Letter - October 2006

 

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One Down ... Two to Go

For the past number of months market participants have been hotly debating the future course of the economy. There have been three major themes. Some have argued that inflation is an imminent threat. Others see recession as the threat in 2007. Still others have made a case for a soft landing which includes moderating inflation and growth but no recession. Over the last month the debate seems to have been tentatively resolved. The inflationary scenario appears to have been tossed out of the ring.

The surge in commodity prices over the last few years fueled the specter of inflation. Oil, base metals, gold and silver rose in many cases to unprecedented levels. However, during August, the upward surge seemed to run out of steam. After reaching $78/ barrel, oil has recently fallen under $60 giving relief at the gasoline pump. Gold, ever sensitive to inflationary expectations, has fallen from $740/oz to as low as $550/oz, a decline of about 25%. And housing prices have begun to come down. Though it is unlikely that commodity prices or real estate will collapse altogether, visions of $100 oil, $1000 gold and ever rising returns on Home Sweet Home seem to have lost their charms for the time being. One down….

Two to go…The remaining contenders in the ring are those bears who see a recession in 2007 and those bulls who anticipate slower but persistent growth, often referred to as a soft landing.

The bears point to a huge rally in the bond market over the last six weeks as proof that the economy is losing its equilibrium. With the rise in bond prices, yields have dropped. The 30-year Treasury bond at 4.90% is now below the short-term Fed funds rate of 5.25%. Lower interest rates often precede a downturn, as investors anticipate lower demand for money and falling inflationary pressures. The bears are strident, warning of a collapse in the housing market and the damage that that could inflict on the economy. Throw in the various concerns about deficits, high consumer debt and mid-term elections…recession!… they argue.

The “soft-landers” agree with the bears that the economy is slowing but anticipate that it will continue to grow at a subdued but positive rate. Falling interest rates, they argue, will act as automatic stabilizers for the economy cushioning the fall in real estate, helping corporate profits and stimulating investment. Corporate balance sheets are exceptionally strong for this stage of the economic cycle and the banking system has rarely been in such robust health. Employment remains strong and stable. In a global economy, demand is also global. The industrializing world may well support the US economy despite softening domestic demand.

The stock market bounces back and forth on a day-to-day basis as the debate continues. Though the Dow Jones Industrial Average recently made a new high, finally topping its previous peak recorded in 2000, there is little widespread enthusiasm. The NASDAQ remains 50% below its peak of 7 years ago!  

We suspect that the market will continue its uptrend but in an unspectacular manner. 2006 is the fourth year in a row of positive returns for U.S. stocks.

Yet, the fact that the stock market is higher suggests to us that the economy will continue to grow modestly into 2007. Investors’ worst fears are seldom realized, which leads us to discount, for the time being, the odds of recession. We continue to hold stocks of industrial manufacturers of steel, chemicals and railcars. Our bet is that continued economic growth will sustain the industrial earnings cycle longer than is generally anticipated. This should lead to higher stock prices as corporate cash flows beat expectations. On the other hand, we continue to scale back exposure to energy and precious metals which we believe have seen their highs for the foreseeable future.

But we monitor the inflationary situation carefully. Having a little inflation has often been likened to being a little bit pregnant. Once prices begin to rise, they are hard to rein in. Nonetheless, for the time being, we consider the fall in energy and gold to be a powerful indicator that inflation will be contained.

With regards to performance of client accounts, we consider 2006 to be a transitional year. After five years of substantially outperforming our benchmark, the S&P 500, we may fall somewhat short this year (though the current rally has given accounts quite a boost this month). Profits taken in the energy and precious metal sectors have to be redeployed into new positions which take time to bear fruit. We try not to let short-term issues distract us from our goal of long-term growth.

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Our firm has been regulated by the National Association of Securities Dealers (NASD) since 1957. Because we have investment discretion over clients’ accounts, new regulations require us to register with the Securities and Exchange Commission (SEC) as well. So now we can look forward to two sets of auditors asking us many of the same questions! As required by the SEC, we offer to all existing clients our brochure which serves as a replacement to Part II of Form ADV Uniform Application for Investment Adviser Registration. It describes in detail the firm’s services and compensation, how our business is run, and the background of our professionals. The brochure is available on our website, www.prherzig.com. We will be sending clients a hard copy under separate cover.

 

Tom Herzig


 

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