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VIEW FROM EDGEWOOD



ECONOMENTS

Edgewood Management Company
April 4, 2005

The View from Edgewood

Last year we wrote frequently about three issues overhanging the financial markets: the election, interest rates, and the price of oil. The election had a blessedly finite life to it, but it looks like interest rates and the price of oil will again be recurring themes in 2005. The first three months of the year saw a close focus on the thoughts and actions of the Federal Reserve, as it continued to incrementally raise short-term interest rates. At some point this year they will get to a level that is noticed by the consumer, but we are not there yet. A number that is of more immediate interest is the price of oil and its major derivative, the price of gasoline. That is a number noticed every day and commented on all the time in the media. Not many people can tell you the current Fed Funds rate; any driver can tell you the cost of a gallon of gasoline.

The Fed has now raised the funds rate seven times since June, taking the rate from 1% to 2.75%. The announcement from its March meeting for the first time hinted that they were worried about inflation, not just concerned about getting interest rates back to a more normal level. How aggressive they will be remains to be seen; the price of oil itself while potentially contributing to inflation, could also act as a brake on the economy and slow it down enough to soothe the Fed's concerns. Many of these issues are barely reflected in longer term interest rates, which have only recently begun an upward move predicted by many over a year ago. Those rates will affect housing activity much more than the Fed's actions.

The price of oil, as we said several times last year, is not back to where it was at its inflation adjusted all-time peak in 1981, but it is at a number that only the most gloomy prognosticators would have envisioned a year and a half ago. Oil inventories in the industrial world are actually above last year's level and Chinese demand growth appears to be easing, yet the markets are pricing in potential supply shortages. We seem to be in a limbo where the price is high enough to get noticed but not high enough to start effecting demand. U.S. gasoline demand actually increased by 2% in 2004.

The stock market's performance in the quarter would have been much worse without energy and basic materials. Removing these two sectors, which comprise 10% of the index, from the S&P 500 and the total index declined by 4.2%, compared to a reported 2% decline. These are sectors growth investors have little or no exposure to. What this has done, in our opinion, is make growth much cheaper and more attractive as it should be in a rising interest rate environment. Rising rates imply a solid economy that should keep profit growth strong. Rising rates also signal that at some point the economy's growth will slow. The sectors that first discount the effects of a slowdown in the economy are the more cyclical ones such as basic materials. Our portfolio companies are well positioned to capture a move away from sectors more exposed to the business cycle and toward more growth oriented companies.


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