latest Federal Reserve survey
indicated that businesses are finding it easier to pass along
price increases. Real estate prices have been soaring in several
parts of the country aided by unusually low interest rates.
Homes have become the piggy banks for consumers as they refinance
to take out cash or use home equity loans. It has been suggested
by some that real estate has replaced the dot.com bubble stocks
of 2000 as a "can't lose" way to big gains.
The Federal Reserve fought off the threat of deflation with
ultra-low interest rates, driving the Federal Funds rate to
1% in mid-2003. They are now in the process of removing the
stimulus by increasing that rate for the seventh time in less
than one year to 2.75% with every indication that they will
continue to raise it until reaching an undefined neutral level,
variously estimated at 3-4%. They would like to see price
stability which some define as 2-2.5% growth in the core Consumer
Price Index, close to the current level. Until recently, the
rising short term rates have had little impact on longer term
bond rates and mortgage rates which are tied to them, but
now with mortgages pushing above 6% a slow-down in housing
and real estate activity could lie ahead.
Rising interest rates also affect the price investors are
willing to pay for stocks. As bonds offer higher rates, price
to earnings ratios for stocks would be expected to decline
just as the price of bonds with a lower rate of interest will
decline to equalize the yield to a buyer compared to the higher
rates on newly issued bonds. As investors look ahead, concerns
over inflation and rising interest rates make them reluctant
to bid up prices.
Stock market returns so far this year have been disappointing
for the broad indices, which are down about 2.5%. The sectors
with positive returns have been energy, materials and utilities.
Oil prices moved considerably higher than expected as strong
demand caught up with supply after years of underinvestment.
Oil stocks were underweighted in many institutional portfolios
and money has surged into the sector during the last quarter
causing share prices to spike upward. Prices in the commodity
markets may also have been driven to extremes by speculative
purchases from hedge funds. U.S. inventories of crude oil
and gasoline have been rising, which seems at odds with the
surge in the futures price, suggesting a sharp reversal in
the price of oil may be anticipated. Energy company earnings
should be excellent, even with somewhat lower prices, but
their stock prices could be vulnerable in the short term when
the commodity price pulls back. Still, the positive longer-term
outlook argues for a significant position in energy stocks.
As the rate of earnings growth slows down to a more sustainable
rate for many companies, some of the larger firms with steady
rates of growth should perform relatively better than both
smaller and cyclical businesses. Several of these stocks in
the consumer non-durables sector have been trading at reasonable
valuations. However, one should recognize that after a long
period of disinflation and declining interest rates, a secular
shift in the opposite direction might be underway. At times,
good news for the economy can become bad news for the markets
due to fears of inflation and higher interest rates. During
past episodes of Federal Reserve tightening there have been
some unpleasant surprises, as over-leveraged organizations
could not tolerate the higher rates. It is important to maintain
sufficient diversification in portfolios to protect against
such developments. Bonds still play a helpful role in this
regard, with shorter maturities and high quality issues suggested.
One should also be patient about committing new cash to equities
in order to have funds available to take advantage of buying
opportunities in a choppy stock market.
Sincerely,
John L. Simpson, CFA
Chief Investment Officer
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