Perspectives
First Quarter 2005
Déjà vu’ all over again. Stock market action during the last quarter felt just like the first part of last year; range-bound. Worries persist about the course of business prospects, but those worries are tempered by current positive conditions. Those dichotomous lines of reasoning are keeping the market trapped in a trading range for the time being.
Predictions of economic distress have not materialized. The much-forecasted economic slow-down keeps being pushed out in time. Undoubtedly the economy will slow; it is just a question of when, and by how much. Profit growth also cannot continue to grow at the 20% rate it has grown for the past two years. However, 2005 should still be an excellent year for profits, if not at that 20% rate. (See our forecast in the next section.)
Oil prices have been the dominant factor in market action this quarter. Energy prices color the outlook for inflation, interest rates and economic growth. For this reason, changes in the price of oil are being closely followed. This is so, even though the cost of energy, after being adjusted for inflation, is still cheaper than it was during previous price spikes and is a much smaller part of the economy than it used to. Against this backdrop, this intense concern seems to be the tail wagging the dog. At the very least it is premature.
Toward the end of the first quarter, interest rates advanced to the forefront as the leading factor driving stock market responses. Too much positive economic data, and investors worry about higher rates and the impact they would have on business activity. Considering that interest rates started moving up from forty-year lows, this also seems premature. Interest rates are not even back to what most economists would consider neutral territory, i.e., that level which does not further stimulate the economy nor hold it back. That rate is considerably higher than interest rates today.
We noted in past issues of Perspectives that inflation is more of a problem than was being recognized generally. Now the Federal Reserve, at its most recent meeting, has signaled that it too is concerned about inflation. Investors worry that this will result in a faster rise in interest rates and a move toward a policy of tight credit, rather than just removing the stimulus. At RCM we doubt the Fed will be so reckless. (See our Forecast section.)
Forecast
Economy
The estimates for the first quarter GDP rate of increase now is 4% and the second quarter’s now is 3.5%. The third and fourth quarter are predicted to slow to about a 2% growth rate. This slowing is predicated on the basis high energy prices and higher interest rates.
We agree that some slowing is likely, but disagree with the predicted 2% growth rate. Some slowing as the recovery matures is an easy prediction. Surely our large and mature economy cannot expand at over a 4% rate indefinitely, but there is no reason that a 3% rate cannot be sustained for years. Because of healthy economic momentum throughout the developed and emerging economies in the world, we believe it is unlikely that the U.S. growth rate will dip substantially below 3% this year (hence our favorable outlook for equities).
Equities
The stock market has been limited on the upside because of concerns about inflation, higher interest rates, worries of a slowing economy, and pressures on future profits. The downside has been supported by the excellent current conditions, good corporate profit momentum, and an economic environment that continues to surprise on the upside.
Both optimists and pessimists have received some economic evidence to support their respective positions. RCM believes the outcome will be a slowed, but still healthy growth for quite a long time to come. We are bolstered in that opinion by the economic momentum we see in the rest of the world, still-accommodative interest rates, and a stimulative fiscal policy (remember running deficits puts extra money into the economy).
After all, we are getting higher energy and interest rates because of world-wide economic strength, not weakness. As a result, RCM predicts profit growth this year should be in excess of 10%. This is down from the most recent 20% rate, yet still a healthy increase. As we predicted in January’s Perspectives, this should produce another better-than-average increase for stock prices. The process of producing that return this year, however, most likely will seem tortuous, with many false starts.
Fixed Income
Interest rates are working higher. The benchmark ten-year Treasury bond rate climbed from just a little above 4.1% at the beginning of the year to about 4.5% at present. RCM anticipates 5% by the end of the year.
Short-term rates are being raised by about ¼% each time the Federal Reserve Open Market Committee meets. This is likely to continue until the Fed-funds rate gets to about 3.5%. Although the Fed has voiced concern about inflation, it is likely to pause and take stock at that point.
The Fed will be careful to avoid any policy error that would trigger a recession or dramatic slow-down such that would make any solution to government funding and future obligations impossible.
Investment Strategy
Equities
Quality, quality, quality is the answer for this market whether the equity is from a large or small company, a growth or a value stock. During periods of heightened uncertainty, quality wins out.
RCM has been successful in finding such companies within many different sectors. They all share the characteristics of an outstanding management team and solid structure. These firms also are well capitalized and have a diverse source of revenues.
Our bias, as always, is to invest in those companies that over time will grow and increase the value of our equity stake. We invest for growth and those companies are doing better than average this year. We have made a few changes and will make a few more to upgrade portfolios. As of the first quarter, RCM’s composite results are well ahead of its benchmarks.
Fixed Income
Our cautious approach to investing funds in fixed income instruments now is paying off. Fixed income portfolios currently are invested in relatively short-term instruments, predominately Treasury securities. As rates have increased, these instruments have been less affected.
Long-term bonds have lost considerable value and non-Treasury obligations have fared even worse as the spread (difference) in yields between these bonds and Treasuries have widened. The spread in yields between high vs. lesser credit quality obligations has been too tight and is now widening to better reflect the difference in risks. As a result RCM has taken some profits in lesser quality issues, including high yield bonds, and purchased short-term treasuries with the proceeds. We do not anticipate investing in longer-term bonds until such time the ten-year Treasury yields exceed 5%.
Talk With Us
As we all know, real estate in certain hot markets is showing signs of potential bubble activity. That is a significant percentage of sales of lots and condos are being purchased by speculators. These are buyers that have no intention of using the property themselves, but hope to later sell it at higher prices. “Later,” in a few markets, is sometimes a matter of days.
Real estate goes through cycles just like every other type of asset. One only needs to look back to the early 1990s for the latest real estate bear market. Before that it was the savings and loan crisis of the mid to late 1980s. Some of us recall the real estate investment trust debacle of the mid-to-late 1970s. Prior to each one of these downturns, similar speculative activity occurred.
Following the crowd so often leads to the same unhappy result as has occurred before. “They aren’t making any more of it” is not a sound rationale to pay excessive prices, because once a break in prices comes, the cost of carrying weighs heavily. Real estate is taxed, must be maintained, and insured. In addition interest rates may go against borrowers. That is why distress sales often occur during down cycles.
Of course good buys may be found even in hot markets. If you need a house, buy one. General observations may not apply to specific markets. Real estate can be a very good asset and is owned by most of us. We are not making these observations for any other reason than to bring perspective to our clients. RCM does not suggest that one sells their home based upon these observations. It is just a warning not to get caught up by the hot market of the moment and the psychology of crowds. If you would like to discuss your investments, Talk with Us.
Major Indices as of 3/31/05
Large Cap Stocks (S&P 500) -2.59
Dow Jones Industrial Average -2.59
Mid Cap Stocks (S&P 400) -0.67
NASDAQ Composite -8.10
Small Cap Stocks (Russell 2000) -5.60
MSCI EAFE -0.77
Lehman Corp. Bond Index 1.80
Inflation 2.7%
(Equity indices are three-month returns excluding dividends)