To print, select 'File' from your browser's toolbar above. Then select 'Print'.

April 2004 Newsletter | Print Friendly Format

Dear Clients and Friends,

The economy is doing fine.  There are no jobs!  These two opposing sentiments summarize current perceptions of the U.S. economy.  Most would agree that signs of global growth are increasingly positive.  In the U.S. fiscal and monetary stimulus continue at a very high rate, and the consensus of economists calls for real GDP to increase by over 4% this year.  Business spending is picking up nicely as anticipated, but not hiring.  Unit labor costs are down 1.7% year over year as rising productivity has more than offset increased compensation.  As a result, after-tax corporate profit margins have reached an all time high above 8%.  Certainly, outsourcing abroad for lower cost labor is one factor, but capital is priced cheaply to labor with low interest rates and bonus depreciation.

The number of jobs peaked three years ago, payrolls are still down 1.8%, but most of the leading indicators have been pointing towards growth.  Jobless claims have fallen to a three year low, private surveys show hiring plans are up and layoff plans are down, hiring of temporary workers is up, and the number of people employed has recently moved above year ago levels.  Finally, the recent 308,000 gain in payrolls for February seems to confirm real improvement.  However, several months of similarly strong reports are needed to establish a meaningful trend.  Also, an estimated 150,000 new jobs per month would be needed to absorb the natural increase in the labor force.

Other positives for the economy include low interest rates, low inflation, and the need to restock inventories.  The dollar is down 9% versus a year ago on a trade-weighted basis, which should boost exports.  Bonus depreciation allows the write off of 50% of certain equipment and software in the first year, but is set to expire at the end of the year giving businesses a strong incentive to accelerate purchases.  Housing appears to be getting a second wind with the latest drop in interest rates.  Yet another round of refinancing could bolster consumer spending.

This healthy economic climate needs rising employment to be sustainable in the long run.  The monetary and fiscal stimuli will run their course; the economic engine has been given a strong jump-start, but all the cylinders need to begin firing to keep it running smoothly.

As part of the global recovery, demand for commodities has soared, especially from China. Copper is up 29% year to date, for example.  Energy prices, for a variety of reasons, have increased as well.  So far, little of these increases have shown up in consumer goods prices, but inflation indicators are showing signs of firming.  The Federal Reserve has been keeping short-term interest rates at very low levels, actually negative after adjusting for even today’s low inflation.  Rates cannot stay at 1% forever,

but it a appears they may be able to avoid any increase until late this year unless employment grows around 200,000 per month for a few months and inflation begins to move higher. 

The eventual increase in interest rates is a cause for concern for both the stock and bond markets.  In 1981 the ten-year U.S. Treasury bond offered a yield of 16%.  Since that time rates have moved down to a low of 3.07% set last June.  The yield rose to 4.6% in September and has since fallen to 3.7%.  Even if the Federal Reserve does not plan to raise rates for some time economic growth and the weak dollar could put upward pressure on rates.  The bulging federal deficit also requires many new treasury securities to be absorbed in the market.  Not only would a general rise in the level of interest rates tend to slow the economic recovery, but consumers who have taken on a record high amount of debt would be squeezed, and the valuation equation for stocks and real estate would be negative.

The stock market enjoyed a strong recovery from March 2003, without a decline of 5% until recently.  A correction began in January for the NASDAQ stocks that had had the strongest gains last year.  It then reached the broader markets in March erasing the earlier gains.  The quarter closed with the S&P 500 up a bit over 1% for the year-to-date.  One can never be sure if a pull back is a normal healthy correction until it is over, but analysts report that the average duration and magnitude of a correction during the first two years of a recovery is eleven weeks and 10%.  During this correction the Dow Jones Industrial Average was down about 4% from its peak in early March.

The economic recovery and rising earnings should support a further advance in the months ahead.  Earnings estimates for the S&P 500 have been rising steadily.  The first quarter is expected to show a gain of over 16%, and the full year is projected at 13%.  Forecasts call for further, but slower gains moving into 2005.  Valuations have become a bit more attractive due to rising earnings and lower stock prices.  The S&P 500 now sells at 17.6 times estimated 2004 earnings which is reasonable in the context of very low inflation and interest rates.  Several new names have been added to portfolios during the first quarter as some trimming has been done in older holdings.  From this point, a rotation into more stable, dividend paying stocks seems likely.

There are numerous risks to consider including terrorism, rising interest rates, unfavorable changes to the tax laws for investors, and higher energy costs to name a few.  Nevertheless, strongly rising earnings, low interest rates and low inflation offer a favorable environment for stocks in the near term.

Your thoughts and comments are always welcome.

Sincerely,

John L. Simpson
Senior Vice President, Chief Investment Officer