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Dividend Equity Portfolio

Weekly Portfolio Update
as of June 10, 2004


The Market This Week

• The S&P 500 was up again this week, +1.3%, and as of Friday was up +4.8% from the recent closing low on May 19, 2004. This move has occurred despite concerns of higher interest rates and higher inflation (the Fed is expected to raise the Fed Funds rate by at least 25 basis points on June 30) and the Iraqi geopolitical overhang. From a technical point of view, market momentum indicators have turned positive, and positive for most groups in the S&P 500 (broad-based).
  
  
• The broadness of the market’s recovery is a very healthy sign and is reflected in roughly similar moves for most of the major indicies.

  

• Also, all economic sectors of the S&P 500 are showing positive gains, although there is definitely a bias toward the economically sensitive sectors.
  
  
         
• The economy continues to move ahead at a fairly robust pace. However, recent company surveys (ISI Group) and unemployment claims have been in a sideways mode for three months now, suggesting perhaps only +4% GDP Q2 versus the +4.5% most economists seem to be projecting.
  
  
• The OECD leading economic indicator was up just +0.2% in May. Its three month growth has slowed from a peak of +9.8% last November to +3.6% recently, and the slowdowns are broad-based—US from +15.1% to +3.7%, Eurozone fro m +10.7% to +4.3%, and Japan from +2.8% to +1.6%. On the price (inflation) front, anecdotal evidence suggests that inflation is accelerating somewhat. In fact this week’s PPI and CPI readings could surprise on the upside. However, the guess is (ISI Group) that if commodity prices continue to cool off (they have already started), so will overall inflation readings. Global competition, technology, and a high output gap (worldwide) should generally keep inflationary pressures in line.
  
  
• According to an ISI Group survey of bond managers, bond portfolio durations were yet at another new low last week, which further heightens the almost unanimous view that long rates are headed higher. It is a point of view so heavily biased in one direction that it the door to contrary thinking and possibly a rally in the opposite direction, particularly in view of the sharp rise in yields we have already experienced, the fact that the economy might be a touch slower, that China has slowed, and commodity prices may have peaked.
  
  
• In the meantime, the ultimate driver for stock prices—earnings progress—continues to move forward well ahead of early expectations. First Call now expects the final tally of earnings estimates for Q2 to be up +25% to +26%.
  
  
• This week was a light week in terms of economic reports. 1) Initial Jobless Claims (June 5) came in at 352,000, up 12,000 and above consensus of 335,000 (although it might have been distorted by Memorial Day adjustments), 2) Import prices rose +1.6% (+7.0% y/y) versus consensus of +0.8%, mostly because of the +10.3% increase in oil prices. Ex oil, prices rose +0.4% (+3.0% y/y, up from +2.4% y/y in April).

The Portfolio This Week

• In the twenty trading days since the recent market low on May 17, the leadership has been cyclically sensitive stocks such as industrials, materials, consumer discretionary and technology stocks, in that order, rather than the more defensive sectors that still have done best year-to-date.  We have lost a little ground relative after gaining strongly the prior six weeks.
  
  
• Can this pro-cyclical tilt continue?  We are not certain that the market will again favor risk given (1) developments in Saudi Arabia as well as Iraq; (2) the uncertainties about the extent and duration of Fed tightening; and (3) the growing expectation that earnings gains are likely to slow meaningfully in 2005 relative to this year, and relative to the first half of this year in particular.
  
  
• We are now doubtful that market returns can exceed 10% this year, in part reflecting expected earnings growth next year.  We also note that in closely contested presidential election years, the market often has difficulty until mid-November and then enjoys most of its gains in the closing weeks of the year (interestingly, whether the incumbent wins or loses).

Trading Activity

• None.
  
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