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Overall Market Outlook
After the jigsaw market of the first quarter we finally saw a positive trend developing in the past few months. This trend is now dubious, not in the fundamental drivers, but rather in the market's ability to rally during traditionally slow summer months. The fundamentals are, notwithstanding one curbing exception (high energy prices), quite solid. Indeed, the market is still negative for the year despite robust earnings growth, still historically low interest rates (more on this later), good if not great GDP growth, etc. So, there is good value in stocks, and, despite possible short-term volatility, we believe that the market should move higher over the next two quarters.
The second quarter corporate earnings that are about to come into play may well prove to be the catalyst for the market. Currently analysts predict that the second quarter earnings growth will be around 7.1%; this belief largely based on the widely publicized view that double-digit growth cannot last forever. While we concur with the latter statement, the former is suspect in our view. Indeed, such attitudes are nothing new—the analysts have been underestimating earnings for the last 2 years; the forecast for the last year's earnings growth was 16%, while the actual number was closer to 21%, so it is fair to say that analysts are notoriously inaccurate in their forecasts. The other source of inspiration for pessimistic forecasters is based on the bad news that is already out: the second quarter's so-called "warning season" (the period when companies say whether they will beat or miss analyst expectations) has been negative, with almost twice as many companies warning of lackluster earnings than those who say they will beat expectations. No fear, we say: the news that is out is not news any longer. So, what are the driving forces behind what we believe will prove to become a solid quarter?
More than anything, it is the continuing improvements in the business fundamentals. The piles of cash accumulated by companies are just now beginning to slip through into business investment. The willingness of businesses to invest, in turn, stimulated manufacturing activity. While the level of manufacturing activity is notoriously difficult to predict, we now see some confirmation of a rebound in manufacturing orders—first in high airline orders for planes (despite record high oil prices) and then from a recovery of ISM (Institute of Supply Management) index (a common measure of capital investment) to a level not seen since last year.
Why then, one may ask, did the major US stock market indices all ended up lower at the end of the first half of 2005? We find that the answer must lie in the various risks that are subconsciously felt by the market. Why do I say "subconsciously"? That is because all of the objective measures of perceived market risk are hovering around their multi-year lows—such as our favorite measure of expected market volatility derived from derivatives trading—the VIX index, which now drifts around 11.0, a level last seen in 1996.
These subconsciously perceived risks come from many sources, among which are
- High oil prices may surpass a threshold beyond which the global economy will suffer;
- US housing market (which more and more economists view as speculative bubble) may crash and take the rest of the economy with it;
- Inflation will rise and the Fed will be behind the curve;
- A weak dollar will cause the loss of foreign investors, which will make borrowing harder for US companies, which will hinder the economy;
- Consumers will stop spending as their debt reaches record levels, gas prices drain their disposable income, and mortgage refinancing will exhaust itself.
Most of these and other concerns have been around for a while, but so far none have materialized. The fear is there, however, so a jittery market is bound to continue. Yet until we see clear indications of one of those fears being realized, the strong fundamentals will ultimately drive stock prices higher.
Second Quarter Performance Review
The market posted a decent gain in second quarter, though not enough to erase its first quarter loss.
For the year the S&P 500 index is still down 1.7%, and Dow and Nasdaq are even lower: -4.7% and -5.4%
respectively. Vega Equity*™ and Vega Equity+™ accounts, on the other hand posted a higher gain of 4% and 4.6%
during the second quarter, and are now positive 2.5% and 2.1% for the year respectively.
| 2nd Quarter
2005 | Year
2005 | Year
2004 | Year
2003 | Annualized
Since Inception * |
|---|
| Vega Equity+™ | +4.00% | +2.10% | +12.00% | +40.00% | +20.70 |
| Vega Equity*™ | +4.60% | +2.50% | +17.60% | +38.00% | +22.60 |
| S&P 500 | +0.90% | -1.70% | +9.00% | +26.40% | +12.90 |
| NASDAQ | +2.90% | -5.40% | +8.60% | +50.00% | +18.90 |
| Dow Jones | -2.20% | -4.70% | +3.10% | +25.30% | +8.60 |
Strategic Direction for the 3rd quarter of 2005
The Vega outperformance during the 1st half of 2005 is largely due to a more balanced exposure to risk factors such as energy prices and interest rates—we reallocate more money to assets that are less likely to be impacted by such factors. Additionally we are now using hedging options to protect us from some of the market volatility should it increase during the summer months. Notwithstanding these precautions our investment approach remains bullish: we now see even more value in stocks than we saw in the beginning of the 2nd quarter. Our equity accounts stay fully invested and we expect the stock market to finish the year higher, possibly going through a few rough months in the process.
Vega Fixed Income Strategy Update
The bond market recovered in the second quarter, as the Fed's tightening had no effect on longer-term rates. We now see almost no value in longer-term bonds: the term yield spread as measured by the difference between the yields on 10-year and 2-year treasuries, is now at just a quarter of one percent. Thus for our clients who need to derive income from their Vega Safety accounts, we have to look at a wider universe of fixed income products, such as CMOs (collaterized mortgage obligations), floating rate instruments, etc. In our previous update I wrote that the Fed's policy looks frozen, and predicted 5 more quarter-point rate hikes (that was after 7 that already happened). Two of those have already materialized, and we are patiently waiting for another three—getting us to the 4.0% target rate. That would be above the current 5-year rate and just below current 10-year rate. So, long term rates must go higher, forcing the bond market lower and making buy-and-hold-to-maturity a reasonable strategy for an individual fixed income investor. Just try not to worry when you see the reported value of your fixed income account decrease—there is no way around such "paper losses"—always remember that you'll get your $1000 per bond back at maturity.
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
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