Letter - April 2007

 

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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 upper hand.

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 2000 highs.

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 drag.

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 electricity.

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.

 

Tom Herzig


 

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