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July 2004 Newsletter | Print Friendly Format

Dear Clients and Friends,

The U.S. economy finally appears to be at the point in its recovery that growth can be self-sustaining after the impact of tax cuts and interest rate reductions will no longer be providing additional stimulation. The latest reports show the economy has shifted into high gear, and is accompanied by growth abroad resulting in the fastest global expansion in 20 years. U.S. Gross Domestic Product in the second quarter should match or surpass the 3.9% rate reported for the first quarter. Signs of strength include the following: the leading index of economic indicators was up 4.4% year over year to an all-time high; the Federal Reserve’s monthly survey of district banks showed growth in the most sectors since the recession ended in November 2001; industrial production rose 1.1% in May, the largest monthly gain since 1997; housing starts slowed slightly in May, but permits were at a new high suggesting starts will rise this summer; retail sales in May climbed 8.9% versus a year ago and nearly 10% excluding autos; and the latest survey of consumer sentiment by the University of Michigan showed further improvement.

Even more importantly, the government reported a strong gain in jobs during May, and revised the figures for March and April significantly higher. Three months ago investors asked, “Where are the jobs?” but no longer. Employment, excluding the manufacturing sector, is up almost 2 million from the low point in 2002 and has moved 1 million above the peak in 2001. The outlook calls for further growth; the latest Manpower survey reported that 30% of employers expect to add to payrolls in the third quarter.

Corporate profits have been strong in recent quarters, but cautious executives deferred investments, and cash has built up to high levels. For the non-financial companies in the S&P 500 cash has topped $500 billion versus $260 billion at the end of 1999. Most corporations have done their borrowing or lined up credit facilities when interest rates were extremely low. Surveys show increased optimism among corporate leaders, which together with ample cash and strong cash flow should lead to increased investment as well as mergers and acquisitions. Consumers have paced the recovery, but now business spending appears poised to pick up the leadership.

Concerns about corporate profits and jobs have diminished, but an old demon has reappeared. Inflation and measures to head it off have replaced jobs as the current focus for investors. Everyone is painfully aware of the surge in energy prices, but reports of other price increases are spreading. Business surveys show the return of pricing power as companies report success in raising prices as much of the excess capacity in the system has been absorbed, and inventories relative to rising sales have plunged.

One year ago the interest rate on the ten-year U.S. Treasury note bottomed out at 3.07% as Federal officials raised the specter of deflation. Interest rates fell to the lowest level in 46 years. This spring investors widely anticipated the move by the Federal Reserve to raise the rate on federal funds at its June 30 meeting. The bond market moved its rates up ahead of the Fed; most classes of fixed income investments showed negative returns for the first half of the year. The ten-year note issued last February at 4% recently was priced at 94.6 to yield about 4.8%, a decline in value of over 5%. Understandably, bond fund managers are bearish and nearly unanimous in their belief that interest rates will rise further exposing bonds to declines in market value. With short interest rates below the rate of inflation and longer-term bonds vulnerable to declining market values if rates rise, it has been a challenging period for bond investors. As market rates moved up significantly of late, some issues with 3-4 year maturities seem relatively attractive.

During the first half of 2004 the S&P 500 advanced 2.6%. Energy, insurance and consumer staples led sector performance. Investors face inflection points from easing to tightening interest rates, from disinflation to inflation, and from economic acceleration to deceleration. Lack of conviction seemed to keep stock prices in a trading range as good news on the economy and earnings was countered by fears of rising inflation, rising interest rates and renewed terrorist activity. Although an earnings slowdown has been predicted since last fall, earnings for the S&P 500 were up 27.5% in the first quarter and could match or exceed that rate in the second quarter. Wage increases have been lower than projected and profit margins are at record highs. For the full year, estimates now call for earnings to rise 18% or better. With earnings rising much faster than expected only three months ago, valuation measures have become more attractive; the price per dollar of earnings for the S&P 500 is now about 17 based on 2004 estimated earnings and 16 on 2005 forecasts down from over 22 two years ago.

The rate of profit growth is probably close to a peak; in the early stages of an earnings recovery smaller, lower quality companies often outperform, but as the recovery matures, larger, more seasoned firms tend to lead. In the face of rising interest rates our review of stock market performance in prior tightening cycles shows overall S&P performance has been positive at the end of the cycles, but various industry groups have performed differently during each period. Fundamentally, a rise in short term rates from 1% to 3% might have minimal impact on corporate America this time and should have been fully anticipated over the past several months. The strong economy and healthy corporate profits weigh positively for stock market performance this year, and stocks should outperform bonds. Our investment strategy will continue to emphasize fundamental research in security selection with close attention to valuation in constructing portfolios.

Your thoughts and comments are always welcome.

Sincerely,

John L. Simpson
Senior Vice President, Chief Investment Officer