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Growth Equity Portfolio

Weekly Portfolio Update
as of May 7, 2004


The Market This Week

• The market continued its agonizing slide from Jan-Feb highs with the S&P 500 experiencing a weekly decline of ‑0.7% and the NASDAQ down ‑0.1%. Through Friday, the S&P 500 was off –5.0% from its Feb 17 high, and the more aggressive NASDAQ was off –11.0% from its Jan 26 high.
  
  
• The focus and the worry was, of course, higher interest rates. A payroll increase of 288,000 for April (consensus was 170,000) and an upward revision to 337,000 for Feb were evidence that the economy was moving ahead at a very robust pace. But, the increase was also a red flag for an earlier than expected tightening by the Fed. Additionally, the level of inflation at about +1.4% y/y (core PCE deflator), although not particularly alarming, was still above the Fed’s 1-1.25% expected rise for the full year. Furthermore, average hourly earnings accelerated, rising +0.3% m/m and +2.2% y/y (still at a very low level, but up and another item to factor in).
  
  
• Almost everyone now believes the Fed will pull the trigger at its June 29-30 FOMC meeting, rather than in August which was previously the widely expected starting date for at least a 25 basis point increase from what everyone recognizes is an unsustainable low Fed Funds rate (1.0%).
  
  
• The 10-year Treasury rate (on which most mortgages are based) has already moved up dramatically (over 100 basis points) to 4.77%. The 10-year Treasury is most reflective of market conditions and is very sensitive to changes in inflation expectations. The 10-year usually moves well before the Fed acts.
  
  
• How high can Fed Funds go in the current environment? That of course depends on the level of inflation and the Federal Reserve’s determination to slow the economic growth because of the imbalances that may have developed and have put inflationary pressures on our resources (mostly labor). In view of current inflation and the 40-year average of Fed Funds over core inflation, that would put Fed Funds at 3.8%. Carrying that thought on to the 10-year Treasury, that would put the 10-year at about where it is now (4.8%).
  
  
• Are we at risk for much higher inflation? Despite the surge in oil prices ($40 per barrel), that hardly seems the case with our huge excesses in labor and manufacturing capacity.
  
  
• How vulnerable is the stock market? In view of surging corporate earnings and the behavior of the market in past cycles, we would make the case that the downside is limited and we are likely setting-up conditions for a strong rebound. In late ’93 through ’94, the 10-year Treasury yield rose rapidly from 5.5% to almost 8.0% in a period of Fed tightening, yet the stock market merely went sideways before surging +37% in 1995. From late ’98 through ’99 the 10-year moved from about 4.5% to 6.5%, yet the market continued to move up aggressively until earnings were threatened in late ’00 (see graph below) .
  
  
• It is interesting to note what market technicians (those who look at pricing patterns only) are perceiving about recent trends. Technicians have generally been looking for a consolidation or corrective phase for many months and apparently investors have now found enough negative news to create one. The Merrill Lynch market analyst commented that “the market’s winter-spring corrective trend appears to be reaching the…no-place-to-hide conclusion which often characterizes the late stage of decline and is a prelude to a forthcoming trend reversal. Most short and medium term momentum indicators (like the NYSE 10-week advance-decline index) are now at or near deeply oversold positions (like in the fall of 2002) which is a precondition for a sustainable new advance.”
  
  
• Earnings growth for the first quarter as measured by First Call, now looks like a +25.8% increase year-to-year. First Call expects Q2 earnings to be up +24%. Analysts’ expectations (bottom-up) are currently indicating a +17.7% gain, but those expectations are rising rapidly.
  
  

The Portfolio This Week

• It was a surprisingly positive week for us. Technology was our strongest sector at +3.3%. Financials (-2.2%) and Retailing (-3.9%) were our weakest sectors, which was typical of trends in the marketplace. The market seems to be reacting to an acceleration in business spending and a slowing in consumer spending later this year. Higher interest rates had a negative impact on the financial sector.
  
  

Trading Activity

• We sold our positions in Forest Labs, primarily because of a high valuation, and the possible difficulty and slowdown in earnings in the transition of Celexa to Lexapro as Celexa comes off patent.
  
  
• We reduced our position in Gilead, again mainly because of valuation.
  
  
• We filled-out our position in Jupiter Networks after the stock declined significantly. In view of the potential spending trends that we foresee for packet-based service provider networks, the valuation looks attractive.
  
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