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Overall Market Outlook
However much we may like to avoid the subject of interest rates, no strategy update nowadays would be complete without it. Thus, let's just get this boring "we-told-you-so-last-time" part out of our way before we proceed to the essence of our strategy.
So, the period of low interest rates is finally over… Or is it? With the Fed tightening cycle beginning, the 10-year T-Bond's yield briefly climbed to almost 5%, but is now back below 4.5%. While indeed, somewhat higher than 4.1% at the time of our last strategy update, it is still very low in historic terms. In fact, excluding the recent period, and a brief touchdown in fall of 1998, you have to go all the way back to 1960s to find 10-year T-Bond yields below 4.5% (see chart on right). So why almost everybody talking head on CNBC keeps saying or implying that higher interest rates are coming and blaming the sluggish stock market of late on interest rates? Do they really believe that the Fed is behind the curve? Mr. Greenspan is indeed patient in raising interest rates, but such stance is so far proving quite prudent indeed. Inflation is well below historic averages; economic growth is stable and economy is far from overheating. Yet analysts' reactions are dramatic.
Frankly, we are not surprised. As usual, market inefficiencies are most prominent in the overreaction arena, exacerbated by analysts' propensity to dramatize in order to get face time on their favorite TV shows. But let's look at the numbers. The current talk is that 10-year T-Bond yield is used in Fed model for pricing equities. But almost nobody mentions that the predictive power of the Fed model is close to zero for the stock prices. There are obvious improvements that one can apply to the Fed model—our favorite is to use it as one of the inputs in econometric model taking into account such parameters as unemployment rate, capacity utilization and consumer sentiment. But our computations show that under these models, even assuming a rather dramatic increase of 10-year T-Bond yield to 5% by the end of the year, the stock market is still about 10% under-priced. Thus, we can only attribute recent slump to overreaction and slow summer trading activity, and regard it as an opportunity to inexpensively increase market exposure in our equity portfolios. Done with the interest rates.
The economic landscape is robust, and despite, possibly, some short-term disappointments will be such in the coming months. What we need now is to translate favorable macro trends into solid corporate earnings. For this to happen we would like to see that the current reasons for worries are not impeding this translation. Thus, the factors that we are closely watching are, in order of importance: employment statistics, housing sector statistics and energy prices.
(Relatively) high unemployment rate has kept labor costs in check so far, thus allowing businesses to maintain the high efficiency as portrayed by historic productivity growth rates. (For the mathematically inclined, here is an economists' joke: "What is the 4th derivative of labor? It is acceleration of growth rates of labor productivity.") Accordingly, any significant changes in the labor costs would be unwelcome at this point. So would be consistently high energy prices ($50 per barrel of crude?), though we are less concerned about these as the dependency of US economy on oil has significantly diminished over years.
The housing sector is another major worry. The growth in the sector has been so high in the recent years that a significantly higher than usual percentage of the economy now depends on it. Unfortunately, unlike our equity or fixed income portfolio, US economy is somewhat difficult to rebalance. Thus the risk exposure to the single risk factor is, in our opinion excessive and is likely to stay this way. Do not misinterpret our concern, however: we believe that a significant change in the trends underlying US housing market is not imminent and is, in fact unlikely until or unless higher long-term interest rates force 30-year mortgages above 7% or so—possible, but implausible. Still, this is a valid reason for concerns.
Second Quarter Performance Review
We entered second quarter of 2004 with a positive economic outlook and cautious optimism for the equities market. And indeed the second quarter turned out well, though not spectacular. Our distribution of risk factor exposures also turned our to be beneficial, allowing our equity programs to easily outpace the market despite our target beta of 1.0.
Our equity programs, Vega Equity+™ and Vega Equity*™ were up on average +3.9% and +5.9%1 correspondingly, compared to (S&P +1.3% DJI +0.8% Nasdaq +2.7%).
Strategic Direction for the Remaining part of 2004
What to expect for the third quarter is far from obvious. Traditionally, end-of-summer is volatile with low volume due to summer vacations allowing for greater inefficiencies. So, the likely market pullbacks during late summer are usually good opportunities to add on to equity positions—that is provided that the economic landscape is encouraging. And it is indeed.
The second quarter earnings are turning our spectacular, just as we expected. An average company in the S&P 500 is beating the forecasts by 4% suggesting 24% earnings growth rate instead of expected 16%. Earnings forecasts for the third quarter keep standing at 15% growth rate, suggesting that fundamental momentum (yes, that word again!) is strong. So despite slow summer months ahead of us, we trust our econometric models, which suggest that S&P 500 at the end of the year will be between 1230 and 1340.
In the micro-economic sense, not much changed since our last equity update: we still like energy sector, some technology names with strong fundamental momentum, European value ADRs and low debt/high dividends stocks. Most of the additions to our portfolio come in the area of smaller-capitalization stocks with attractive valuations. Some specific names we recently added to our portfolios are Sola International (NYSE:SOL)—a maker of eyeglass lenses (a successful turnaround story, in our opinion), Orbital Sciences Corporation (NYSE:ORB)—a small airspace company that is almost a monopoly in small satellite launches, and Conmed Corp (Nasdaq: CNMD), a maker of surgical equipment, with forward P/E of 9, 16 and 13, all considered deep value stocks in their corresponding industries.
Such emphasis on value stocks would generally be considered conservative, but we believe that our portfolio now strikes a perfect balance between sound conservatism that is warranted for periods of expected volatile market, and reasonable exposure to known risk factors.
Vega Fixed Income Strategy Update
Fixed income is generally a place for conservatism. Or, at least, investment grade fixed income is. Yet the yield on the investment grade bonds is so low today, that building up the high grade fixed income portfolio is not a very good value proposition. With the strong economy and excellent corporate earnings prospects we generally feel safe betting on the lowest acceptable grade, shorter maturity bonds in both Vega Safety™ and Vega Wise™ programs. Even then, the average yields on Vega Safety™ and Vega Wise™ programs stay low at 3.4% and 5.9% correspondingly.
Vega Alternative Strategy Update
For the information on performance of our hedge fund products please contact us directly as by SEC rules we are not allowed to make such information publicly available. In general, however, our hedge fund strategy follows the same guidelines as our equity portfolios enhanced with additional instruments such as short positions and derivatives.
Yuri Drozd, Chief Investment Officer
Dr. Vladimir Naroditsky, CFA, Head of Research
1Vega Capital Group LLC ("Vega") is an independent adviser registered with the Securities & Exchange Commission. The performance shown reflects actual performance for representative accounts. One representative account is selected for each strategy. The selection of representative account is based on the following factors: cash flows into or out of account for the reporting period, size of account sufficient to be representative of the strategy, average trading expenses. Performance of other accounts managed under the same strategy may vary. The firm maintains a complete list of its' accounts performance, which is available upon request. Past performance is not indicative of future results. Accounts under Vega's management are not insured against loss of principal, and may loose value. The U.S. Dollar is the currency used to express performance. Returns are presented net of management fees and include the reinvestment of all income. In addition to an advisory fee, performance shown includes any additional custodial or service fees. The advisory fees are calculated as follows: for Vega Equity Plus accounts, the fee of 0.5% per quarter is charged quarterly, in advance, based on the closing balance on the last date of the previous quarter; for Vega Equity Star accounts the quarterly fees consists of management fee of 0.375% per quarter charged in advance, based on the closing balance on the last date of the previous quarter plus performance fee, charged in arrears equal to the 10% of investment gain for the quarter above all relevant watermarks and hurdle rates for the account. Vega's schedule of advisory fees vary based on product and type of client and is contained in Form ADV-II. Additional information regarding the policies for calculating and reporting returns is available upon request.
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