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VIEW FROM EDGEWOOD



ECONOMENTS

Edgewood Management Company
April 5, 2004

The View from Edgewood

The market started the year strongly, but gave back all its gains by the end of the quarter. There were many reasons for the market’s first quarter round-trip; the usual suspects offered the usual rationales, ranging from the weather to the need for a correction after ten months of one market direction: up. After the strength of the market in 2003 it was not totally unexpected that the market would pause to digest last year’s gains and to consider the signals on the state of the economy.

As we said in our last letter we expect 2004 to be a good year for the U.S. economy. This is being fueled by very low interest rates, tax cuts, and a weaker U.S., dollar. However, these very factors are causing some nerves to be jangled in the markets. Rates can’t stay low forever, the deficits may have to be partially reduced with tax hikes, and a weak dollar may scare away foreign investors. Higher oil prices are being felt most directly at the gasoline pump, although in fairness it must be pointed out that the all-time high inflation adjusted price for gasoline was just under $3 per gallon (in 2004 dollars) back in 1981. Rising gas prices do act as a regressive tax, taking away discretionary consumer dollars that would otherwise be spent on domestic consumption and exporting at least some of those dollars overseas.

It is easy to see why the markets were whipsawed in the first quarter. Expectations that last year’s strong economy would start to translate into job growth did not become apparent until the March job survey released on April 2. The earlier job reports were quite disappointing, causing a surprising rally in the bond market and causing the equity market to question its assumption of solid growth this year. The strong March job report helped the second quarter get off to a strong start that we think will continue as corporate earnings begin to be released the first full week of April. There are many indications that this should be a strong quarter; the single biggest indicator is the fact that earnings pre-announcements, which come late in the preceding quarter or the first two days of the new quarter, have been minimal.

Strong corporate profit growth seems to be leading to stronger job growth. Two constituencies have a keen interest in the employment numbers to be released over the next several months. Fed watchers will be adjusting their view on when tightening may occur and election watchers will be weighing how new job creation or the lack of it will influence the election festivities this fall. The Fed has tried to keep interest rate moves away from national elections dates, which probably means if they have taken no action by August they will do nothing until after the election.

To show how volatile the view is on this: the general sentiment was that they would do nothing this year until the strong March employment numbers were released. Now many think June or August are possibilities for the first round of tightening, since 2000, which was an election year when the Fed stopped acting in June.

The political effects are harder to gauge. Massive fiscal and monetary stimulus kept the economy from falling further during the post-bubble recession, but all the bullets have been fired and fiscal policy is going to turn restrictive next year. The election will probably be close enough that September’s job number, which is released in early October and is the one before the election could be much more influential than usual.


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