4th Quarter 2005: Slowdown in Sight?

Fourth Quarter 2005
Market Commentary

Slowdown in Sight?

Much has happened since our last communication, both in the economy and in the market. With three quarters of the year behind us, the economy continues to move along at a solid pace. Corporate earnings have been strong, and forward earnings estimates look impressive. Indeed, valuations on many stocks and stock groups look compelling. Despite this, however, all three major market indices are down for the year; causing us to examine what may be happening under the surface of the market that may be causing a shift in investor sentiment.

We have commented in the past on various problems surrounding the market. Last quarter (July) we discussed the pricing pressure on residential real estate. Prior to that, we noted that our twin deficits were weighing heavily on the economy, particularly the trade deficit. In April we gave an overview of the supply - demand factors affecting oil, the inflationary aspects that result from it; and the Federal Reserve's response to all the above.

This report will give a brief update on these issues, plus a background on the shape of the consumer, as to his/her savings. Two thirds of the U.S. economy is driven by the consumer, and we're concerned that the consumer is beginning to slow down. Our concerns about the consumer, however, flow directly from three items of which we have addressed earlier in previous commentaries. These items are oil, inflation, and interest rates.

The price of oil now resting at $64, is 10% off its multi-year high of $70, set just several weeks ago. While the price of oil has been steadily rising over the past year and a half, the situation worsened in September with the onslaught of Hurricanes Katrina and Rita, which combined to present us with the worst natural disaster in our history.

Weekly Crude Oil Price


The path taken by Katrina, particularly, swept through the Gulf of Mexico, not only devastating the city of New Orleans, but also taking out about 20% of US oil production located along the gulf coast. It also damaged a significant percent of our refining capacity, as well as much of our port facilities. In turn, these port facilities near the mouth of the Mississippi process close to half of the oil we import from abroad.

The government responded to this by both opening the spigot of our strategic petroleum reserve (to approximately 2 million barrels of oil per day), and obtaining oil from similar reserves in Europe for an approximately equal amount. Were it not for this incremental supply of oil in an already very tight energy market, we well may have seen near term prices shoot as high as $100 per barrel; which, by the way, is what Goldman Sachs had previously estimated the price of oil could reach. That prediction occurred before the Hurricanes developed.

Oil is a primary feedstock of our electric power plants, without which our economy would grind to screeching halt. It is also a primary component of petrochemicals, and is utilized for, and imbedded in literally thousands of products, particularly if one includes industrial gas in the product mix. Therefore, industrial output is critically dependent on available supplies of energy, and any change in supplies can cause major disruption.

All this has led the inflation hawks on Wall Street to run for cover, and shift funds into hard assets, causing a sharp drop in the stock market for the first two weeks of October. The price of gold, traditionally a hedge against inflation, has been rising in recent months, and (while still well below all time highs set in 1980) is nevertheless sitting at $470, close to a 15 year high. Other items causing inflationary concerns are also rising. Such factors include rising unit labor costs and producer prices (up 4.2% in the most recent reported quarter); along with $3 per gallon gasoline, and expectations of sharp increases in home heating oil for this winter. Further, consumer prices surged in September by the largest amount in more than 25 years, again largely because of Hurricanes Katrina and Rita's impact on energy prices. In fact, energy prices soared at the fastest pace on record, as the Labor Department
recently reported that inflation jumped 1.2% in September alone, as a consequence of these developments .

As inflation, and/or expectations of inflation rise, so also do interest rates. The Bond Market, which has been relatively flat for the last several months, has finally started to fall (causing rates to rise), reflecting inflationary concerns on the part of the investors.

Interest Rates
Not to be outdone, Fed Chairman Alan Greenspan, who has been matching every uptick in the price of oil with short term interest rate increases (11 consecutive ¼ point hikes at every Fed open market meeting since July 2004), has viewed Katrina and Rita with some degree of indifference, having just raised the overnight bank lending rate to 3¾%, against suggestions that it pause in deference to Hurricane Katrina. Greenspan went on to say that "although Katrina and accompanying energy price volatility have increased uncertainty about near-term economic performance…they do not pose a more persistent threat."

According to many economists, Katrina's net effect will probably slow the expansion of our gross domestic product (GDP) by a percentage point or more in the third quarter, resulting in a real growth rate around 2%. The Fed itself reckons that 100 basis points of tightening reduces economic growth by 1.1% after two years. By that rule of thumb, expect that the 275 basis points that the Fed has already cranked in will result in hits to GDP beginning next year, all other things being equal.

In fact, this may already be happening. The past three months (July - September) have witnessed a number of economic indicators which, while rising, were doing so at a slower rate than a year ago; and also at a slower rate sequentially than in the previous two quarters. GDP growth was 4.2% in 2004, 3.8% in first quarter of 2005, 3.4% in second quarter of 2005. Due to the triple threat to the economy listed above, and exacerbated by the hurricanes, the third quarter will come in lower yet, and, according to ValueLine, ease down toward a 3% growth rate in fourth quarter 2005, and early 2006.

We have often been skeptical about the U.S. savings rate, in that it does not include equity build up in either retirement plans or home equity. Nonetheless, the savings that are included are constant over a period of time and they have been declining.


The savings rate in July was a minus 1.1% which was an all time low. Further, the savings rate was minus 0.7 percent in August, the third straight month it has been in negative territory. A negative savings rate means that Americans are spending all they earn in a given month and then some, dipping into past savings or borrowing to finance spending above their earnings level.

If one were to do the equivalent of a nationwide cash flow analysis, as any corporate executive will tell you, you need positive cash flows to finance future projects and future expansion.

So, if we're looking at the consumer (on a macro basis) spending more than they make, and add budget constraints on the rising price of gasoline and home heating oil; and then overlay that with a higher cost of money - we've got a problem with the average consumer.

We also commented in our third quarter report that $223 billion has been borrowed against home equity over the past year (2004) , and that approximately half of this money showed up in increased spending by consumers. As such, we feel that many consumers have been tapping into their home equity for some spending money. Therefore, if residential real estate prices stall, consumers will have a tougher time using their homes to fund the purchases they want.

We believe that the Federal Reserve's policy on continued rate hikes has a lot to do with addressing this problem. We also feel that the Fed should have tightened banks lending requirements some time ago, but it does appear that they are beginning to address the problem now. Pending legislation limiting interest write-offs to $500M and less loans addresses speculation on the high end of the market, and continued interest rates hikes will eventually affect home mortgage rates. How this all plays out may take months to evaluate, but we think it will have an impact of cooling down residential real estate.


The factors discussed above affect all of us in different ways and to different degrees. One bright spot in all this, at least for the near future would appear to be large U.S. multi-national corporations. We say this because, continued pressure on the twin deficits of which we have written previously, could cause the dollar to decline. If so, this helps corporate America in the international marketplace, as our goods (priced in dollars) become cheaper for the foreign purchaser; and there's plenty of money sloshing around the international marketplace (particularly Asia) to buy U.S. goods. We believe this will enhance corporate earnings, and earnings are the driving force behind stock prices.

Indications are that fourth quarter earnings of the S&P (heavily weighted with multi-national companies) are expected to be up significantly year over year. Therefore, despite all the attendant problems, we continue to believe that well diversified equity portfolios will provide protection against the external shocks and will do well in the days and weeks ahead.

Further, there is a very real need for manufacturers and retailers to restock inventories, which could lead to a short term spike in production. Also, there is an economic impact of federal and local spending in the Gulf Coast to repair hurricane damage. Current estimates of this expenditure range between $100 and $150 billion; and most of this will be spent within the next six to nine months. Finally, we are approaching the Christmas and Holiday season, which traditionally has been a strong period for both the economy and the market.

In conclusion, it will be some months before we know the full extent of the hurricane damage, and what the final cost will be to rebuild New Orleans, and repair valuable infrastructure along the Gulf Coast. One thing we know for sure is that whatever the cost it will be passed on; which further clouds the horizon as to inflation fears. Moreover, we feel that the multiple problems of high energy prices, rising inflation, rising interest rates, and low savings rates will put pressure on the US consumer. As a result, we feel the best way to invest in the current environment is to remain cautious and focus in on high quality, blue chip companies with solid dividends that can participate in both domestic and international growth.

As always, thank you for your support.

Bill Schnieders

Jim Schnieders, CFA

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