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Newsletter Q1 2003
January
1, 2003
Sources of
U.S. Economic Growth
Consumption
represents 70 percent of
U.S.
gross domestic product and remained
strong during 2002. Economists
define consumption as household spending on consumer goods and services.
The negative wealth effect and a slowdown in mortgage refinancing are
likely to slow consumer spending in 2003.
Michael Palumbo, a Federal
Reserve Board economist, was the keynote speaker in December at an American
Enterprise Institute conference that considered the “wealth effect” on
consumer spending. Palumbo concluded
from his studies that a change in wealth will change consumption by a factor of
approximately four percent, with a lag that extends over three years.
The negative wealth effect of the stock market decline has been offset to
some extent by rising house prices for a net decline in household wealth of $3.5
trillion since 2000. Household
wealth has declined to 4.9 times disposable income from 6 times disposable
income in 2000. Consumers must
now look more to disposable income rather than wealth to fund consumption.
In
spite of higher house prices, equity as a percentage of household real estate
value has declined to 56.4% from 65.0% in 1989, primarily due to cash-out
refinancing. This has boosted
consumer spending but weakened household balance sheets.
According to a study published by Economy.com, approximately 20% of the
economic growth since late 2000 is directly attributable to the mortgage
refinancing boom. In 2002,
over $170 billion in cash was raised from cash-out refinancing, nearly quadruple
the amount for 2000. Fannie Mae
estimates that $85 billion of that amount was used to finance consumer spending.
More layoffs of state government employees and higher state taxes are expected
for 2003, as states around the country attempt to balance their budgets.
The Center on Budget and Policy Priorities released a study two days
before Christmas. The report said,
“The budget deficits now looming over state governments will likely reach $60
billion to $85 billion in state fiscal year 2004 and constitute the largest
state budget gaps in half a century.”
California
Governor Gray Davis recently projected a $34.8 billion state fiscal deficit for
the next 18 months, which represents 45% of the general fund.
The bubble in technology stocks increased government receipts from
capital gains for several years until 2001.
Since then,
California
state receipts have sunk all the way
back to pre-Bubble levels, while inflationary pressures persist on the
expenditure side.
The
U.S.
government is doing its part to
support the economy with deficit spending. In
the first two months of fiscal 2003, the federal deficit reached $119 billion.
Tax receipts declined by 12.1% from last year while spending increased by
5.1%. If proposals for additional
tax cuts are passed or defense spending increases substantially for a major
conflict, the federal deficit could reach alarming proportions.
The
United States
economy continues to rely heavily on
foreign investment. According
to the
Financial
Market
Center
, foreign investors supplied 26.1% of
total funds raised by all sectors in
U.S.
credit markets during the third
quarter of 2002. Morgan
Stanley estimates that the U.S. dollar remains about 15% overvalued after its
recent decline. Given the huge
current account deficit and recent currency losses, foreign investors may lose
their penchant for dollar-denominated securities.
If the dollar declines further, domestic manufacturers should benefit and
lower net imports should contribute to final demand.
Jane
D’Arista, economist at the
Financial
Markets
Center
, provides a useful critique of Federal
Reserve policy. “Greenspan and his
Fed colleagues – like the vast majority of central bankers around the world
– have declined to take responsibility for the conditions that cause market
bubbles. As the evidence of the past
two centuries suggests, bubbles typically arise out of excessive and unbalanced
credit flows. And Chairman
Greenspan’s assertions notwithstanding, large increases in debt relative to
economic growth – for example, the ten percentage point jump in mortgage
borrowing as a share of GDP since 1997 – provide a fairly reliable signal that
a bubble is evolving.” D’Arista
concludes, “Home equity borrowing is a poor substitute for increased profits,
investment, employment and disposable income.
And consumption spending financed by excessive debt accumulation is not a
path to a sustainable recovery.”
I
plan to maintain a cautious approach to the financial markets in 2003.
The S&P 500 currently sells at 29 times trailing reported earnings
(before adjustments for stock options or realistic pension expense).
The current price level of the S&P 500 does not fully reflect
potential risks to the economy. The
probable opportunity cost of missing the next bull market remains low.
Additions
Electronic
Data Systems Corporation (EDS) is a leading global information technology
company. Its services include
information solutions, business process management, e-commerce solutions,
consulting, and product lifecycle management.
The price of the stock declined substantially in September due to a
combination of factors. EDS lowered
revenue and earnings guidance for the second half of 2002, based upon lower
revenue and asset writedowns associated with the US Airways and Worldcom
bankruptcies. The company also had
lower revenue from General Motors and underperformance on some contracts.
In addition, EDS decided to unwind some derivatives obligations to
purchase its own shares at a cash cost of $225 million.
EDS, however, continues to be competitive in its industry and has an
order backlog that exceeds $80 billion from customers with multi-year contracts.
In December, EDS finalized a $4.5 billion, 10-year deal with Bank of
America and a $1.3 billion outsourcing contract with ABN Amro.
EDS currently sells for 9X estimated earnings and has a dividend yield of
3.4%.
Sears,
Roebuck & Co. (S) is one of the nation’s largest retailers with over $40
billion in revenue. Sears has a
large financial subsidiary that manages $29 billion in credit card receivables
and accounts for more than 60% of its operating income.
The price of S declined in early October after two top executives in the
credit card subsidiary resigned and the company increased its loan loss
reserves. S sells for 5X the
consensus estimate of $4.75 per share for 2002 and has a dividend yield of 3.9%.
Mirant
Corporation (MIR) 2.5% convertible senior debentures due
6/15/21
were purchased for several accounts at
a significant discount to par value. Mirant
is among the largest suppliers of electric power and natural gas in the
United States
. Mirant
is in the process of selling some foreign operations and lowering its debt load.
The bonds have a BB/B1 credit rating and an unusual put feature, allowing
bondholders to put the bonds to the company at par value on
6/15/04
. At
the time of purchase, the yield-to-maturity was 8.7% and the yield-to-put date
was 66.3%.
Updates
The
price of Holly Corporation (HOC) rose after the company finally settled
litigation with Longhorn Partners. The
company will pay Longhorn Partners $25 million as a prepayment for future
deliveries from the Longhorn pipeline. Industry
margins have tightened as product prices have not kept up with recent price
increases in crude oil. Positions in
HOC were reduced in early December to provide a source of cash for other
purchases.
In
October, Sirius Satellite Radio (SIRI) announced a recapitalization plan.
The plan, if approved, will convert $700 million of debt and $525 million
of preferred stock into common stock, and raise $200 million from the sale of
additional common stock. The company
projects that the plan will provide funding through the second quarter of 2004,
when an additional $75 million may be required to get to the breakeven point. The
exchange offer is conditioned upon receipt of valid tenders from debt holders
and approval of the restructuring by shareholders.
SIRI has filed a preliminary proxy statement with the SEC and a final
proxy should be issued soon.
ITLA
Capital Corporation (ITLA) announced that its banking unit, Imperial Capital
Bank, has received regulatory approval to convert to a
California
state chartered commercial bank from a
California
industrial bank.
The bank will be able to offer its customers the full services of a
commercial bank beginning in 2003. ITLA
also announced agreements with Household International Inc. relating to tax
refund anticipation loans and commercial credit card products.
As a result, ITLA announced that it expects earnings for 2003 to exceed
$4.50 per share, about $1.00 higher than analysts were estimating at the time of
the announcement.
ICN
Pharmaceuticals (ICN) announced that it has taken shareholder action to remove
all but one member of the Board of Directors of Ribapharm, Inc. (RNA), its 80%
owned subsidiary. The ICN Board of
Directors was displeased with actions by the RNA Board of Directors, including
the recent approval of cash bonuses and stock option awards without shareholder
approval or public disclosure. ICN
has obtained a temporary restraining order from the Delaware Chancery Court
preventing the RNA Board from taking any further actions outside the “ordinary
course of business.” Larry Smith,
an analyst at Gerard Klauer, thinks ICN is likely to offer shares for the 20% of
RNA that is owned by the public.
If you have any questions regarding your accounts, please do not hesitate to
call me. I wish you a happy and
prosperous new year!
Sincerely,
Robert
G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.