April 16, 2004There’s an expression used in these parts that goes, “If you don’t like the weather wait a few minutes, it’ll change.” From our North Texas vantage point we appear to have been experiencing a market environment that closely fits this phrase. The winds of change seem to be picking up speed and changing directions as fast as an early spring thunderstorm. Just in the last few weeks the market has been surprised by strong economic data.
Since last year, we have been discussing the outlook that has shaped our 2004 strategy, which we will refer to here as “The 3 Cs”:
As the first quarter came to a close, it appeared that only one of these beliefs was working for us – commodity price strength. In fact, the rise in commodity prices, including oil & gas, has been a significant contributor to our outperformance since last December. Our portfolios have clearly benefited from an emphasis on the basic materials and energy sectors, which have been leading market performers as commodity prices have risen and the market has acknowledged the sustainability of these higher prices. In fact, our energy stocks are a key reason why our portfolio has outperformed the benchmark Russell 1000 Value Index since the beginning of December. Six of the top 8 performers in that time period are energy stocks and as a group they accounted for 1/3 of our portfolio’s return.
In the past few days, we have received confirmation that another leg of the strategy is coming to fruition – Climbing interest rates and inflation. During the first quarter of 2004 interest rates remained near historical lows, and even declined further on the longer end of the yield curve, as investors believed the Fed was likely to keep the Fed Funds rate at 1% for an extended period. Economic data, including high unemployment claims and a benign CPI, seemed to indicate that there was no real reason for the Fed to begin raising rates anytime soon. However, in the first two weeks of April the market has been presented with three very compelling pieces of data that significantly increase the likelihood of a Fed rate hike. Specifically, the March employment report showed that over 300,000 new jobs were created in the month while more than 500,000 new jobs were created in the first quarter of the year. Both figures are significantly higher than expectations and point to legitimate strength in the labor market. Next, we received news of much higher than expected retail sales in March. Finally, we learned that the Core CPI, the inflation index that excludes volatile food and energy costs, rose by almost 3% on an annualized basis over the past 3 months (vs. a belief that inflation was hovering in the 1.5% range.) Because it has refused to believe that higher interest rates and inflation were a threat, the bond market has responded violently to this data. The yield on the 5-year Treasury bond has jumped from 2.78% to 3.44% while the 10-year Treasury yield has climbed from 3.84% to 4.40% since the release of these data points. The chart below displays not only the substantial rise in the 10-year treasury yield over the past two weeks, but also the significant decline in yields during the first quarter of the year. Because our portfolios have been positioned for higher interest rates, this first quarter decline negatively impacted our performance. However, our portfolios have benefited greatly from the rise in rates thus far in April.
The final “C” in our strategy is the belief that corporate spending will be a bigger factor in economic growth in 2004 than consumer spending. The strong retail sales data for March might appear to refute this theory. However, we have never believed that the consumer would stop spending, but merely that corporate spending would be more robust relative to expectations than consumer spending. Such a trend would allow companies in the manufacturing and industrial segments of the economy, whose revenues are driven by corporate spending, to grow faster than those in the service segment. Although it’s too early to call this race, the early returns are encouraging. Data from a variety of industrial companies indicates that demand is increasing and the operating leverage that has been created through three years of cost cutting is leading to higher earnings. Companies such as General Electric (GE), Dupont (DD), and Eaton Corp. (ETN), have reported very strong first quarter results, expressed optimism about the future and subsequently been rewarded by the market with higher stock prices. In addition, economic indicators such as the ISM Manufacturing Index point to a rapid improvement in manufacturing activity over the past 6 months. Our continued focus on companies in the industrials sector of the market puts our portfolio in position to benefit from this trend.
The bottom line is that while markets have swung in many different directions this year, our strategy has not changed. In fact, we are very encouraged by this recent data and remain confident that our portfolios will produce market-beating returns in 2004. Historically in a period of rising rates, sectors such as energy, materials, and consumer staples have outperformed. These are three areas in which we have greater than benchmark exposure. The sector that generally performs worst in a rising rate environment is financial services. As evidence, note that during the first two weeks of April, as rates began to rise, this sector declined more than 3.5% while the benchmark Russell 1000 Value Index fell only 1%. We hold a much lower than benchmark weight in financial stocks and expect to be rewarded for this approach over the next several months. In addition, higher interest rates generally lead to a reduction in investor risk appetite as well as a slower pace of economic growth. As we’ve been saying, our portfolios are well positioned to benefit from such an environment. In fact, we’ve already seen a reduction in risk appetite with high quality, low beta, and high dividend yielding stocks outperforming since the end of January.
Value managers have often been criticized for being early with their strategic positioning. We were early with our projection for strong performance of energy stocks resulting from higher oil & gas prices, but since December of 2003 this strategy has paid off handsomely. It appears that we were also early with the climbing rates and corporate spending components of the strategy, but they too appear to now be working in our favor. It’s not always easy to bet against the consensus, but our long-term performance record indicates a willingness to do so and demonstrates the potential gains available.
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