July 8, 2004The first half of 2004 has produced some expected, as well as some surprising, results. It was a shock to see the Pistons beat the heavily favored Lakers in the NBA Championship and Howard Dean looked like a shoe-in for the Democratic nomination back in January. But rather than discussing sports & politics, let’s focus on the financial markets. When the year began, it was widely believed that interest rates would move higher, ignited by a shift in Fed monetary policy, and that economic growth would slow somewhat from its torrid pace of late last year. Most believed the stock market would perform well in the first half of 2004 as tax cuts continued to provide a boost to consumer spending, but that the market would be weaker in the second half as higher interest rates and the loss of fiscal stimulus took its toll. In addition, we believed that a decline in investor risk appetite would result in a rotation out of the stocks which led the market last year, namely speculative, low quality stocks, and into higher quality, reasonably priced, lower risk stocks. Have these expectations been met? What forces have driven the markets this year? What is the outlook for the second half of the year? Most importantly, how did Westwood perform? These questions are addressed below.
Market Performance: Although the decline in risk tolerance occurred as expected, the market failed to meet its first half return expectations due to a sooner than expected revaluation of stocks by investors. The broad stock market, as measured by the S&P 500, rose a mere 3.5% during the first six months of 2004. Although the year began in a fashion similar to how it ended 2003, with the market jumping almost 2% in January, stocks quickly settled into a sluggish sideways pattern. In sharp contrast to last year, the best performing stocks year to date have been lower P/E, lower beta (i.e. less speculative), and higher dividend paying stocks. In addition, the best performing sectors have been Energy, Industrials, and Consumer Staples while the more aggressive sectors, such as Technology and Consumer Discretionary, have been laggards. And finally, larger cap stocks have begun to outperform smaller cap stocks while value stocks have beaten growth stocks.
Along with the change in market leadership, the markets provided their usual volatility during the first half of 2004. However, a variety of factors drove market sentiment during the past 6 months. Both anticipated and unanticipated events motivated investors to buy and sell stocks as the year progressed. The key drivers are discussed below:
Higher Interest Rates: The first whiff of potentially higher interest rates came in late January when the Federal Reserve changed the wording of its policy from keeping the Fed Funds rate at 1% “for a considerable period” to “having patience” with this low level of rates. This subtle attempt by Greenspan & Co. to prepare the market for higher rates was successful in that it resulted in the beginning of the decline in investors’ risk appetite. This change in investor preference produced a rotation out of the speculative stocks that performed so well in 2003 and into the higher quality, less aggressive stocks that have led the market thus far in 2004. The bond market didn’t buy it though, and bonds actually rallied during the first quarter, sending rates lower. That changed however, in early April when it was reported that 300,000+ jobs had been created in March and more than 500,000 new jobs were created in the first quarter of the year. This was the piece of data needed to convince investors that we were not in the middle of a “jobless recovery” and that the Fed now had the information necessary to move rates higher. As a result, the 10-year treasury yield climbed by 1% as investors began selling bonds in droves. In addition, equity investors reacted rationally to the more certain likelihood of higher rates by beginning the process of pricing in a slower pace of economic and earnings growth, resulting in a much needed stock market correction.
Inflationary Pressures: Core CPI data released in April and May indicated that inflation was growing at a 3%+ annualized rate in 2004, much faster than expected. This data further fueled the belief that a Fed rate hike was imminent and resulted in continued selling of bonds and weakness in stocks.
Higher Energy and Commodity Prices: Fueled by rapidly increasing demand and limited new supply, the prices of crude oil, natural gas, and other commodities (including steel, copper, aluminum, milk, and soy beans) rose rapidly during the first half of the year. These higher prices had a real impact on consumers as gasoline prices reached all time highs and manufacturers were forced to pass through the higher costs involved in the production of their products. During the second quarter, speculators sold their positions in commodities following successful attempts by the Chinese government to slow economic growth, resulting in a reduction in the price of many industrial commodities. In addition, pledges by OPEC to increase daily oil production brought the price of crude oil down from the low $40s/bbl to the high $30s/bbl. However, the still high prices for these commodities had a negative impact on consumer spending and a positive impact on the performance of stocks in commodity-related industries.
Surprising Manufacturing Strength: In addition to the much stronger than expected levels of job creation, the rapid rise in manufacturing activity also took the markets by surprise. Although the consumer has historically led the economy out of recession, the industrial sector has been a big factor this time around. In fact, manufacturing activity, as well as hiring, hit levels not seen in 20 years during the first half fueled largely by significant increases in corporate spending. Although the rapid pace of growth cooled somewhat by the end of the second quarter, it has remained at levels that demonstrate the industrial segment of the economy has rebounded from the depths of the 2001 recession and should continue to be a key contributor to economic growth.
Surprisingly Strong Corporate Earnings Growth: Earnings growth was very strong in the second half of 2003, with S&P 500 operating earnings growing 21% and 28% in the 3rd and 4th quarters of the year, respectively. As a result, it seemed reasonable to believe that the pace of growth would slow in 2004. However, that has not been the case. In fact, S&P 500 operating earnings jumped 27% in the first quarter of 2004 and are expected to rise another 20% in the second quarter. Only four times in history have earnings grown at 20%+ for four straight quarters and, because the stock market is a discounting mechanism, in three of those cases the stock market declined the following year. Although rising earnings were a key catalyst for the market’s advance in 2003, this year investors have begun to believe that the current pace of growth, particularly in the face of higher interest rates, is unsustainable. In addition, investors recognize that job gains lead to higher wages and, ultimately, lower corporate profits.
Other Factors: Continued instability in Iraq, the media’s focus on the presidential race, the perceived slowdown in Chinese economic growth, and concern over the U.S. budget deficit all contributed to the market’s sluggishness during the year’s first half.
Outlook for the Second Half: The headwinds that caused market weakness in the first half are all still very visible as we enter the second half of the year. As expected, the Fed ushered in a change in monetary policy when it raised the Fed Funds rate by 0.25% in late June. Investors can now look forward to gradually rising interest rates as the Fed attempts to manage that fine line between warding off inflation and killing economic growth. In addition, energy prices remain high and inflationary pressures continue to build. And first quarter GDP was recently revised down from 4.4% to 3.9% while certain segments of the economy are beginning to show signs of weakness, indicating that economic growth has begun to slow. One positive note is the fact that the second quarter sell-off has resulted in much better valuations for stocks. Although the tailwinds of low interest rates, tax rebates, and rapid earnings growth are likely behind us, it’s still easier to be bullish when stocks are trading at a forward price/earnings ratio of 17x vs. a P/E of 19x (the level before the sell-off) and investors are demonstrating a healthy level of risk aversion.
Even with more reasonable valuations, market gains will be harder to come by as we move forward into the mid cycle of the current economic expansion. The key will be finding stocks that can continue to grow earnings in spite of the slower growth, higher interest rate environment. We continue to believe that certain stocks leveraged to energy and other commodities, as well as those in the industrial segment of the economy, are reasonably valued and have better growth prospects than the market believes. In addition, we think the trend in favor of higher dividend paying stocks will continue as investors recognize the value of a “bird in the hand” in a lower nominal return environment.
Westwood Performance: The Westwood Large Cap Value composite outperformed the benchmark Russell 1000 Value Index, gaining 4.2% during the first half. Although we underperformed in the first quarter largely due to early positioning for a rise in interest rates that failed to materialize, we made up for it in the second quarter. Our focus on Energy & Industrials paid off while our underweight to Financial Services and Consumer Discretionary stocks benefited performance as rates finally began to rise. In fact, as the accompanying chart shows, our portfolio beat the benchmark by a significant amount in the second quarter. In addition, our peer group rankings have risen dramatically. We performed in the 38th percentile for the six-month period, as ranked by Morningstar, and the 7th percentile for the second quarter. Our performance over the past seven months, from 12/1/03 to 6/30/04, is very indicative of how we can perform in a rational environment. During that period, our LargeCap portfolios returned 12.6% vs. 10.3% for the Russell 1000 Value Index and 8.8% for the S&P 500. We cite this period because we believe the turn in the market, away from low quality, speculative stocks and in favor of high quality, lower P/E, dividend-paying stocks, began in December of last year. Furthermore, we believe this trend will remain in place as economic and earnings growth continues to slow and interest rates and inflation rise. The portfolio is demonstrating a tremendous amount of positive momentum as we enter the second half of the year, and we are convinced that we are now in a “Westwood Market.”
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