Newsletter Q4 2004
October 13, 2004
The Parallel
Universe of Government Economic Reports
The
experience of most Americans is at odds with the economic reports issued by the
U.S. Government. John Williams, an economist and guest contributor to Gillespie
Research, says that there “is good reason for the gap between common perceptions
and government reporting: government data are biased in politically correct
directions and increasingly have diverged from common experience and reality
since the mid-1980s. Inflation and unemployment reports are understated, while
employment and other economic data are overstated, deliberately.” Williams
cites several examples of changes in economic definitions and methodologies, or
manipulation of data. Two economic statistics that are frequently discussed in
the media are the consumer price index (CPI) and the public debt.
Various
analysts have identified three methodologies used by the Department of Labor –
Bureau of Labor Statistics (BLS) to compute the CPI that understate the actual
inflation rate. They are: 1) geometric weighting of CPI components, 2) hedonic
adjustments for quality improvements in products, and 3) the use of a rental
equivalency index for owner-occupied housing.
John
Williams has analyzed the shift from straight arithmetic weighting of CPI
components to a geometric weighting during the early 1990s. Arithmetic
weighting measures the changes in prices of a fixed basket of goods to estimate
the rate of inflation in terms of maintaining a constant standard of living.
Geometric weighting changes the weighting of CPI components within the fixed
basket of goods. The geometric weighting method automatically lowers the
weighting of CPI components that are rising in price and increases the weighting
of CPI components that are dropping in price. According to Williams, the net
effect of geometric weighting is to reduce CPI on an annual basis by 2.7%
compared to the traditional arithmetic weighting methodology.
Hedonic
adjustments are applied by the BLS to CPI components representing 46% of the
weight of CPI to adjust prices downward for quality improvements. Steve
Leuthold of the Leuthold Group cites new car prices as an example of how hedonic
adjustments understate inflation. Since 1979, the average price paid for a new
car in the U.S. has risen from $6,847 to $27,940, a 308% increase. The CPI
adjusted new car series, however, has risen by only 71% during that period.
Thus, 237% of the price increase has been eliminated due to the estimated
quality improvement of cars. The CPI calculation for automobiles appears to
measure the price increase in some parallel universe in which consumers are
given a choice of buying a brand new 1979 automobile or the 2004 model with the
quality improvements of the last 25 years. PIMCO, a money management firm in
California, estimates that CPI would be between 0.5% and 1.1% higher each year
since 1987 without hedonic adjustments.
Owner
occupied housing costs have a 22% weighting in the CPI calculation. The
component index is not measured by the actual price of housing but by the
estimated rent on owner-occupied housing. The BLS conducts a housing survey to
measure the change in implicit rent, which is the amount a homeowner would pay
to rent or would earn from renting their home. In recent years, U.S. housing
prices have been increasing at a faster rate than rents. Thus, the CPI
component for owner occupied housing understates the housing inflation that many
people actually experience.
In the
2003 Financial Report of the United States Government, the U.S.
Government reported that its net liabilities had increased by $285 billion to
$7,105 billion. The report states that “additional responsibilities” including
Medicare and Social Security are excluded from the balance sheet because current
accounting standards do not permit it. The additional responsibilities
(actuarial projections for 75 years) would add $27,720 billion to the
Government’s net liabilities. The increased obligations of Social Security and
Medicare during the year had a significant impact on the combined amounts, as
the combined balance sheet net liabilities and additional responsibilities
increased by $3,701 billion for fiscal year 2003.
Another
large increase in additional responsibilities is expected for 2004. The
Medicare Prescription Drug, Improvement, and Modernization Act of 2003 was
enacted on December 8, 2003, after the end of the fiscal year, which ends on
September 30. The Department of Health and Human Services actuaries estimated
that the legislation would result in direct spending outlays totaling $534
billion over the 2004-2013 period. The 75-year period net present value
estimate was not available at the time of publication. The legislation did not
include a funding source, so the present value of expenditures will increase
additional responsibilities by an equal amount on next year’s pro forma balance
sheet.
If you
are wondering how the U.S. Government will be able to meet its obligations,
reliable sources in Washington, D.C. inform me that they plan to wire the funds
from a parallel universe – the same one where you can buy that brand new 1979
automobile.
Additions
Canadian
Natural Resources Limited (CNQ) was purchased early in the quarter. CNQ
explores, develops, produces and markets crude oil and natural gas. The company
has proved reserves of more than 1.5 billion barrels of oil equivalent, located
mostly in Canada and the North Sea. CNQ’s Horizon oil sands project seeks to
develop an additional 6 billion barrels of mineable bitumen resources in
Alberta, Canada and produce 232 thousand barrels/day of light synthetic crude
oil by 2012. CNQ currently sells for 9.8X 2004 estimated earnings.
United
Kingdom Treasury bonds due 3/7/08 were purchased for several accounts. At the
time of purchase, the yield to maturity was 4.88%.
SLM
Corporation floating rate bonds due 8/11/14 were purchased for some retirement
accounts. The bonds have a credit rating of A/A+ and pay the higher rate of
4.25% or a floating rate equal to 80% of the 10 year U.S. Treasury bond.
U.S.
Treasury bills due 11/18/04 were purchased for many accounts. The T-bills serve
as a short-term money market alternative while I expect interest rates to rise
further.
Updates
UTStarcom (UTSI) lowered its earnings guidance for 2004 to $.80-.85 per share.
Earnings guidance for 2005 remains at $2.00-2.20 per share. The 2004 EPS
guidance was lowered due to a change in revenue recognition timing of a $290
million contract with Japan Telecom, as well as the maturation of the PAS
(wireless local loop) infrastructure market in China. The company reports that
international bookings continue to be strong and core business revenue growth of
25% in 2005 is anticipated. After the recent stock price decline, four UTSI
executives and one director purchased nearly $5 million worth of the company’s
stock. Positions in UTSI were increased during the quarter.
Holly
Corp. (HOC) received $156 million in July for the sale of 49% of product
pipeline and terminal assets transferred to Holly Energy Partners (HEP).
Including the general partner interest, HOC retains a 51% interest in HEP.
HOC has
a lawsuit pending in the United States Court of Federal Claims against the
Department of Defense relating to claims totaling approximately $298 million
($9.38 per share) with respect to jet fuel sales by two subsidiaries during the
years 1982 through 1999. It may be several more years before HOC’s claim is
ultimately settled, but the company is optimistic based upon a similar claim by
Pride Petroleum that has been adjudicated.
If you
have any questions regarding your accounts, please do not hesitate to call me.
Sincerely,
Robert
G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.