A Battle Royale
Since the year began, bulls and bears have been
fighting a Battle Royale for the hearts and minds of
investors. For the moment, the bulls seem to have the
After rallying since last May, the market turned
nasty in late February. The sell-off caught many by
surprise and elicited frenzied commentary in the press.
Some say it was due to a one-day 9% decline in the
Chinese stock market which had bubble-like
characteristics. Others point to Japan and a reversal of
the yen “carry trade,” an interest rate and currency
motivated strategy. Still others claim that a slow-down
in the US economy required a market correction. Whatever
the reason, the bulls have shrugged it off and come
roaring back. The Dow has been hitting all time highs
though other indices still lag well below their year
Despite the bull run, we have to admit that our
sympathies lie with the bears though we have not yet
thrown our hat in their ring. The following issues are
of concern and bear watching.
Many in Congress want to raise taxes, both by raising
rates and by refusing to index the alternative minimum
tax (AMT) to inflation. The AMT situation is bad enough
but repeal of the Bush tax cuts on dividends and capital
gains would be a big blow to the stock market.
World trade has increasingly been an engine of
prosperity for both the US and world economy. Yet, there
is a growing movement against free trade. Witness the
recent tariff on imported Chinese paper. Charles
Schumer, senior senator from New York, has for months
led a campaign of bashing China on “unfair” trade and
currency values. This may play well to the electorate,
but it does no favors for the US economy.
Then, there is the collapse of the housing bubble.
Speculators are abandoning their properties to the
banks. Some high risk borrowers, who arguably should not
have gotten loans, are defaulting on their mortgages.
Lenders are going out of business. Lending standards at
the big banks are getting tougher, restricting credit to
the housing market. There is an over-supply of homes on
the market forcing home builders and private sellers to
lower their prices. The downturn in home construction
lowers demand for a wide range of products ….an economic
Finally, the US economy has been slowing and is
projected to grow at below the 3% long-term trend. As
companies become more conservative in their outlook for
growth, capital expenditures which were supposed to
surge this year have been disappointing so far. This
undermines expectations for GDP growth. What’s an
investor to do?
And yet, we have a hard time getting really bearish
on the US economy or stock market.
The world is increasingly interdependent. While the
health of the world economy in the past relied on US
growth, that is less apparent today. Despite slowing US
growth, economic growth outside the US is booming.
Goldman Sachs recently adjusted its growth estimate for
China in 2007 from 9.8% to 10.8%. The Asian Development
Bank also raised its estimate for growth in Asia to over
7%. Those are big numbers. Even the European Union is
experiencing uncharacteristic vigor.
Commodity prices continue to rise further, suggesting
that foreign demand may compensate for weakness in
domestic US demand. Recent numbers point to robust
exports of US goods and services as an unexpected source
of strength for US GDP. Perhaps that was what the chief
economist of the IMF was thinking when he recently said
that “recession does not stalk the US economy”. Instead
of the US being the engine of world prosperity, the rest
of the world has become a determining source of US
growth. The great unexpected might be that the
under-trend growth of GDP in early 2007 will give way to
a reacceleration in the later part of the year.
We take some comfort in the observation that the bear
case has been widely disseminated and, therefore
discounted by the market. The end of the housing boom,
for example, has been widely anticipated and so far has
caused little systemic harm. Gasoline at $3/gal seems a
distraction, not a disaster in light of strong
employment and rising incomes. Meanwhile, the US stock
market is at a historically reasonable valuation. The
contrarian case argues for a pick up in earnings growth
and therein lays the hope for a robust US stock market.
We have a maxim at P.R. Herzig & Co.: when lacking a
profound insight, talk about natural gas. We remain
bullish on natural gas because:
Green is “in.” Natural gas is the “clean burning
fuel” which environmentally sensitive investors should
love. There is increasing public opposition to coal as a
fuel source to generate electric power. In its recent
bid to win regulatory approval for the acquisition of TXU, a large Texas electric utility, the buyer promised
to scrap plans for eight coal-fired, electric generating
plants because of environmental concerns. That’s fine
but Texas needs the electricity from those plants.
Nuclear power is a good option but it still makes voters
uncomfortable. Our guess is that with its relatively low
level of harmful emissions, natural gas-fired capacity
will meet at least some of the future demand.
Energy security is “in.” Natural gas is available
from politically secure, North American sources. Very
little is imported. Supply is not imperiled by the whims
of questionable allies or hostile foreign governments.
Low cost is “in.” At $8/ btu, natural gas sells at
the energy equivalent of about $40/bbl oil. Furthermore,
gas plants can be built cheaply and quickly. Coal, the
cheapest and most domestically abundant fuel source, is
slow, dirty and capital-intensive to turn into
Gas prices are going up, we think. Natural gas
reserves in North America are ample but not unlimited
and finding costs are rising. The cost of drilling for
gas has been rising due to a shortage of skilled
employees and drilling equipment. As a result, drilling
activity has slowed, inhibiting the growth of reserves.
This suggests that, in the face of rising demand, the
price of natural gas should trend higher. This is good
news for investors in selected natural gas producing
royalty trusts that combine financial strength and large
payouts that will rise as the price of natural gas
rises. Current expectations are that they will yield
8-10% payouts over the next 12 months.
Alternative energy still has problems. The potential
for alternative, renewable energy sources such as solar
and wind power is still some ways off in the future.
Both industries have been growing rapidly, spurred by
government subsidies, but can’t compete on cost with
traditional sources of energy. Furthermore, a severe
shortage of production capacity for key components has
hamstrung growth. For example, the type of silicon upon
which solar cells are based remains in extremely short
supply, keeping the cost of solar cells high. New orders
for wind turbines are currently subject to a two-year
backlog. Despite expectations of rapid long-term growth,
numerous studies suggest that wind and solar will still
represent less than 10% of world energy use twenty years
from now. Fossil fuels will be around for a long time
and natural gas remains our fuel of choice.
Clients who closely monitor individual stocks may
have noticed an unusually large drop in Healthcare
Realty Trust on April 12. For existing owners that was
actually the result of good news. The company will pay a
$4.75 per share dividend on May 2, and the price was
simply adjusting for the fact that buyers on April 12 or
later would not receive that dividend. Please call if
you would like further information on this or have any
other questions about your investments.
Please read our important notice
about these letters and the securities they mention.