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
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
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
* * *
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.
Please read our important notice
about these letters and the securities they mention.