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INVESTOR UPDATE
JULY 2003
The stock market came back to life in the quarter, defying continued weakness in the economy and traders’ seasonal rule of “Sell in May and go away.” In a broad-based rally, the Dow Jones Industrial Average gained 12.4% and the S&P 500 moved up 14.9%, bringing the 12-month return on the benchmark index to a negative 1.5%. The most beaten-up issues fared the best, with the technology-laden NASDAQ composite bouncing 21%. Stocks also performed well abroad, with gains for American investors magnified by a 5% fall of the dollar against the euro. Bonds rose in tandem with stocks, pushing the yield on the benchmark 10-year Treasury down to 3.52%.
Baker Ellis accounts enjoyed a strong quarter, with typical equity-oriented accounts registering solid double-digit gains (please see your individual performance report for details.* A major development was the buyout of one of our core positions, TMBR/Sharp Drilling (TBDI). Patterson-UTI Energy announced in May that it would buy the 80% of the company that it does not already own for $20.20 per share in cash and stock. Although the deal delivered a premium to shareholders, we felt the company was worth even more in the consolidating land drilling industry. With only modest upside left in the stock pending completion of the deal, we opted to take profits and move on to other opportunities.
While the stock market is a good leading indicator, the economy remains weak. Technically we are in a recovery, which began in the third quarter of 2001. Nonetheless, gross domestic product (GDP) grew at a revised annualized rate of only 1.4% in the first quarter. Unemployment has ticked up to 6.4% as manufacturing jobs continue to flow overseas.
Against this backdrop, the Fed cut overnight interest rates by another quarter-point, to 1.0%. This is the lowest level in 45 years. While the market seems convinced that Alan Greenspan and the Fed have an almost mythical ability to eliminate busts, 12 previous rate cuts and massive fiscal stimulus have failed to get the economy humming. With their traditional ammunition running low, policy makers are discussing “unconventional measures” to boost growth. Fed Governor Ben Bernanke’s recent comments that the government could always turn on the printing presses to release more dollars into the economy showed a surprising lack of concern for a possible resurgence of inflation.
Our view is that the Fed, after contributing to the bubble by holding interest rates down, has created other inefficiencies and dislocations in its zeal to keep the post-bubble economy afloat. Rock-bottom interest rates help reduce the cost of debt for companies and consumers, but they also allow inefficient companies to remain in business and punish savers – especially retirees – who must take more risk in order to generate an acceptable yield on their investments.
In addition, repeated rate cuts have contributed to an economy increasingly dominated by financial engineering. A full 40% of earnings represented by the S&P 500 now come from lending, trading and other financial activity, according to a recent study by Morgan Stanley. We are skeptical of the sustainability of this trend – not to mention its social value – and wonder if the Fed is in some ways simply postponing the adjustments that ultimately will have to occur.
Our outlook for the stock market is cautious. In its typically mercurial fashion, the market has shrugged off fears of war, terrorism and corporate malfeasance and now appears convinced of a second-half recovery with renewed strong growth in corporate earnings. Polls show bullish sentiment at the highest reading since the peak in 2000. This often is a good contrarian indicator: when everyone is convinced that stocks are going up, the opposite can occur because optimism is already factored into stock prices.
Speculation is not yet washed out of the market. Many of the biggest gainers in the quarter were the lowest-quality stocks – speculative biotech issues, Chinese Internet companies and penny stocks. While the gain in the NASDAQ may look tempting, we remind you of one of the most basic mathematical truths of investing: a percentage loss in one period followed by an identical percentage gain in the next period is still a loss. If you put $100 into the NASDAQ 100 at the top and lost 80% over the next three years, you would have $20. If you then gained 80% over the next three years, you would have not your original investment but $36. We prefer to compound growth at a steady rate.
While stocks look more attractive to us than bonds, valuations in aggregate are not cheap if an earnings rebound does not materialize. The S&P 500 now trades at 23.1 times estimated earnings for this year, and close to 26 times estimated core earnings – expensive by historical measures. While breadth was truly extraordinary in the second quarter (470 of 500 stocks in the S&P advanced) we believe that such correlation cannot continue indefinitely and individual stock selection will become increasingly important. Given our view that inflation ultimately will resurface, we are especially enthusiastic about our plays in the worldwide energy and natural-resource sectors. We have been reducing holdings in the financial sector, where many stocks have had a great run but we believe comparisons will become more difficult as spreads begin to narrow.
Best wishes for a safe and happy summer.
Sincerely,
Brian C. Baker, CFA
Barnes C. Ellis, RIA
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