A "Frank" Assessment

10/15/2004 12:00 am EST


Frank Cappiello

Chairman and Managing Director, Montgomery Brothers, Cappiello, LLC

In one of the most all-encompassing speeches, I’ve ever heard, Frank Cappiello discusses his overview of the outlook for the US market, interest rates, energy, and housing, as well as prospects for global growth in China and India. Here’s his commentary.

"The course of the US economy and the US stock market depends on four factors whose direction tells us how solid or precarious the economic climate is: mood, money, momentum, and mergers. Mood, or the confidence of consumer and businessmen in the future of the economy. This depends on profits for corporations and financial prospects for consumers. The mood of consumers is positive, but they are worried about oil price inflation and Iraq. Businessmen are cautiously optimistic as sales are going up and profits are rising. As for money, interest rates reflect current expectations for a slower economy as well as low inflation figures. A cycle of interest rate increases are expected for next 12 months. And the federal budget deficit is now at record levels. This situation is bad long term with accumulated deficits raising the total national debt.

"Momentum appears to be weak. A year ago, as economic statistics improved, stock prices went up and businessmen and consumers became more enthusiastic about the future. Today, the stock market has stalled as worries about rates, oil prices, and Iraq continue, yet the economy continues to improve. Finally, mergers remain important for corporate health and investors (particularly for acquired company stockholders). Mergers result in bigger and more efficient business operations. This is good for the overall economy, but bad for job creation. Recent announcements of mergers and acquisitions are growing.

"Overall the US economy is still growing but the rate the of expansion is likely to slow. Fuller employment is expected but will take time. Current unemployment rate is well below the 6% average assumed by most economists to be the norm over the past 20 years. It will take longer than expected to get to 5% unemployment. Effect on consumer to date: worried but still spending. Household net worth hit a record $44.4 trillion at the end of 2003. Price gains in equities and houses added over $2 trillion to assets in the fourth quarter of 2003. Consumer debt is less of a problem than generally perceived. Debt servicethe costs of carrying mortgages and consumer loans is relatively low. Note that the consumer accounts for 67% to 70% of our total economy. Further note that the US has about 138 million workers who earned a record $9.2 trillion in 2003, spent $7.8 trillion, and paid over $1 trillion in direct taxes and almost $800 billion in FICA taxes.


"Recently Greenspan noted in a speech that his biggest worry for the future was not the economy, trade deficit, or the housing bubble. His worry is the national debt and budget deficits. What he’s saying is that if these deficits continue, Medicare, prescription benefits, and even Social Security will be unaffordable and impossible to fund when the first of the aging baby boomers start retirement in eight to ten years. What is unique in this past down cycle (2001-2003) is that total debt in the US hasn’t declined but rather increased dramatically. Consumer debt is up 11% year over year. The ability of consumer to carry debt improved but worrisome since it can’t continue. Most household debt is fixed (mortgages) therefore increase in rates won’t hurt much. But credit card debt interest will go up.

"The current budget deficit for the year ending 9/30/04 estimated at $420 billion. A half trillion dollars is a lot of red ink but (as noted previously) measured against our annual economy GDP of $11 trillion not as bad as Japan, Germany, and France who have larger annual deficits in terms of their GDP. But these annual deficits add to our problems. We must pay interest on debt and rates are already rising so more deficits are added to pay the increase. Meanwhile, more than 40 states have a continuing crisis on debt although data shows recent improvement. Few states have embraced budget cuts. Some taxes were raised but the problem has been postponed rather than solved permanently. Of further concern, foreigners such as China and Japan now own 37% of our national debt and this level rising. Although we don't view it as a short-term problem, on a long-term we must also consider what might happen if they decide not to continue to buy.


"Is housing in a bubble? Look at the facts. In terms of demographics, the US is in a sweet spot of population growth. Its 300 million people make it the third largest population in the world. One-third of our population are ‘boomers’ born between 1947-1961. The leading edge of these boomers is now 57 years old. One-third of this ‘baby boomer’ population consumes two-thirds of GDP. Soon that leading edge will be looking at retirement. The trailing edge of the boomers are now 43, and are pushing up demand for housing. Plus, echo baby boomers (children of baby boomers) now have a leading edge around 32 years old and a trailing edge around 18 years old. Since the 1970s, baby boomers and echo baby boomers have been driving retailing and housing.

"Home prices have gone up every year since the 1960s with one exception. Historically, we’ve had bubbles before but regionally, such as California in the 1980s to early 1990s. Prices there had risen 90% in six years but in the 90s prices fell for five years and then took four years to recover. Today, prices are rising much faster in certain areas. In New York City, prices were up 30% in first quarter and are up in almost equal amount in Orange County FL, Palm Beach FL, and Washington DC, due to a lack of land and rising demand continue to be the cause. We’re seeing baby boomers and their children ‘echoes’ who want houses, thus, housing costs up 25-30% in past few months. Mortgage rates are going up and as rates rise, the housing boom will slow. Thus in my view, the bubble is here but it’s still regional. The bubble is mainly on the East and West coasts, near the two oceans and the Gulf of Mexico.


"Oil prices are up. Why? Supply is less due to OPEC quotas, problems in Venezuela, lower than expected Iraq production, and more stringent environmental regulation. Meanwhile, demand is increasing. China has doubled consumption since 1990. About 7%-10% of world oil production is now consumed by China and rising. Since 2000, 40% of world oil production increase used by China. We may also see rising oil demand in the US due to a recovering economy, a colder winter in the Northeast, and insufficient refinery capacity. The Energy Department says the US imported 11.5 million barrels of oil a day in 2000. That figure will rise to 16.6 million barrels by 2015. This leaves the US open to political blackmail or terrorist disruption of supplies en route to the US. Extra security has already driven up gas prices. Geopolitical is also impacting prices. We estimate about $6-$8 a barrel of current oil prices is fear of damage to Mid-East oilfields and subsequent shortage.


"Japan is still sorting out its mess, which began as the financial bubble, which burst in 1989. The government has been working on financial and banking reform. It is slow, but we are seeing positive results so far this year. Japan has dozens and dozens of big companies with superior technical and capital strengths, such as Sony, Hitachi, and Fujitsu. Nikkei Dow high in the late 1980s was 39,000. Today it’s around 11,152. We consider Japan a good long-term investment opportunity here.

"China can be viewed as a great stock growth, with even greater stock prices. Since 1990, China’s population has increased by more than 150 million to 1.3 billion. That increase is close to the entire population of Japan. China is the world’s fastest-growing, big economy. It is seeing rapid urbanization, with people fleeing farms to work in the cities. The consequences are staggering. In effect, China must build a Philadelphia or Houston every other month to house these people. They are woefully behind. By 2020, all major Chinese cities will be connected by a highway grid totaling 55,000 kilometers. This highway net would be second to the US. China is still working out the problems in accountability and investor rights. China is still a centrally planned and controlled economy. Finally, China’s recent growth has had an enormous impact on commodities other than oil. China’s consumption of cement is now about 50% of global production. Steel is about 40% of global production, and coal is about 30%.

"India is second to China in world population, with 1 billion, and is perhaps the best long-term opportunity. India is where China was in the late 1980s somewhere between emerging and developed. Its economic reforms are slow but sure. We are seeing the growth of consumer and a developing middle class. While the second largest nation in population, it is not as good an investment area as China, but Chinese stocks are not cheap, while Indian stocks are. India also has English speaking professionals, and it is where most of the US jobs are going. About 400 million Indians speak and understand English. The expanding middle class has fueled a boom in consumer spending. That propels growth in other segments of the economy. China has five million cars, and India has just one million, although its population is only slightly smaller. China has a 200-million mobile-phone subscribers and India merely ten million. The long-term opportunity for growth is staggering.

"By end of year, 3,600 miles of new roads linking India’s major cities will be nearly ready. And with another 10,000 miles due in the next four to five years, this new highway system will help companies to dramatically reduce their costs while moving products around the subcontinent. Banking too is seeing big improvements, with competition and liberalization of the industry and lower interest rates are allowing banks to function better offering easier access to loans. Small companies and consumers are starting to benefit substantially from this change, which should help economic growth. In short, India is well underway in the process of shifting to a higher-growth path that long-term will surprise to the upside. In summary, India is one of the better long-term stock markets.


"First, interest rates always matter for equities. The influence of interest rates on the equity market is profound. While some experts argue that interest rates are not that important to the equity outlook, the historical facts argue otherwise. Interest rates have been a major boon for stocks over the past 20-odd years. Indeed, a quick breakdown of the two major contributors of equity returns will show that corporate earnings have been accountable for about 60% of the price of equities since 1980, while the decline in interest rates, and the subsequent multiple expansion in the market’s multiple, has contributed the other 40%. Interest rates rising may be of greater concern to equities at this time, since the S&P 500 is more rate-sensitive in terms of financial stocks today than it has been in several decades. A sustainable rise in the long end of the bond market would at least dampen equity returns going forward.

"How far and how fast interest rates rise will depend on the rise in energy costs, which may indeed slow the economy, doing the work of more expensive money. Tighter Chinese monetary policy, if it succeeds in cooling that overheated economy, also may take some pressure off commodities. Looking ahead to 2005, Washington may actually be forced to do something about half-trillion dollar budget deficits. Whoever is elected probably will want to get the dirty work out of the way early in their Presidential term. And could all those less-than-positive prospects for 2005 be creeping into the collective mind of the market, the ultimate discounting mechanism? In sum, we like big capitalization over small capitalization stocks. We are neutral to bearish on US Treasuries, and neutral to positive on the US dollar. We consider real estate to be overbuilt, and expect that oil will decline. In Europe, we like UK and German banks. In Asia, we like Japan and India. We would avoid commodities."

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