1st Quarter 2004: Headwinds and Tailwinds

First Quarter 2004
Market Commentary
 

Headwinds &Tailwinds

Tailwinds

Since our most recent Commentary in November of last year, the economy has continued to improve. In recent months, a combination of stronger earnings, greater liquidity (there is still $2 trillion in money market funds on the sidelines), tax benefits from last years legislation, the lowest interest rates in 40 years and both monetary and fiscal stimulus have acted as a tailwind behind the markets - pushing stocks up as the path of best resistance.

The third quarter of 2003 saw the economy grow at the fastest pace in nearly 20 years. While the rate of growth (8.2% after adjustments) proved to be unsustainable, the third quarter marked the fifth successive quarter of improvement. The fourth quarter of 2003 was also strong, registering a 4% improvement year over year.

The Components of this growth have become broader based in that manufacturing has now joined the consumer in moving the economy forward. In December, the Institute for Supply Management announced that its manufacturing index jumped to 62.8%, the highest level since December of 1983, and the fifth straight month of improvement. The Commerce Department reported that business spending on computers and software rose 15% on an annualized rate; indicating that business is finally loosening its purse strings. This bodes well for further growth, since inventories have been at low levels, and should begin to rise along with sharp increases in new orders. Helping also are coincident increases in personal income. In addition, according to CBS Market Watch, as of January 22, 7 of 10 leading economic indicators have turned up. (Figure 1)*
The good news accompanying this data is that inflation remains at low levels, rising 1.9% for calendar year 2003; well within Federal guidelines. None of this was lost on the stock market, which registered its best year since the market top in 2000.

There is substance behind these numbers, in that corporate earnings of S&P 500 companies that have already reported have averaged better than 20% year over year results for the first quarter. Thompson First Call, which records financial results for major institutions, expects final earnings numbers to average 26% increases from continuing operations. If so, that would be the best showing in over ten years. Further, analyst estimates for full year 2004 earnings are for further growth, settling in at double-digit rates. Thus, the economy has been moving forward on all cylinders, and shows every indication of continuing that trend, all other things being equal.

Headwinds

Along with the improving economy, however, we have previously commented on some of the negatives in today's environment as well. Specifically, we have historic budget and balance of trade deficits on the domestic front, and a continuing conflict in Iraq on the international front.

These are negatives, which are essentially headwinds. They are events, which could curtail and perhaps stall the positive signs we have reported. We note that in business, a good idea never seems to take hold unless and until it is joined with the money necessary to finance it. So too do negatives just remain lingering negatives until either enough money or enough opposition emerges as an opposing force. The Administration well understands this, as they have favored money creation to fight the war on terror, and money has been created to jump-start what was a sagging economy up until a year and a half ago. But the reaction to the money that has been requested to pay for this has been met by increasing opposition. Or, as Newton observed some years ago, every action is met by an equal but opposite reaction.

This opposition or reaction, as the case may be, are headwinds and represent potential stumbling blocks to the markets path of progress. Fanning the fire, so to speak, are the opinions of some, including conservatives, that President Bush has pushed the envelope in terms of his proposed $2.4 trillion budget for next year. He is pushing for a number of new projects that require deficit spending apart from the war on terror, which is encountering resistance. On top of this, the recent Medicare bill, which was estimated to cost $500 billion over ten years, now appears as though it may cost close to $100 billion more.

In addition, the political battles, which typically occur in an election year, are gathering strength, and could well act as another headwind. More important, on January 26, Alan Greenspan, Chairman of the Federal Reserve Bank, has announced that he will soon deliver a speech criticizing the spending plans of the Administration, and the budget deficit - now estimated at a record $500 billion for the current fiscal year. (Figure 2)*
The relevance of this, in our opinion, is not that anything fundamental has changed; rather that Mr. Greenspan has a track record of rattling financial markets whenever his prognostications are interpreted as leading to higher interest rates and/or a tightening of the money supply. Indeed, the market's upward rally beginning late last year came to a screeching halt the day of his announcement, and has been in a corrective mode ever since.

At the present time, we view the current correction in the market just that - a correction of a market whose rebound had probably gotten a little ahead of itself; and was probably due for a rest. Nonetheless, we recall prior statements by Greenspan, and believe that he may well position the Fed as a headwind against a) incremental spending, and b) accelerated growth beyond the 4% GDP figures of the fourth quarter, that the Fed may consider inflationary.

Our position on interest rates has been that they will inevitably rise, but that it will be relatively contained, such that we will not get any major structural shifts that will cause rates to jump back to double digit levels. We could see Federal Funds rates back up to 2 ½ or 3% (now 1%); and the prime rate (now 4%) back up to 6 or 7%. Were this to occur, there would undoubtedly be a reaction in bond and preferred stock prices; but probably not enough to warrant speculating on the timing of such a move, particularly for those with laddered maturities who utilize the current income stream.

That said, we now believe that Mr. Greenspan may be beginning to shift gears, and that upward changes in short rates could occur before the election. This in turn implies a headwind in the short term, for the stock market. We should add, however, we believe that the long end of the bond market should be relatively well contained - as we believe that longer time horizon investors are more concerned with deflation, and will tend to gradually extend maturities if and as interest rate hikes occur.
Stepping back from all this, we see a stock market that will probably be choppy for some months, despite powerful economic progress; yet we still see an upward bias to prices. Yes - we are concerned with the budget deficit, and its impact on the national debt (figure 3)* as well as a sharply deteriorating trade balance, (figure 4)*. We also previously indicated that we have concerns that the debt, in and of itself, and particularly against the backdrop of a falling dollar, could make it increasingly difficult to finance our deficits.

Having said that, we also believe that the United States is the only locomotive that is powerful enough to turn up the world economy at the present time. We have essentially become the buyer of last resort for almost all developing nations. If we achieve 1-2 more quarters of 4% or so GDP growth here - we may well then see the economies of Europe and Japan improve to a level approaching we are now; and at that time, we will probably also experience greater fiscal and monetary restraint than at present. So we see clouds or headwinds on the horizon; but in our judgment, they are not powerful enough at the present time to offset the stimulus.

Therefore, in the meantime, we intend to stay with winning positions; but we also are mindful of the headwinds, which are beginning to emerge. Thus, given the different cross currents we see in the market, we intend to keep a shorter leash on stocks, for all the reasons indicated above.

As always, we thank you for your support, and invite any questions you may have.

Bill Schnieders
Jim Schnieders, CFA
*Please call the office at 626-584-6168 for a copy of the graphs.

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