21 Oct 2005 October – The Month of Truth
Well, I’m back from a wonderful wedding and honeymoon. It was an extraordinary time and I couldn’t be happier with my new life. Thank you all for your well-wishes.
October, as usual, has been a cruel month to stock and bond investors. It is a time when investors look at the year as a whole and when companies do much of their house cleaning for the year. The added pressures of an unusually high number of destructive hurricanes, especially in the Gulf of Mexico with the commensurate higher energy prices have added downward pressures on the market. So far this month, the S&P 500 is down 3.7%, the worst monthly decline since December 2002’s drop of 5.9%.
Economic releases for the past few weeks were mostly mixed, but some of the headline indices surprised to the downside. The Unemployment rate increased from 4.9% to 5.1% in the wake of hurricanes Rita and Katrina. Largely due to rising energy prices the Consumer Price Index jumped 1.2% in September, the largest spike in 25 years. But the core inflation rate which excludes food and energy has not risen much indicating that companies are having difficulty passing along their higher energy costs to consumers.
The market’s recent decline indicates that investor sentiment may finally be souring due to high energy prices and a Federal Reserve bent on raising rates despite potential damage to the economy.
With investor sentiment and psychology turning down, what of the actual benchmarks of growth – corporate earnings? Though we are early in the third quarter reporting cycle, many of the latest reports also suggest a slowing. As of Wednesday, October 19th, one fourth of the companies in the Dow Jones Total Market Index had reported earnings. The average of those companies’ reports showed an increase of 8% over the third quarter last year. The rate of increase for the second quarter of 2005 was 16% with about the same number of companies reporting then as now.
The two largest brakes on our economy are the Fed’s anti-inflationary campaign with its increasing short term interest rates and historically high energy prices, each likely to continue for a while. The Fed has been very open in their public comments about the risks of inflation and their intention to continue raising rates. So far the markets have doubted their conclusion. The price of gold, perhaps the best inflation indicator, is down 3% since the government announced the 1.2% CPI spike in September. Yields on US Treasuries have increased as well, but not as much as one might expect in the face of relentless Fed tightening and the potential threat of inflation from high energy prices.
What of energy prices? If we believed what stock traders suggest we might think that the price of oil was headed for the $30’s and $40’s soon again. During the month of October Exxon’s stock declined over 16% to a level where it traded when oil was $40 per barrel. It is probable that energy prices will fall from here, but it is doubtful, given all the constraints on supply as well as continued global demand, that we will see oil fall below $50 per barrel in the foreseeable future. Accordingly, we believe it prudent to hold our oil and oil service stocks for the long-term, although we will likely reduce our slight overweighting during the next rally.
The consumer is slowing his spending in the face of higher gasoline prices and yet-to-be seen heating bills, but we don’t think he is leaving the party. Some of the consumer’s spending power is supplied by equity loans against their homes. But as most of these loans are tied to an ever-increasing prime rate, it is reasonable to assume this source will decline or even dry up. The other major driver of consumer spending, productivity continues to rise in the 2-3% per year. It should keep incomes rising ahead of inflation.
We believe the U.S. economy will shrug off the latest difficulties just as it has the host of others it has endured these past four years. Growth will likely slow and there will be some accompanying short term earnings pains, but next year should see a re-acceleration of growth in the first or second quarter. The re-acceleration will likely bring higher stock prices as the stock market will begin to anticipate this growth by early next year, if not before.