October 31, 2005

 

Recall the story of the Greek mythological hero Odysseus and his return from Troy, as chronicled in the Odyssey. It was a long and arduous journey taking ten years and was beset by perils and misfortune. Along the way, this hero freed his men from the drugs of the Lotus-Eaters, rescued them from the cannibalism of the Cyclopes and the enchantments of Circe. He braved the terrors of the underworld with them, and while in the land of the dead, received advice on his next journey. From there on, the travels became even harder for Odysseus, but they would have been much worse if it weren’t for the advice he received. With his newly acquired knowledge, he then steered his ship past the perils of the Sirens. While he could not save his men from themselves, he was able to guide them safely through a very perilous path.

We view today’s economy in much the same way; a ship sailing past the perils of rising rates, higher inflation, escalating commodity prices, record deficits and swings in investor sentiment.  A preliminary reading of 3.8% for third quarter GDP clearly shows that the economy was in a strengthening phase prior to Hurricanes Katrina and Rita. We had seen strength in economic indicators such as manufacturing orders and employment statistics.  However, in the post hurricane environment, economic data has weakened, and Federal Reserve officials continue to carry the view that inflation, not economic growth, is their top concern. As the Fed continues on its path of raising interest rates to combat the forces of inflation, investor sentiment will continue to swing from confidence to fear of the years ahead.  

Before expanding on our thoughts for 2006, however, it may be useful to review how we derive our outlook. On a regular basis, our research team analyzes the current and expected economic conditions in an effort to quantify risks and potential return for the coming period.  Numerous important macro-economic variables are scrutinized independently to provide an overall perspective on the entire economy. Likewise, the fundamental opportunities for each of the individual companies that comprise the S&P 500 Index are analyzed and then reassembled to form an overall equity profits outlook. This exercise is not conducted with the objective of precisely predicting what will happen in the economy and markets, but rather to provide a rational framework to assist the portfolio team in making investment and asset allocation decisions.

From our analysis, we develop an “Operative Scenario,” which we believe is the most likely outlook for the year ahead. To assess potential risks to our Operative Scenario and provide a risk matrix within which to invest, we consider up to three alternative extreme scenarios. Giving prior thought to these alternative scenarios assures that there is no undue pressure to “follow the crowd” should the perception of economic and market conditions change.

Individual estimates are also derived for economic output (Real GDP), inflation (CPI), corporate profits of the S&P 500 companies, on both a capitalization-weighted and equal-weighted basis, and equity market valuation (Price/Earnings ratio). In addition, our interest rate forecast, which incorporates these capital market assumptions, is superimposed on the current Treasury yield curve.

With that background, our views on the coming year should be seen as an extension of the trends we have been experiencing for some time.  We remain cautious in looking at what lies ahead for the economy in 2006.  And while we are optimistic, we remain cognizant of the risks that the economy must face as it moves forward. 

Our current Operative Scenario, which we have labeled “Flat-World Curve”, after Thomas Friedman’s bestseller on the subject of increasing globalization, suggests domestic real GDP will rise less than 3% in 2006, which is below the pace of previous years. We believe that the economy will continue to be supported by strength in corporate expenditures and global demand.  Continued government spending, augmented by massive expenditures associated with hurricane relief, will provide support to the overall economy but may also place stresses on productive capabilities and resources. The result will be increased cost pressures and an inflation rate that drifts slightly higher, causing the Federal Reserve to maintain its current course of bumping short-term rates higher. The manufacturing sector will experience a marginally faster growth rate than the service sector as rising short term borrowing costs and persistently high energy costs will negatively impact consumer spending. 

While short-term rates are projected to rise on modestly higher inflation, a record current account deficit continues to pressure the dollar. Long-term rates, currently at low levels, should remain low as foreign central banks continue to reinvest their trade dollars back into U.S. securities. The result, as the chart above shows, is that long-term rates are artificially depressed by 0.75-1.00% and the yield curve becomes inverted (short-term rates are higher than long-term rates). However, unlike previous years, inversion of the yield curve reflects worldwide economic conditions and is not a predictor of impending domestic recession. 

We believe that prices for crude oil and natural gas while remaining elevated as domestic and global demand stresses current production capabilities, will settle below current levels. As crude oil prices moderate, companies will post mildly better results.  Our expectation for the combined operating profits of the companies that comprise the S&P 500 is growth of approximately 10%, to $84.00 per share on a market capitalization-weighted basis, or $3.10 per share on an equal-weighted basis. This pace of earnings growth is slower than previous years and may disappoint some investors, especially when compared to pre-bubble growth rates.  In this environment we believe that equities are attractively valued and offer low double-digit return opportunity.

Details on our Operative and Alternative scenarios appear above. Under the risk matrix presented, our current investment strategy remains focused on high quality companies showing positive and improving fundamentals, strong free cash flow generation and unrecognized value. We continue to invest in companies that have healthy balance sheets, generating strong levels of free cash flow and efficiently utilizing that cash to reduce debt, repurchase stock or initiate or increase dividends.  We expect to find more of these companies in the manufacturing sector, than in consumer-related areas as worldwide demand boosts profits. These are times when skilled stock pickers will out perform. Our strong performance thus far in 2005, as well as during stock picker’s markets over the past two decades demonstrate our ability to perform in markets such as the one we foresee.   We are confident our strategy remains appropriate for the foreseeable future and we look forward to discussing our outlook with you in greater detail.

Click here here if you would like a printable version of this article.

 

This information is provided for clients and prospective clients of Westwood Management and Westwood Trust, hereinafter "Westwood" and their employees. It is not an offer or solicitation to sell securities. The information provided here is copyrighted by Westwood and may not be used without its permission.