2nd Quarter 2005: Deficits, Oil and the Fed

Second Quarter 2005
Market Commentary

Deficits, Oil and the Fed
April 20, 2005

Last week - the stock market took it worst hit since 2003, with the Dow Jones Industrial Average falling close to 400 points in the last three trading days alone (April 13, 14 and 15), index averages now show the DOW down -6% for the year the S&P -5%, and the NASDAQ -11%.

We have been cautiously optimistic on the market, believing that the expanding economy is still intact, and that the trend of rising earnings - coupled with a relatively flat market, brings P/E (price earnings) ratios to reasonable levels - and should provide good opportunities for selected stocks.

All these things are still essentially intact, yet given the recent correction in the market, we felt it timely to discuss our view of what is happening.

We believe last weeks correction was caused by three important factors. These factors are the budget deficit, trade deficit, Oil, and possible inflation that could arise from any or all of these three items.

1. Budget Deficit. We've reported frequently on the twin deficits, and continue to feel they are acting as a major deterrent to the stock market. Nonetheless, we view the deficits differently. As we mentioned in our commentary of October 2004, the budget deficit, while problematic, is not in our judgment as worrisome as much of the media is presenting it. At current levels of approximately ($450 billion) it is only 4% of last years GDP of (11.4) trillion. This is less than most of the European countries, none of whom have - or are experiencing the growth of the U.S. The 2004 GDP growth of just under 4% for the U.S. is almost twice the 2.2% average growth rate world-wide, as calculated by the European Organization for Economic Development (OECD). Because of this growth factor, we believe the budget deficit is manageable.

Further, a high percentage of our deficit (over a third), is due to Iraq, which we hope and pray is starting to wind down. Irrespective of one's opinion on our involvement there, we believe that total dollars allocated to Iraq will begin to fall; and while we believe it will be with us for some time, it should decline as a percent of the overall budget deficit problem.

2. Trade Deficit. The big storm brewing - and what we believe is the major factor pushing stocks lower over the past two weeks, is a trade deficit that was $60 billion in February alone, and is now running at a rate exceeding $700 billion per year.

We wish we could be as hopeful on the trade deficit as we have described our feeling on the budget deficit. This one is beginning to have characteristics that we view as being much worse than the media portrays it.

For starters, the trade deficit is the outcome of a trade policy, some of which we view as very questionable, specifically policies designed to integrate the world into one free trade zone. The problem is, free trade isn't free - it comes at a great price, particularly for those workers whose jobs have been replaced by workers overseas.

Over the course of this year, we will comment further as trade developments unfold. Suffice to say at the present time, most of our trade deficit comes from two sources - a) oil and b) imports of U.S. goods made overseas. The reality is that 50% of our manufacturing base is now overseas. U.S. business has capitalized on the discrepancy between the cost of foreign labor (particularly China), and the lack of auxiliary expenses that go along with hiring people in the U.S. Many foreign countries don't have the concern or laws for their workers that we have here.

This directly plays into the less than robust job growth in the U.S. Historically, at this point of time in our economic cycle, we should be adding 200,000 - 250,000 jobs per month. This expansion has only seen half of that.

Further, while U.S. profits have been up and strong, one could argue that a good part of the incremental profits have occurred by not only using foreign labor at a small fraction of the cost here (without any of the peripheral expenses for U.S. labor); but also, to the degree that products made in China and India are sold here - the profit margin on those sales becomes much larger.

Also large multinational corporations are also taking advantage of a tax law that allow U.S. companies to keep profits of goods made overseas untaxed - as long as those profits stay in the country of origin.

President Bush is now trying to change some of this by allowing U.S. companies a window of time in which to repatriate foreign profits held overseas, and subject them to a one time 5.5% tax. Were they to have brought profits home earlier, they would have been taxed at 35%. This proposal by Bush, in our opinion could have a stimulative effect on our financial markets and probably accelerate mergers and acquisitions activity.

For example, the recent acquisition of Gilette by Procter & Gamble is a forerunner of this. This entire transaction could have been financed by repatriated profits. Some reports we have read estimate $400 billion of repatriated profits could come back to the U.S. via this proposal.

(3) Oil. While the price of oil, which reached $57 per barrel two weeks ago, has now fallen back to the $50-$51 range, it still represents an increase of over 25% from year-end levels.

There are some that think this is an unsustainable rise; yet those hopes were somewhat defrayed last week by a Goldman Sachs report predicting $100 oil, and the chief economist of the IMF (International Monetary Fund) predicting surging demand for oil by developing nations on the
one hand, - and limited new supplies from the OPEC cartel on the other. This combination will tend to keep prices high.

The underlying problem is that developing nations - China and India specifically - have each increased their usage of petroleum products several fold - if for no other reason than to keep pace with the energy needs of the thousands of "outsourcing factories" which the U.S. and other countries have built within China to take advantage of low labor costs.

Moreover, China, in fact, has gone from becoming a net exporter of oil to the second largest importer behind the United States. We can't do much about the oil. The demand/supply equation is very fragile. Meanwhile, we're not finding a whole lot of oil in Texas or Oklahoma. Its pretty well played out as to new fields. Where we are finding oil is in deep offshore basins, such as the North Sea, the Gulf of Mexico, and even offshore Africa and Newfoundland. The problem is that such drilling is very expensive. They require drill rigs - some priced in the hundreds of millions - that have to endure 20-50 foot waves, high winds, and then drill several
hundred to several thousand feet depths to find the oil. All of this is very expensive. So what we have is an increasing demand for oil at an increasing rate by developing nations, and a decreasing supply at higher costs from the larger oil producer countries.


This combination of higher energy prices and larger trade deficits are starting to show up in the governments inflation numbers. While the government has spent a lot of time talking about energy strategies, no clear energy policies have emerged. On the other hand, the government is trying to address the trade deficit by putting pressure on the Chinese to revalue their currency upward. For the last several years, it has been pegged to the dollar. This is long overdue, and we believe it is a fait accompli.

The bad news is that the labor differential is so great, that the Chinese will still be able to undersell the dollar, particularly with no quid quo pro - as it relates to environmental policy, health care, and the like. So, our assumption is that the Chinese will take their currency up by 10% or so;(some economists believe its 40% undervalued). Either way, a rising Chinese currency is going to cause all those goods at Wal-Mart and other retailers to go up in price. That's assuming that American spending habits remain constant in the near term (and that's a good assumption given our proclivity to spend). If so, that's inflationary.

Heretofore, we have been importing deflation from China and other countries and marketing it through our retail stores. If we're looking at rising prices because of this structural shift, the markets are going to have Greenspan and the Fed to contend with - and that in our opinion - is what's making investors nervous. This is a very delicate operation, but we think the current weakness is overdone; that corporate earnings will remain strong, and that when the U.S. decides to address a problem - you don't want to be on the other side of it.

Even as we speak, some Senators are proposing a tariff to get a better balance between the U.S. and China. We buy 30% of their exports; they buy 3% of ours.

The Fed

This leads us to the most important variable - the Federal Reserve. Historically, whenever the Federal Reserve decides to address an economic problem with a policy of raising short term interest rates, stocks have ultimately suffered, because, as Investors Business Daily had pointed out they usually go a step too far. Historically, previous rate hikes cycles have often caused market downturns. (Please contact us for the chart.) This is quite possibly what caused the downdrift last week.

In our opinion, however, the Fed has been very cautious so far; and if they let nature take it's course on the above described problems, this correction that we appear to be in, will once again, turn out to be an opportune time to buy stocks.

We say this because, despite all the problems listed above, earnings remain strong, and the underpinnings of the economy are good. The S&P 500 index had earnings up 20% in 2004 versus 2003; and are expected to be up another 8% in the first quarter 05' versus 04' results. Historically, earnings have been the key determinant underlying stock prices, and price movement has been lagging the underlying earnings growth.

We are just beginning to get 1st quarter results as we go to press, and the results are generally good, albeit not up to expectations; IBM being a case in point. IBM's earnings came in 6¢ above 2004, at 85¢ per share, but 5¢ under estimates. Also their guidance going forward indicated weaker sales. Likewise, 3M reported a 12% gain in earnings, but it too, missed sales expectations.

All told, some 13% of S&P 500 companies have now reported, with over half exceeding analyst expectations, with another 25% in line with expectations.

Both companies mentioned above are economic bellweather stocks, and therefore, any hint of a possible slowdown has the effect or reverberating across the market. This is what investors responded to last week.

Investors have locked on to what they see as disappointing sales growth, while overlooking strong fundamental earnings. Also, there have been mixed reviews on the outlook for the current quarter. U.S. consumer confidence numbers came in lower, housing starts tilted down, and job growth is still mediocre. Add to that the high price of gasoline, and investors have become jittery.

But the primary concern is the Fed, and the Feds primary concern is with inflation. We believe however, as mentioned earlier, that much of the tightening is behind us, and that the market may be discounting fears and concerns which might not occur, including an overreaction by the Fed.

The good news is that the market is always looking forward, and that we are finally beginning to address problems with both oil and the trade deficit. Having said that, we see some near term headwinds, but still remain cautiously optimistic that we will work through these problems, and
that corporate earnings will prevail and will lead to higher prices once this correction period is over.

Best regards,

Bill Schnieders

Jim Schnieders, CFA

*Please call the office at 626-584-6168 for a copy of the graph

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