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October 2004
Dear Clients and Friends,
The economy and markets move in cycles from expansion to
deceleration to contraction to expansion again. As the final
quarter of 2004 begins, it appears that both are entering
the deceleration phase. Real Gross Domestic Product (GDP)
is slowing from over 4% growth toward 3%, still a good rate.
Earnings for the Standard and Poor's 500, having recorded
four consecutive quarters of growth in excess of 20%, are
now expected to be reported with gains in the mid-teens for
the remainder of the year. Projections for 2005 earnings call
for 6-10% growth. This diminished outlook should not be shocking
as the economy transitions from its recovery following the
recession to a longer-term, more sustainable expansion.
The strong stimuli from government spending, tax cuts and
low interest rates worked as anticipated. Consumers led the
recovery with higher disposable incomes, reduced interest
payments and cash received from refinancing mortgages. Corporations
aggressively cut costs to maintain profits and benefited from
record profit margins as business recovered. Beginning in
March of 2003 the stock market enjoyed a sharp recovery that
combined with rising real estate values to boost consumers'
net worth to a new high.
The recovery was not confined to the U.S. but became global
in scope, led by China. Their exports of low cost products
fueled an enormous demand for raw materials, raising prices
of many basic commodities and energy. China's explosive expansion
has influenced both U.S. inflation and interest rates in other
ways as well. Imports of Chinese manufactured goods have reduced
the costs of many products in this country while the payments
for these goods have built enormous reserves of dollars in
China. Much of this money has been invested in U.S. bonds,
helping to finance a daily trade deficit with the rest of
the world that is estimated at $1.8 billion. This process
in which the U.S. buys goods and pays for them with IOU's
has been compared to the "vendor financing" that
technology companies offered their customers in the "bubble"
that ended painfully in 2000. If and when the music stops,
a meaningful rise in interest rates seems most likely.
Perversely, this strong global growth has now encountered
supply constraints. Energy poses a particular problem with
several major sources of oil threatened by terrorism, revolution
or political struggles. As September came to an end, oil prices
were spiking above $50 per barrel compared to $16 five years
ago. In the short-term, it is difficult to predict how high
oil prices will go. Hurricane season will pass and producers
have strong
incentives to increase output just as consumers will be pressing
to reduce usage. Oil companies have been reluctant to invest
in the exploration for new sources based on fears that prices
would decline sharply as they increased supplies. Recently,
they have started to step up their efforts and increased supplies
should result. In the near-term, higher energy prices act
like a tax increase on consumers putting a drag on spending
for other products.
Rising energy costs coupled with rising interest rates could
slow the economy more than was expected a few months ago.
The Federal Reserve seems on a course to gradually increase
short-term interest rates from the extremely low level of
1% to a more normal level, perhaps 2-3% in the low inflation
environment experienced recently. Longer-term interest rates
have come down from 4.8% on the ten year U.S. Treasury Note
in June to under 4% at the end of September in spite of three
increases in the Federal Funds Rate. Lower inflation expectations
and/or forecasts of slower economic growth may be among the
reasons for the slide in longer rates but, in turn, they will
help accelerate some sectors of the economy such as housing.
Business prospects are probably stronger than might be inferred
from the low level of interest rates but the spike in energy
costs may brake the expansion depending on the magnitude and
duration. If oil prices pull back with increased supply coming
on the markets as expected, stock prices could move higher,
in line with improving earnings. Reduced uncertainties after
the election could also provide a lift for investment markets.
The stock market has traded in a narrow range in 2004, catching
its breath after last year's gains. Earnings have expanded
nicely, allowing valuations to come down to more normal levels;
the S&P 500 now sells at about 15 times estimated 2005
earnings, a relatively attractive level versus a 4% ten year
bond.
Some pundits make nice livings pointing out what could go
wrong in geopolitics, the economy, corporate failures and
the like. Long-term investors certainly need to be aware of
potential problems, and be prepared to act as needed, but
should not become paralyzed with fear. Good basic research
should reveal solid companies with healthy prospects that
can, with patience, be purchased at attractive prices.
Sincerely,
John L. Simpson, CFA
Chief Investment Officer
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