Author: stav

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There has been a significant decline in investor expectations over the past several weeks. The presidential election, price-fixing in the insurance industry, product recalls in the pharmaceutical industry and record high oil prices have been pressuring stock prices. We have gone above and below the 10,000 level on the Dow Jones Industrial Average several times this year. Surprisingly Treasury bond prices have shown a significant amount of resilience as investors in the equity markets moved to the sidelines. Crude-oil futures had crossed the $55 a barrel level, which is the highest point since oil futures started trading on the New York Mercantile Exchange in 1983. Rising oil prices can seriously hurt equity valuations over time as investors begin to fear higher energy costs, weaker corporate profits and lower consumer confidence.

Among Mr. Bush’s most ambitious domestic economic goals is additional income tax code reform. The President is expected to study ways to make the system less complicated and move it more toward a tax on spending, as opposed to income. He also wants to make permanent the tax cuts passed in his first term. The pressure to amend the tax code partly comes from the unpopular Alternative Minimum Tax provision that exists in the present code. Any significant tax-reform plan will be very controversial and hard fought in the Congress. We are optimistic that Congress will pass a rational energy bill that would benefit energy investments. We also believe that a meaningful tort reform bill has a chance of passing in the Congress, and this could have a broad benefit to the financial markets.

The first half of the year’s surge in job growth increasingly looks like an aberration. The hurricane season certainly did not help the situation in the third quarter, but The Bureau of Labor Statistics believes the effect of the storms will ultimately be small relative to the overall job growth picture for the entire year. The economy is still moving forward, but slower than expected as we indicated in our last Outlook. The strain on the U.S. economy from rising oil prices is a further risk to GDP growth in 2005.

The Federal Reserve Board is likely to stay “measured” in raising interest rates. We interpret “measured” to mean quarter-point steps are still the basic plan, with periodic pauses. December remains the best chance for a pause before year-end. We assume a 2% federal funds rate at the end of 2004 and 3.5% by the end of 2005. Core CPI inflation might inch up to around 2% by year-end. Given our GDP growth expectations, the risks associated with higher inflation are probably low. Our 2005 forecast for GDP remains at 3.5%, but high energy prices could significantly reduce that number. Obviously higher gasoline prices and home heating fuel costs could push total CPI inflation up and GDP growth down next year.

Unlike the period in the 1990’s when excess oil producing capacity was 5 to 10 million barrels per day at a time when worldwide oil demand was 72 million barrels a day, at the present time demand is approximately 82 million barrels per day and maximum capacity is considered to be approximately 83 million barrels per day. In 2005 the expectation is that oil demand will increase again and may even exceed current production and refining capacity.

In the meantime summer and fall inventories of crude oil, gasoline and heating oil have been drawn down, and they will probably not fully be built back in time for the winter heating season. Furthermore, refinery capacity and shipping capacity is fully utilized leaving no room for supply interruptions. Oil companies continue to justify capacity expansion on $25 a barrel oil, which suggests that supplies could remain tight for a considerable period of time.

The degree to which the exchange rate of the dollar will maintain its present level depends on foreigners’ willingness to reinvest these funds back into the United States. It is worth noting that in July net private purchases of U.S. treasury bonds and notes fell to $18.3 billion from $23.0 billion, and in August net private purchases of U.S. treasury bonds and notes swung to a negative -$4.4 billion from a positive $18.3 billion. Moreover, in July private net cash inflows into the U.S. were $73.8 billion and in August it declined to net cash inflows of only $37.4 billion. This represents approximately a 50% decline. Making up the short fall were dollar purchases from foreign central banks. Should the foreign exchange value of the dollar decline further, we can expect an improvement in our current account deficit if imports slow and exports increase. However it seems reasonable to assume that we can still expect a further devaluation of the dollar. Should this occur we would expect rising prices for precious metals, commodities, collectibles and imported goods.

The current price of energy, gold and industrial raw materials as well as overall market trends corroborate our view that equities representing “hard assets” offer some of the best opportunities for investors. The future earnings, cash flow and dividends from the companies we like often are not reflected in their present asset values. We expect that the high-dividend paying companies in this area will do particularly well in the current market environment. Other companies which should benefit from these conditions are in the following industries; defense, building materials, machinery and railroads. The companies we favor in these groups generally have extra cash on hand to allocate towards capital spending, dividends, share-buybacks and debt reduction.

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Most companies are richly valued at present even assuming the sustainability of the economic recovery. In the late 1990’s an Internet/technology driven business boom pushed the unemployment rate to record lows and economic growth to record highs. We do not feel that there is anything in the system today that can bring back so much economic excitement or investor optimism. High oil prices, terrorism and the structural imbalances caused by large federal budget deficits and trade deficits have altered the economic landscape.

It is noteworthy that many Wall Street firms have recommended an under weighting in energy and are now moving to a market weighting for portfolios. Energy (oil and gas) represents approximately 7% of the S&P 500 while financials represent about 25% of the S&P. However, in 1980, when energy prices peaked, energy company equities were 25% of the S&P while financial company equities represented 7% of that index. Today’s valuations of energy companies, particularly among the independent producers in the U.S., sell for as low as 3 times cash flow from operations. Moreover some of the great beneficiaries of current high energy prices are paying dividends yielding 7%-10% per year and have the potential to raise their dividends in the future. At a time when many investors are trying to increase their returns in a historically low interest rate environment, we still believe that investments in the energy sector are particularly attractive.

While consumers continue to benefit from cheap Asian imports, goods and services that are produced in the U.S. are rising in price more than the official inflation statistics are indicating. The overall price inflation view now suggests that consumer incomes are likely to get squeezed in the current environment. While corporations have been accumulating cash, paying down debt, buying back stock, and raising dividends, consumers are having to grapple with rising household expenses and heavy debt loads. Consumers may find it necessary to cut back on spending – particularly if interest rates keep rising.

We are always dealing with uncertainty and a range of challenges when attempting to describe future economic outcomes. However, the combination of the U.S. government’s fiscal and monetary policy becoming less expansive and record high oil prices suggests that the equity markets may well remain under pressure. Let’s not forget that the 4% growth of GDP has been built on large U.S. fiscal and trade deficits totaling 10% of GDP (a very high percentage) and a forty-year low in interest rates. Should we expect strong growth if energy prices remain high, interest rates rise, consumers find it necessary to cut back on spending and Washington attempts to rein in the deficit?

Deflationary forces still lurk in the background and high energy prices will act as a tax on consumption while the tools of economic management-fiscal and monetary policy-are in the process of being reversed. High quality fixed income investments should also do well in this environment. We believe that most economists will have to revise downward their growth expectations including the most recent Federal Reserve Board expectation of 4 1/2 – 5% growth for the second half of 2004. From what we see many investors are not prepared for this change.

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While we are on the subject of the strengthening of the dollar, it is important to note that the appreciation of the dollar against the Japanese yen has removed the need for the Japanese to embark on currency intervention to prevent their currency from rising. The effect of the Japanese intervention had been to increase demand for U.S. Treasuries, which had the effect of putting downward pressure on our interest rates. Since the Japanese demand for U.S. Treasuries has been reduced, U.S. deficits now need to be financed from other sources thereby tending to put more upward pressure on U.S. interest rates.

Recent data showed that the U.S. economy’s gross domestic product rose a healthy 4.2% in the first quarter of 2004. Growth would have been even stronger had it not been for a deceleration in inventory investment. Inventory accumulation will likely help the U.S. economy’s growth going forward, as production ramps up to meet a projected strong seasonal shopping period in the second half of the year. Corporate earnings in the first quarter were strong, with profits generally better than forecasts. The May 7th report of a rise of 288,000 people in April’s non-farm payrolls is also further evidence of the U.S. economy’s strength.

The outlook for Federal Reserve Board policy is very straightforward. If the employment data continues to remain strong, the Federal Reserve Board will raise interest rates. If, on the other hand, the employment data starts to show some weakness, they probably will be hesitant to raise interest rates. To make matters a little disconcerting, financial markets are beginning to reflect the influence of a significant increase in energy and commodity prices. Companies are starting to pass on some of the increased costs of energy and raw materials. Therefore deflationary pressures have begun to moderate. Rising commodity prices are increasing the costs of finished goods, and price deflation from China has now given way to an accelerating inflation.

Keep in mind that Federal Reserve Chairman Alan Greenspan has said repeatedly that strong productivity growth and falling unit labor costs have been key factors allowing the Central Bank to keep interest rates low. Labor costs in the U.S typically represent about two-thirds of the overall cost of producing goods and services. Unfortunately the first-quarter saw an increase in labor costs due in part to the rising costs of providing healthcare and pension benefits to workers. If this trend persists, the rise in unit labor costs is another reason for the Federal Reserve Board to raise interest rates.

If interest rates continue to rise this year, the financial markets could experience an unusual degree of volatility. In an attempt to reduce their risk exposure financial institutions sell their long-term fixed-income securities. Borrowing short and investing long often works well when interest rates are falling. However, leveraging long-term assets on short-term borrowing can be disastrous in a rising interest rate environment. The carry trade could be a critical factor in how the financial markets behave for the rest of 2004. Moreover, instability in the Middle East, high-energy prices and rising inflation have added to the financial markets’ unease. Nevertheless, we continue to find appealing equity and fixed income investments that are benefiting from these conditions.

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China, with 1.3 billion people, is rapidly industrializing resulting in the most significant increases in energy and industrial commodity prices in memory. Moreover demographic changes in the United States have augmented demand for housing, which is also increasing demand for energy and industrial commodities. Because interest rates are so low home-ownership has become more affordable in spite of rising home prices due to strong demand. Moreover because housing is a home grown product and not an imported one, pricing power exists in the homebuilding industry. In fact where U.S. goods and services do not have to compete with overseas suppliers, prices have been rising much faster than the government’s measure of inflation as represented by the Consumer Price Index. For many consumers and investors to offset higher costs in a low interest rate environment, capital is flowing to higher yielding securities.

In the 1970’s and 1980’s the main issue confronting the Federal Reserve was fighting inflation. Today inflation, as measured by the Consumer Price Index, is at very low levels even as energy and commodity prices have risen substantially. In today’s economy commodity prices have a much smaller influence on the U.S. Consumer Price Index than they have had in the past. This is evident as we have become more of a service-based economy with productivity gains driven by automation and technology, while over time we have outsourced increasing amounts of industrial production to lower cost nations. Consequently, the Federal Reserve Board has been more concerned with deflation than with inflation. Unless employment growth would get so strong as to put real upward pressure on U.S. labor costs, we should expect an accommodative monetary policy to continue.

Last year oil prices in the United States averaged $31 a barrel and this year oil is selling for approximately $36 per barrel. Wall Street analysts for the past two years have expected oil to sell between $18 and $24 per barrel and have recently raised their targets to $28. In so doing they have also raised their estimates of the value of many oil and gas companies.

As clients of our firm know, many of our energy investments have yields of 4% to 9% and not coincidently benefit from negative exogenous forces, a stronger economy, inflation of commodity prices, the need for the United States to import 50% of its needs and increased electric power generation which is often fueled by oil and gas. In 1980 the oil and gas sector represented more than 25% of the S&P 500 and is now 6% to 7% of that index. Oil and natural gas equities look particularly attractive at their current valuations. Looking ahead we believe that earnings and cash flow in this sector will be stronger than expected if oil and natural gas prices persist at relatively high levels.

The homebuilders in recent months have rewarded their shareholders with stock buybacks and increased dividend payouts. A number of homebuilders, who in the past have not paid cash dividends, have initiated a quarterly dividend, and they are quite confident that they will be able to sustain and increase their dividend payouts over time.

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The inflation picture remains very favorable for a continuation of low interest rates. However, several factors are pressuring prices: medical/health costs are rising, local and state governments are increasing taxes, commodity prices are moving up across the board and the U.S. dollar is weak. However we still feel that the Federal Reserve will resist interest rate hikes until at least the third quarter of 2004 and probably into early 2005. Strong economic growth should not result in a rising inflation rate unless that growth is strong enough to generate much higher employment growth and significantly higher industrial utilization. We do not believe that industrial capacity will tighten enough to cause that to happen. The Federal Reserve will be able to remain accommodative for the majority of 2004, in our view, because of technology related productivity gains as well as deflationary manufacturing pressures from Asia.

The natural gas industry in particular should have another strong year in 2004. The National Petroleum Council recently released a study on natural gas supply and demand that projects that domestic production can only satisfy about 75% of future U.S. domestic requirements. Natural gas prices are likely to remain high and the government could encourage an increase in drilling and new pipeline and processing construction. Companies that supply natural gas to the U.S. market should continue to enjoy high profits and excellent free cash flows for the foreseeable future.

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Today’s economy has benefited from the enormous stimulus that has been put into the system. While classic third and fourth year economic stimulus programs in advance of presidential elections keeps everyone’s focus on near-term improvements, the amount of debt that is being put on the system on all levels appears to be unsustainably large. Recently, Fed Chairman Greenspan observed that Congress keeps increasing spending out of proportion to tax revenues thereby abandoning fiscal prudence. It is under these conditions that portfolio management will face the challenge of compounding rates of return in a low interest rate environment to both meet clients’ objectives and compensate for a declining U.S. dollar that continues to lose value over time.

The start of 2004 looks solid, mostly because of low interest rates, tax refunds, and mortgage refinancing activity. In a presidential election year it is typical to expect the Congress, the Treasury Department, and the Federal Reserve to keep the economy moving in a positive direction. Against this backdrop, the Federal Reserve is expected to hold the key short-term interest rate steady at a forty-five year low of 1% at their next meeting on December 9th.

The Consumer Confidence Index rose again to 91.7 in November, up from a revised 81.7 in October. The index, the highest since September 2002, was well ahead of the 85.0 projected by analysts. Consumer confidence is now at about its highest level since the recession officially began. Unfortunately global terrorism fears have not gone away and are once again in the headlines after terror attacks in Turkey. We believe that as long as these kinds of attacks are scattered and on foreign soil they probably will have little affect on consumer activity. However, improvements in job creation are a crucial ingredient for a sustained high level of consumer confidence. The vigorous economic growth continues to be accompanied by strong increases in productivity, as corporations under global competitive pressures find ways to reduce costs and expand output without hiring new workers.

Job growth could remain disappointing and consequently monetary policy is likely to remain quite loose throughout 2004 in advance of the presidential election. The corporate profit story, while much improved, is not quite what it appears to be. We note that corporate after-tax profits estimates for the third quarter annual rate of $515.4 billion on a GDP of approximately $11 trillion is virtually unchanged from the $514 billion in 1999 when the GDP was $9.3 trillion. So while the economy looks stronger, profit growth has not kept pace and therefore job creation is likely to remain a challenge unless moves to protectionism accelerate.

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The most recent Congressional Budget Office (CBO) reports on the outlook for the federal government deficit indicated continuing $500 billion deficits that would persist for an extended period of time. Moreover, as we all know President Bush has requested to congress an additional $87 billion for Iraq, Afghanistan and additional security. These supplemental budgets are no different from corporate pro forma accounting adjustments where, in this case, the government is able to think it can mask the true dimension of the deficit. It should also be noted that the CBO assumed that the economy would be strong when it came up with the $500 billion deficit estimate.

Today effective investment strategies must be able to target positive compound rates of return in an environment that is differing markedly from past periods. Economists have been blindsided too many times by looking at the past to anticipate the future. In an analysis where capital will always flow to the highest rate of return we continue to favor domestic energy and particularly U.S. natural gas companies. Liquefied natural gas (LNG) is now being discussed in earnest as a necessary source of additional energy. We also favor uniquely positioned technology companies at the forefront of productivity and change and that benefit from their leading competitive positions. We also believe that quality, high yielding securities can appreciate in this environment because income continues to be difficult for investors to generate. We have acquired positions in precious metals mining companies for the first time in our 32-years as a firm, as they benefit from powerful macro forces including ongoing excessive monetary stimulus. With respect to precious metals, we believe that the dollar and most other currencies are likely to continue to lose value relative to hard assets. The printing presses in the U.S. and in major countries around the world are creating currency at a very rapid rate. There are weeks where the U.S. alone is creating dollars at an annual rate of $2 trillion. Other attractive investments include companies that have the ability to restructure and enhance their common stock valuations. Finally, another interesting investment opportunity emerging in the United States involves infrastructure. The most recent and public example of under-investment in this area is the electric transmission grid. Many billions of dollars of capital will have to be spent to upgrade, repair, modernize and expand the U.S. infrastructure.

Before the end of this year the SEC is likely to permit the creation of an ETF (Exchange Traded Fund) on the New York Stock Exchange, which will be backed by gold. This will enable institutions to have a direct participation in the gold market without purchasing bullion. The fundamental gold supply and demand factors also indicate considerable support for the price of gold. Over the longer term one can argue that the physical demand for gold should outstrip gold mining production by a wide margin. The deregulation of the gold market in China as a precursor to their joining the world of major industrial nations should also provide strong support for gold over the longer term. Under these circumstances ownership in quality gold mining companies can contribute meaningfully to the total return of an equity portfolio. It is especially interesting to note how unpopular a notion it is to invest in gold related investments perhaps suggesting a strong contra indicator. It appears that to be upbeat on gold one is still viewed as a killjoy and a pessimist regardless of the facts that backup such a position.

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• Consumer demand and business spending
  At the present time, growth in consumer and business spending is likely to remain slow, but a positive trend has been all that is needed to result in better financial markets. However, it is important to note that the U.S. economy is being supported by the strength in housing and the ability of consumers to refinance their mortgages without which growth would be virtually nonexistent.

• Interest rates
  We expect current inflation rates to decline further and the Federal Reserve to maintain short-term interest rates at historically low levels for the foreseeable future. Furthermore, recent statements by Fed Chairman Greenspan indicate a likely further reduction in short-term interest rates.

• Availability of credit, the difficult employment outlook, and prospects for a lower U.S. dollar are also important variables to consider in assessing the health of the U.S. economy and the financial markets.

1. More than $6 trillion of liquid assets barely earns any interest.

1. Dividend-paying common stocks are attracting significant capital flows as a result of the need for yield.

1. The new tax reduction act will provide some economic stimulus as well as lower the cost of capital as both the capital gains tax and the tax on dividends have been reduced.

1. The depreciation of the dollar will result in better business for exporters and can bring about higher reported earnings for U.S. multinational corporations.

1. Hedge funds still carry near-record short positions on both the New York Stock Exchange and the Over-The-Counter market, and as they cover their short positions by buying in shares and also initiate new long positions, they can be a powerful force in pushing equity prices higher.

1. If markets continue to rise, cash on the sidelines will be forced into being invested. The market is professionally dominated at the present time and investors are not willing to miss a rising market. In fact the latest mutual fund flows indicate that $16 billion flowed into equity funds reversing many prior months of outflows.

A cyclical recovery in the second half of 2003 has already been factored into equity valuations. We think that the case for a new broad-based bull market is difficult to make. Nonetheless, companies with operating and/or financial leverage can do reasonably well in this environment. Many of the equities that we follow will not need a strong consumer or business-spending environment to deliver an excellent total rate of return.

To give you a sense of how easy it would be for the Federal Reserve to lower long-term interest rates, we list below the national debt in the public hands beginning with the year 2016. Notice how few long-term bonds are outstanding.

As can be seen in the following graphic, the total national debt in the public hands from the year 2021 to 2032 is an astonishingly small $294 billion out of the total national debt of $6.5 trillion. With so few bonds comprising the long end of the market it would not take many dollars to influence rates. As of the end of 2002, the average maturity of the national debt was only sixty-six months. Since there is so little long-term Treasury debt outstanding that one can purchase to lock in a reasonable return, with total liquid assets in excess of $6 trillion earning almost no interest, demand for yield has had a significant impact on raising Treasury prices.

As of this writing we expect the European Central Bank to lower interest rates and the dollar to continue to depreciate over time. It is important to recognize that overseas’ economies which are running trade surpluses with the United States can purchase U.S. Treasury bonds to prevent their currencies from appreciating too rapidly and damaging their export industries. This process tends to lower U.S. interest rates. At the present time, the two-year Treasury is yielding 1.22% or less than the federal fund’s rate of 1.25% suggesting another decline in the federal fund’s rate is in the offing. We believe we are currently in a powerful bear market rally where the opportunity to capture substantial capital gains can occur. Many investments that we continue to favor are beneficiaries of the current rally but are also in secular up trends – an important distinction as it is impossible to know with certainty when the rally will exhaust itself.

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Negative Economic Forces Persist

Wall Street’s economists are being asked, “Will the economy recover when the Iraqi war is behind us?” The answer we hear is “I don’t know.” The reason given is that negative economic forces have been at work long before geopolitical issues over Iraq began burdening the economic outlook. We have often indicated that despite a possible powerful, tradable market rally after Saddam Hussein’s regime falls, fundamental U.S. economic issues will still have to be resolved, and it is these issues that are likely to prevent a strong market from being anything but temporary.
Traditional investors are not driving current market activity. The stock market’s gyrations have been the result of some 6,000 hedge funds attempting to take advantage of war-related short-term opportunities while investment funds for the most part have been sitting on the sidelines. The most recently published short-interest positions on the New York Stock Exchange showed an increase of over 4% amid speculation on higher oil, gold, and treasury prices as a result of the war. As the war comes to conclusion hedge funds are unwinding positions by buying back shares they sold short and selling bonds, gold, and oil to participate in what they believe will be a stronger overall market. We should also expect a temporarily stronger market environment as cash sitting on the sidelines gets invested and the war-risk is diminished. It is worthwhile noting that the week the war began, the Dow Jones average surged 1,000 points as hedge funds reversed their positions as described above.

Energy Prices Remain Strong

We continue to hold a minority view with respect to the outlook for energy pricing, particularly oil. Most analysts believe that the price of oil will decline to the low 20’s and possibly into the high teens as occurred after the first Gulf War. However, today’s conditions are different from the first Gulf War experience in the early 90s. Since our last Outlook oil supplies in storage in the United States have declined even further and are at twenty-seven year lows; and Nigeria, a two-million barrel a day exporter of high quality oil, has been experiencing civil unrest. Major oil producers, Shell and Chevron/Texaco, had declared force majeure on 40% of their Nigerian production, further tightening the oil market. In the Middle East we do not know how long Iraqi oil will be off the market, but formidable production difficulties keep cropping up. The challenge for United States producers will be to rebuild gasoline supplies for the summer driving season and at the same time rebuild inventories for next winter’s heating season. As for natural gas, it is in tight supply and is likely to remain so for a considerable period of time.

Pressures Brought On By Growing Budget Deficits

The Administration’s supplemental budget request of $75 billion for the war effort will add to the fiscal deficit bringing the total close to $400 billion or approximately 4% of GDP. Moreover, it is likely that another budget request will be submitted raising the deficit even further. In spite of a significant increase in the total budget deficit over last year, some important programs are still being under-funded putting in question the size of future deficits. As an example, the government’s costs associated with providing health, education and other human services are growing more rapidly than tax revenues and the potential long-term growth of the U.S. economy.
The effect of federal government under-funding in combination with higher Medicare costs has resulted in a 12.4% premium increase for medical benefits in the private sector. These higher costs will be passed on to consumers and businesses putting a further burden on them. This is in addition to the economic and tax squeeze on consumers and businesses brought on by the need to eliminate state and local budget deficits.

Interest Rates Could Head Lower

We would expect the economy to do better eventually to the degree that it has been held back by the war. However, once it becomes clear that the U.S. economy is still operating considerably below its ideal rate of growth, the probabilities for further Fed easing are high. Moreover, as we wrote in our December Outlook, the Central Bank is prepared to use unconventional methods to reduce long-term interest rates.
The prospect of a no-growth economy is not a comfortable scenario for the Federal Reserve. Since the amount of outstanding Treasury debt in the public hands which matures in twenty years or longer totals only about $235 billion, it would not be difficult to bring down interest rates should the Federal Reserve decide to intervene in the long-term Treasury market. In a speech supporting this possible course of action, Fed Governor Bernanke referred to Fed’s capping long-term treasury yields at 2.5% in the 1940s.
In the private sector, companies are fast retiring high cost debt, which denies portfolios the opportunity of receiving the higher interest income. This is making high dividend-paying securities increasingly difficult to find. Consequently, there is a strong demand in the face of shrinking supply for high-yielding securities that is lifting their prices thereby increasing the total returns to their present owners.
Growing Pension Fund Liabilities Pressure Earnings
It is important to emphasize that, as we mentioned in prior issues of The Outlook, the pension fund liabilities of corporations are likely to be a significant depressant on corporate earnings for the following reasons:

• The SEC is concerned about many companies’ pension rate-of-return assumptions. Rate-of-return assumptions range from 8-10% in many cases. If, or more likely when these assumptions are lowered, companies will have to contribute significantly more to their plans from their earnings.
• Companies are using discount rates in establishing their liabilities that bear no relationship to the rates of return currently prevailing in the financial markets. When more realistic discount rates are acknowledged, pension fund liabilities will increase.
• The government’s Pension Benefit Guarantee Corporation, charged with insuring companies’ pension liabilities, is currently under-funded by $3.5 billion. However, last year, it had a surplus of more than $7.5 billion. The airline industries’ pension plans are currently under-funded by $18 billion and overall U.S. defined benefit plans according to the PBGC’s calculations are now actually under-funded by some $300 billion. We expect that companies will have to pay higher fees to the PBGC. In addition, if the Financial Accounting Standards Board changes the rules for pension fund accounting by requiring companies to reflect their pension funds’ true liabilities on their financial statements, then earnings’ predictability will be greatly diminished.

Weakness In Many Sectors Of The U.S. Economy

The unemployment situation deteriorated in February and March, and we believe that the labor market is still slowing. Moreover, it appears that the loss of jobs is part of a secular trend where manufacturing and service sector jobs are moving overseas. Accordingly, weather, Iraq, and seasonal adjustments may be only part of the real underlying reasons for the economy’s weakness. We cannot help noticing a pattern of weakness across many sectors of the U.S. economy. With consumer demand slowing, high-energy costs, and pricing power confined to only a select few industries, jobs are being cut to shore up margins.
Finally, sudden acute respiratory syndrome is something to be watched closely since the recent outbreak of the SARS virus has geoeconomic ramifications. A great deal of manufacturing outsourcing is based in Asia, which also has been the fastest growing economic region. At the present time, growth rates are being lowered as travel has begun to be seriously impacted by the spread of SARS and manufacturing efficiencies are being reduced.

Our Portfolio Focus

Mutual funds that have broadly diversified portfolios will likely find the current outlook particularly difficult. Hedge funds account for a significant percentage of the overall market’s trading activity and exacerbate volatility. In this environment our portfolio focus continues to be on high-yielding securities with growth prospects and clear under-valuation. Notwithstanding attractive exceptions to this, the ability to compound rates of return will be more dependent on the income flows that a portfolio generates than it has over the past several years.
In spite of a difficult economic environment, this continues to be a stock pickers’ market where capital-building opportunities can be found. For example, we recently purchased an equity position in a multi-billion dollar retailer after they announced their intent to restructure by selling a major part of their business to unlock value. The shares have begun to appreciate sharply while still yielding nearly 3.5%, and we estimate a reevaluation well in excess of the current price. These are the kinds of investments that should be included in portfolios where suitable.

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Confronting Today’s Investment Outlook

In confronting today’s investment outlook, geopolitical issues play some part in establishing the direction of the markets in the short term, but by no means are these issues the determining factors. We cannot point to any convincing reasons to believe that a new bull market cycle can begin from these levels when the S&P 500 yields 1.9% and sells at twenty-seven times 2002 operating earnings. On the contrary, the economy’s anemic growth (last quarter’s real GDP growth was estimated to have slowed to a .7% annual rate) is insufficient to withstand the strong headwinds that will likely hit as state and local budget deficits swell. Municipalities must use a combination of borrowing and raising taxes and cutting services and employment to close their budget deficits. Economic weakness in Europe and Japan and high and rising energy costs are making matters even worse by undermining consumer confidence and corporate profits. The longer global economic and geopolitical risks linger, the longer the financial markets are likely to be under pressure.
Geopolitical forces including the loss of Venezuela’s oil production, however limited in duration, have pushed up oil prices. We understand that significant reservoir and well damage has occurred in Venezuela. Venezuela’s oil fields probably will require nearly $6 billion of investment to restore production to former levels. Oil prices have risen 75% over the past year and natural gas prices have risen over 70% since this past December. We do not need to be reminded of the impact of energy shocks on the US economy, but this time the shocks will hit the system at a particularly weak point of the economic cycle when only consumer spending is keeping the economy growing. The question is how long will consumers continue to spend and take on more debt before they will have to cut back.

Anemic Business Spending and Investment

The outlook for business spending and investment remains weak. Businesses want to see a clear path to higher revenues and improved earnings before committing to increasing capital outlays. Companies also need to pay down debt and improve free cash flow in order to satisfy the rating agencies. They risk credit downgrades and increases in their cost of capital if they fail to improve their capital structures and deliver satisfactory results in this regard.
The outlook for business spending contrasts somewhat with the outlook for consumer spending. Cash flow generated by home-mortgage refinancing has effectively been able to keep consumer spending in positive territory. Consumers have used some of the interest-rate mortgage relief provided by refinancing to restructure their debts. This could indicate a long overdue start to the recovery in household saving rates. The above actions should provide a better foundation for consumer spending over time.

Pressures on Pension Plans

In recent years corporate America became accustomed to adding pension plan surpluses to their earnings or making only minor cash contributions to their pension plans. Investment managers have been reaching the actuarially assumed rates of return for their pension plans with oversized profits from equity investments. This has now come to an end. The problem now weighing heavily on many companies, both domestic and European, and carrying over to the broad equity market is that companies must take significant cash charges against 2003 earnings in order to fund their benefit plans’ bare minimum asset requirements. In addition, the rating agencies are reviewing corporate balance sheets for possible credit downgrades if their pension and benefit shortfalls meaningfully impact their debt/equity ratios.
Public companies that had assumed rates of return on their pension and benefit plans of 9 – 11% have begun lowering their expectations and have had to inject cash and/or stock into their plans to meet their objectives. Some companies have lowered their expected rates of return to 9%, but we believe that these return assumptions are largely unachievable for large funds given the present low-level of interest rates and stock market over-valuation. If this year proves to be difficult then we should expect a further lowering of expected rates of return next year and more corporate injections of cash and equity which will come out of profits. These contributions will depress 2003 reported earnings and also are likely to result in further reductions of stock price multiples, particularly if further contributions will impact next year’s earnings as well.

Possible Mutual Fund Redemptions

After constantly adding money to mutual funds throughout the ‘90s investors redeemed a small portion of their equity mutual funds last year after experiencing almost three years of losses. Last July $51 billion exited equity funds. If this year’s equity returns continue to be negative, we would not be surprised to see a surge in mutual fund redemptions resulting in a significant market decline. Should this occur, we will have a major buying opportunity.
For many years, the notion of relative performance and relative returns held sway. Institutions that beat their benchmark indices were considered by their sponsors and consultants to be adding value. At the present time, fiduciaries can no longer be satisfied with good relative returns that nevertheless produce losses. Foundations, endowments, retirement funds, pension and profit sharing funds as well as individuals must confront their spending plans in the context of losses and forty-year record low interest rates. Strains are being experienced by many organizations and even individuals’ plans for retirement have been postponed. As a result, many are remaining in their jobs longer making it more difficult for new entrants into the labor market to find employment.

Federal, State and Local Government Deficits

Another issue that must be addressed for 2003 which requires careful consideration with regard to its potential to destabilize the financial markets is the fiscal condition of government at all levels. The federal, state and local governments are now running substantial deficits because of the following: a weak economy has caused tax revenues to decline, state and local government pension assets have underperformed and employee health benefit costs keep rising. President Bush sent Congress a $2.23 trillion fiscal 2004 budget that seeks a major spending increase for the military and slashes billions of dollars in taxes. It does not count the costs of a possible war with Iraq. The federal budget projects a deficit of $307 billion in 2004, up from the expected $304 billion in the fiscal year now under way. The White House estimates the deficit will be 2.8% of GDP in the current year, which ends in September 2003, and 2.7% in 2004.
The U.S. combined federal, state and local budget deficits are in excess of $400 billion and our current account trade deficit is approaching $600 billion this year. For state and local governments to bring their costs in line with revenues they will have to reduce the number of employees that currently total approximately 18 million people. The U.S. economy has never run combined deficits of $1 trillion or 10% of GDP in one year. More so than in the past, the administration’s attempt to stimulate the economy will increase the trade deficit since increasing consumer spending will go to purchase foreign-made products particularly from China. We should expect the presence of such a high and growing trade deficit to result in a further depreciation of the dollar. We believe the U.S. and global economy must adjust to these large and unsustainable imbalances. The only question is how and when.

A Positive Outlook for Energy

Investment opportunities always exist no matter the outlook. The important question to ask is where will capital flow and how can one achieve positive returns in order to compound capital. Current inventories of U.S. crude oil supplies are at twenty-seven year lows and must be rebuilt to prevent possible supply dislocations, and as we said earlier the loss of Venezuelan oil production exacerbates supply shortfalls. In addition, increased natural gas demand and declines in drilling activity over the past two years have resulted in U.S. natural gas inventories now below the five-year average. Increased natural gas demand has been augmented by the cold weather. Our views are that higher energy prices are most probably going to exist for a longer period than many expect. At the same time equity valuations are discounting significantly lower oil and gas prices. Accordingly, we believe that investment in North American oil and gas producers at current depressed prices represent investment opportunity. Some of these companies are selling for as little as three times cash flow from operations and yielding over 4%.

A Positive Outlook for Precious Metals

A sector that has been neglected for more than twenty years until recently has been gold. The price of gold has appreciated against all major currencies since the start of the year as a result of the interaction between forces that relate to gold both as a commodity and investment vehicle. Renewed tension between the U.S. and the Middle East, weakness in the equity markets and the decline of the U.S. dollar have brought renewed interest in gold assets. In addition, investment buying of gold is being driven by prolonged increases in the United States Federal and current account deficits and the continuation of a generally turbulent global economic and political climate. Uncertainty in the global banking sector and strong consumer demand in Asia have also been noteworthy factors affecting the price of gold. Finally troubled situations in Venezuela and other important economies in South America support the buying of gold as a safe haven. Asian central banks have large and growing currency reserves. They hold almost $1 trillion in official reserves, and Japan has nearly $500 billion in central bank reserves. The United States is running large trade deficits with these countries so their central banks are continuing to accumulate additional dollars. Their gold holdings are a minor percentage of their total reserve assets as seen below and are likely to increase over time. Moreover, Malaysia has been discussing the creation of a gold-backed dinar – an Islamic currency for trade purposes. China opened its first gold exchange in Shanghai last October. As the European Central Bank, the Japanese Central Bank and the Federal Reserve attempt to re-inflate their respective economies, we expect the interest in hard assets – precious metals and many commodities – to continue to increase.

World Official Gold Holdings According to the World Gold Council

Gold’s percentage share of foreign central bank reserves:
China 2.0%
Hong Kong less than 0.1%
Japan 1.7%
Korea 0.1%
Kuwait 7.4%
Malaysia 1.1%
Russia 8.0%
Saudi Arabia 7.3%
Taiwan 3.3%

False Parallels Between the 1990 – 91 Gulf War and the Present

The great majority of strategists and market commentators appear focused on the parallels between the 1990 – 91 Gulf War and the present. They believe that once the Iraq situation is behind us a stronger market environment reflecting gradually improving economic fundamentals will result in a rebound of the equity market. Bearing in mind that deteriorating market conditions have been going on well before Iraq was an issue, our view is that there is more to the story than just geopolitical events in the Middle East. Notwithstanding the fact that the fear of war has been hurting the global equity markets and that the absence or disappearance of these fears will result in equity-market rallies, there are significant differences between the world economy of the early 1990s and today’s global economy.
While it is always unwise to attempt to forecast the stock market, it is nevertheless apparent that the economic fundamentals for the U.S. and most global equity markets are weak at best. There is a reason why United States interest rates are at a four-decade low and money funds barely pay interest. As the Bush Administration targets the market with a proposal to eliminate the taxation of dividends, which may or may not pass, the investment trends emerging involve a greater emphasis on absolute returns rather than relative returns. Dividend-yielding common stocks and high-yielding equity securities will be increasingly important as the reliance on capital gains alone may prove insufficient in compounding returns under present conditions.

Conclusion
The underlying fundamentals point to a slow economic recovery at best. They favor a modest pick-up in business and consumer spending in the second half of 2003. The greatest immediate risk to this view is the potential danger associated with the pending showdown with Iraq. We think 2003 will be a difficult year for the U.S. economy and expect investors to favor stocks that pay substantial dividends, have strong balance sheets, predictable cash flows and have conservative business plans.
Should a market decline occur driven by investor capitulation that has not been present throughout this down-cycle, great values will appear. In the meantime it is important to be in a position to produce positive returns in a difficult environment by concentrating on investing in the following: asset-rich securities, high-yielding securities, and companies that can grow their revenues in a deflation-prone global economy. Maintaining good cash reserves should prove advantageous under present circumstances.