Letter -July 2006





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Red in Tooth and Claw

Lord Alfred Tennyson referred to nature as “red in tooth and claw.” We think it is an equally apt metaphor for the action of the stock market over the last two months. It has certainly been a bloody and stressful period, a reminder that benign bull markets can turn vicious and that bear markets inevitably arrive.            

After hitting highs in April, the market sold off sharply and relentlessly during May and June. Having had spectacular gains over the last few years, emerging markets overseas were particularly hard hit. US investors in foreign markets suffered a double set back. In addition to falling prices, currencies fell as well. Fortunately, by the end of June, markets worldwide stabilized. The worst seems to be over for now but investors have been put on notice. The bull market is aging and volatility and risk have increased.

The market hates uncertainty. The recent sell-off reflects a raging debate as to the future direction of interest rates and the economy. Is the economy growing too strongly requiring higher interest rates to contain inflation? Is the economy sharply decelerating sending it back to the stagflation of the 1970s? Will Mr. Bernanke and his colleagues at the Fed raise interest rates too far and send the economy into recession? Or, perhaps everything is fine as the economy heads for a soft landing, corporate earnings continue to grow and the stock market, having shaken out the nervous Nellies, heads for a new high. Depending on what day of the week it is and what newspaper you are reading, it could be any one of the above.

We are not great fans of the hypothesis that inflation is about to come roaring back 1970s style. We take solace in the fact that, with the exception of oil, commodities sold off sharply over the last few months. Gold, that monetary canary in the mine shaft, fell 25% peak to trough and is currently down about 12% from its April high of $730. The fact is that the disinflationary impact of monetary tightening takes anywhere from a year to eighteen months to take effect. The current slowing of the economy is a result of the rise in interest rates since last year when they were a full 2% lower. Similarly, a slowing economy today should inhibit inflationary pressures tomorrow. Our concern at present is not inflation but that the Fed will raise interest rates too high and induce a recession in 2007

Despite concerns about a miscalculation by the Fed, our inclination is to believe that the economy is on track for sustainable growth, albeit at a more moderate pace than recently. The housing market, as expected, has begun to cool. Consumer spending is moderating as the price of gasoline takes a bite out of slowly growing discretionary income. The corporate sector, however, seems poised to take up the slack. Robust earnings along with extremely strong balance sheets flush with cash suggest that capital expenditures will begin to pick up. Corporate investment is capable of driving the economy to moderate, sustainable growth of between 2.5% and 3.5% through 2007. We continue to monitor developments closely. As the Fed pushes interest rates higher, the outlook is far from clear. Therein lays the risk and opportunity.


As is typical, we began to buy Intel (INTC $18.25) too soon and watched it fall 20% before the recent rally. Intel remains a story for 2007. After having lost market share in the server market to competitor Advanced Micro Devices (AMD $22.50), it is launching a competitive response this summer introducing its own line of power saving chips. Meanwhile, the company should soon finish a major reassessment of its operations and is expected to announce a corporate restructuring aimed at lowering costs. Finally, as Microsoft (MSFT $23) launches its new operating system, Vista, later this year, there is the potential for a PC replacement cycle that would go a long way towards improving Intel’s numbers. Investor patience could well be rewarded. We await an opportunity to add to our modest positions. Risks include unsuccessful strategy execution and further delays to Vista introduction.

The stock of Seneca Foods (SENEA $23.75, SENEB $23.75) unexpectedly and uncharacteristically surged recently as the market anticipated improved year-end (March) results. Improved they were, coming in just shy of $1 for the quarter and $2 for the year.  The company seems to have gotten its costs under control and to have taken advantage of somewhat firmer pricing. While the first half of fiscal 2007 could continue the improved trend, it remains to be seen if management has in fact turned the company around. Having owned the stock for over 10 years, we are expectant but skeptical. Let’s hope that it will not take another ten years for a good quarter! Risks include higher material costs (steel) and the possibility of a disappointing vegetable crop. 

While we have taken modest profits in oil stocks, we are loath to act too precipitously. The price of oil remains stubbornly above $70/barrel but, absent any political fireworks, is reluctant to move higher. Second quarter production cuts by Saudi Arabia along with high inventories (much of which is sitting in oil tankers at sea) support the notion that there is a political premium in the price that has little to do with supply and demand. Nonetheless, we are sticking with our energy investments for now but changing our emphasis. At current prices, the risk/reward ratio between oil and natural gas seems to be heavily in favor of natural gas. On an energy equivalent basis, oil should sell at 5 times the price of gas. Currently, with gas at $6/mbtu, oil is selling at a multiple of 12. Because natural gas is relatively cheap compared to oil, it should be able, at a minimum, to maintain its current price even should oil prices slide. The price differential should also result in growing demand for gas as it is substituted for oil. As a result, we have recently added to positions in natural gas producer Hugoton Royalty Trust (HGT $29) while taking profits in companies concentrated in oil production. Risks include cooler than normal summer temperatures and a warmer than usual winter.


Tom Herzig


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