2003 - Treading Lightly Through the Investing Minefield

As we look at the investing environment in 2003 it appears that, of the woes that beset the market last year, some continue to be worrisome while others appear to be dissipating or are of less concern. We liken the things we do worry about to a minefield through which investors must find their way carefully.

We continue to worry about the war with Iraq. We don’t expect that war would cause another recession. Rather, we worry about the effect of a spike in oil prices, possibly to the $40 per barrel level we mentioned last quarter, from its current level in the low $30’s. High oil prices continue to exact a tax on the American consumer. Every $1 increase in a barrel of oil increases gasoline prices by 15 cents and every penny increase in gasoline cost takes $1 billion out of consumer spending.

The market appears to believe that the war will be fought later this year (or never fought at all), that it will not be costly in terms of either lives or dollars and that it will be swiftly and successfully concluded. It is interesting to recall that the stock market bottomed a few months prior to engagement during Desert Storm, that it had already started to improve prior to the first shot being fired and that it experienced outstanding results in the years following that bottom. Obviously, if the conflict becomes more protracted than the market expects or proliferates geographically there could be large negative effects on the markets, on inflation and on economic growth.

We also worry about the U.S. consumer. At two-thirds of U.S. Gross Domestic Product (“GDP”) the consumer is the key to economic health until such time as a new capital spending cycle emerges. If the consumer is the key to the economy, the employment picture remains the key to the consumer since robust employment leads to increases in personal income and increases in consumer spending.

On the jobs front, the news is not great. The January employment report showed that December payrolls declined by over 100,000 jobs, the largest decline in ten months, indicating that economic growth is stalled for the moment. In fact, job growth has been completely absent from the employment picture throughout the early stages of this recovery, especially in the manufacturing segment. The four week average of unemployment claims was stable throughout December though, allowing personal income to rise slightly which is positive for consumer spending.

While we expect consumer spending to be up modestly this year, its strength to date has been driven primarily by autos and housing refinancing. Both of these areas have probably peaked. Mortgage refinancing in 2002 placed between $100 - 200 billion in spending power into the economy. This year that number is expected to be less than $100 billion. Beyond the first half of this year, fiscal programs are expected to provide the engine for incremental consumer spending. Tax cuts and other fiscal incentives will replace, at least in part, the money to fuel spending that had been available from refinancing.

Because consumer spending continued at a high level throughout the recession, consumers never went through a “wringing-out” period. Hence, consumer spending in the early quarters of the upturn will not produce the up 6 or 7% quarters that characterized the early stages of previous recoveries. However, because of fiscal stimulus and modestly rising incomes, our estimate for consumer spending this year is up +3%.

Despite our worries, the U.S. economy continues to move ahead. In fact, GDP is up +3% over the past four reported quarters. While this is not as strong as the level of growth ordinarily seen coming off a recession and while it is below GDP potential and below trend, it is still growth. We expect +2.7% GDP growth for this year and some acceleration from that number in 2004.

We remain convinced that the low level of capacity utilization in the U.S. economy is cyclical and that it will improve as the economy strengthens. As you may know, capacity utilization is currently around 75%, only a point off its low of 74% in December 2001 and lower than the long run 82% average rate that has existed since 1967. This implies excess capacity within the economy and limits the ability of corporations to raise prices. It also implies that, as revenues grow, profits and profit margins will expand.

The long run average rate of growth of productive capacity in this country is between 2 - 3%. Yet, capacity skyrocketed during the 1990’s, with fully 7% capacity growth in the year 1997 alone. These additions were well absorbed as long as demand remained high. But when demand collapsed a huge imbalance was created. In fact, in some technology-related product lines demand has fallen to almost nothing. While the dearth of technology demand is disheartening, technology is also the sector with the highest likelihood of great innovation. Consequently, demand will return when innovation makes the existing capital stock obsolete. We know from experience that this occurs rapidly in technology - based industries.

New capacity is not being added to the U.S. economy right now so that any evidence of a pickup in production, such as the recently reported strong data from the Institute for Supply Management (“ISM”), should cause steady increases in utilization and, hence, expanding margins.

We also don’t think that underfunded pension liabilities will harm the economy, at least in the near term. The combination of lower interest rates in fixed income and disastrous stock market returns over the past several years has taken many plans, especially in the manufacturing sector, from overfunded to underfunded. This “double whammy” has begun to concern corporate financial officers.

A few years of decent stock market returns would wipe out the underfunding, just as it did in the early 1990’s. A single percentage point increase in interest rates eliminates a third of GM’s current underfunding. Also, the most underfunded plans are concentrated in the auto, steel and airlines companies. While those situations are very serious - the General Motors underfunding was a factor in a recent cut of that company’s debt rating - most major corporations have seen an erosion of their surplus, not yet a move to an underfunded status.

Companies have many years to correct the situation. During that time, they can adjust expectations so that the deficit does not continue to balloon. Simultaneously, they can correct the underfunded position with contributions, just as they had to do throughout the 1970’s and 1980’s.

About a third of S&P500 companies do not have pension obligations at all because they have long since terminated their pension plans or never had them. Also, in a time of low interest rates one way to reduce your funding requirement is to shift asset allocation to common stocks. A shift in pension assets toward the stock market could exert huge demand for stocks, as occurred in the latter half of the 1970’s.

We are not anticipating a large number of additional corporate financial debacles. Ten of the twenty largest bankruptcies in history occurred in 2001-2002 and the default rate on U.S. corporate debt was as high as it was during the savings and loan scandal in 1990. But a majority of the bad news appears to be out and the healthier economy is likely to dramatically reduce high profile bankruptcies.

At present, dividend yields are growing faster than earnings with the S&P 500 yield at 1.7%. Simultaneously, dividend yields on stocks substantially exceed the yield on 90 day Treasury bills, which is at 1.2%. Since 1970, the market has risen by an average of 8.9% in the six months after the convergence of the yields on T-bills and stocks.

Another market negative which we believe is overblown is deflation. Every time economic activity slows and/or bond yields move to lower levels the media raise the specter of the United States economy “turning into Japan.” Admittedly, Japan’s economy has been in desperate straits for a long time as, despite interest rates that are effectively zero, the country has been in recession for twelve straight years and its stock market has declined 78% since 1989.

The fact is that the United States is not Japan. In the U.S. the work force is more mobile, capital flows more freely, there is no rampant cross-ownership of stock, the banking system is healthier, corporations are more global and less leveraged and, most importantly, the economy is not as subject to interference from and management by the government. Thus, the U.S. economy is better able to right itself, in the event of excesses and/or shortages, than is the Japanese economy.

It’s true that our economy currently evidences deflationary tendencies. If these phenomena are cyclical and part of the recessionary downturn we will dig out of the morass as soon as we see improving utilization, increasing demand, rising earnings and, finally, some pricing power. On the other hand, if deflationary conditions are structural and endemic to the economy the economy will grow slowly for years and corporations will have no pricing power.

We believe that the deflation our economy is currently experiencing is cyclical not structural. Our conclusion is based on leading indicators, not data already reported. Small and medium sized businesses have experienced sufficient demand that price increases are now occurring. Temporary employment numbers have improved and advertising spending is quite good. Finally, business confidence, a major leading indicator, has been generally moving upward.

Perhaps the best indicator of the fact that deflation in the U.S. economy is cyclical is the fact that corporate earnings have begun to increase and stock prices, always a leading indicator, have improved in the last few months.

If deflation stays with us, we must remember that there are winners with deflation as well. As long as consumer wage increases exceed the rate of inflation consumers will perceive that they have stronger purchasing power. Deflation winners will be companies that can become low cost producers, are increasing productivity or have a specific competitive advantage. Think Dell Computer.

Despite our conclusion that this deflationary period is cyclical, we also think deflation in the U.S. economy will continue into 2003. This should keep interest rates lower for a longer period of time than many had thought.

Despite a recent falloff in housing numbers, the housing market remains excellent. Housing starts are still running at a healthy 1.6 million annual rate, reflecting very healthy continuing demand. The “housing bubble,” to which so many refer, is actually an attempt to get to the issue of rising housing prices. But housing price increases peaked two years ago and, since then, prices continue to increase but at a decreasing rate. At present, home prices are still up modestly nationwide. If the recession is truly behind us, it is fair to conclude that there was no housing bubble and, if there was, it certainly didn’t burst.

We think the issue of expensing stock options is on the way to being resolved. While accounting authorities and corporate officers are still wrestling with the idea of whether or not to require expensing, we don’t think it particularly matters. Some companies (admittedly those for which options are not a large part of compensation) are already expensing options. Others will wait for an SEC or accounting standards mandate before they do so.

Companies with the biggest potential options expense are those in which the related stocks have experienced the largest declines. It may be that generous options packages, in a saner environment, will not be required as compensation by potential employees. Whatever the outcome, Oakwood has always factored in an assessment of options cost as part of the fundamental analysis of any company.

Navigating the investing minefield in 2003 will be tricky, as always. At Oakwood, we will traverse this minefield by seeking quality in every issue we buy for clients, whether it is a bond or stock. We are also relentlessly focused on the economic and market factors that affect prices and stand ready to reposition portfolios if an advantage can be obtained for our clients.