Download antidote for the silly season - Needham Advisory Corporation

INVESTMENT QUARTERLY
ANTIDOTE FOR THE SILLY SEASON
The bi-annual silly season, otherwise known as election day, is upon us and the markets
seem to hardly notice the likelihood of a shift in power or any of the other economic
asteroids that are collecting over our heads. With the S&P 500 and the Dow Jones
Industrial Average returning 5.65% and 5.35% respectively for the third quarter and
8.56% and 10.91% year to date, the stock market does not seem too concerned with the
real estate slowdown, the cost of energy, or the fact that the elections may bring gridlock
to our legislative process. Even the bond market reversed the upward pressure of Federal
Reserve actions with the Lehman Intermediate Government Index posting a 3.17% return
for the quarter and a 3.18% return for the year to date. It appears that the operative
assumption going forward at this point in time is that we are definitely going to have an
economic “soft landing” or maybe just a “touch and go” practice landing before the
economy resumes its’ upward momentum. Can anything upset this goldilocks scenario
before we see a 12,000 DJIA providing a new base as we move toward the 20,000 level?
Lower oil prices, reduced nominal inflation and expectations that the Federal Reserve
may ease back on the interest rate throttle have allowed the market to soar to what some
see as an overbought level. Maybe the attitude is make your money now before Iran and
North Korea develop deliverable nuclear capacity. Every once in while the market gets
into modes that see all news as good just as in other times all news is considered bad. We
are currently in the all is good phase. But, lower oil prices may only be temporary if we
are to believe some forecasters. The speculation in oil by hedge funds is being wound
down and as usual the pendulum swings too far lowering oil, gas and coal energy costs
across the board. A number of respected forecasting services are looking for oil to stay in
the $65 to $70 range next year which should keep energy costs up. Despite lower
inflation numbers resulting from the current declines in energy costs, some of the Fed
Governors are concerned about the prospects for higher inflation, noting that outside of
housing the economy is doing quite well. An increase in interest rates would certainly
bring a halt to expectations of a rate cut early in 2007 and knock out one of the
underpinnings of the current market rally. If the inflation rate shows continued strength,
as some fear, then Fed Chairman Bernanke’s prediction of a gradual continuing reduction
in inflation may be more wish than reality. Higher inflation rates would logically lead to
higher interest rates and an economic slowdown.
Housing and the geopolitical environment are the other wild cards that are currently
being overlooked in the market’s rally. It is still too early to predict where and when the
housing correction will end. If it is even moderately severe it will impact the economy
significantly. Optimists are looking toward a rebound in early to mid 2007 while the
major home builders are expressing less faith that we have seen the bottom. The last few
years have shown us that we are greatly dependent on countries that do not like us for
energy, our lifeblood. The threat of nuclear proliferation in countries or allies of countries
that provide us our energy reduces our ability to react without facing the potential for
higher energy prices, reduced supplies or both.
In addition to these concerns, it looks like the House of Representatives will be controlled
by the democrats and the Senate will likely end up in a tie, effectively placing our
government in gridlock as we head into what is normally a good period for the market,
the third year of a presidential term. If the economy slows for any of the earlier
mentioned reasons, it is hard to imagine what form of economic stimulus will come from
congress, particularly when a weak economy could play into the democrats’ election
strategy for 2008.
How do you invest at times like this? We believe that politics, economics and
geopolitical issues average out over time. While it is easy to get irrationally exuberant at
times of market highs, history has shown that these are not always the best times to
invest. What we think makes sense is to look at individual companies with good future
prospects, solid balance sheets, that are reasonably priced relative to their fundamentals
and buy them when the market is overlooking them for some silly season reason. If you
are patient and have made wise purchases and diversified your investments you should
receive a satisfactory return over time, regardless of the political, economic and
geopolitical environment at the time.
Robert B. Needham, CFA
October, 2006
DJIA
S&P 500
(9/30/06) 11718.45
(9/30/06) 1339.15