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VIEW FROM EDGEWOOD



ECONOMENTS

Edgewood Management Company
July 7, 2005

The View from Edgewood

Hard as it may be to believe, we are now halfway through 2005. Short-term interest rates continue to rise; long-term rates on bonds have declined; the price of oil has risen; while the major stock market indices have barely moved. Actually, the indices rose nicely in the second quarter, making up almost all the ground they lost in the first quarter, but from a long term perspective they have shown no progress for the year.

The strangest relationship continues to be long-term interest rates and the price of oil. Ten years ago a large spike in the price of oil would have set off inflation alarms that would have sent the interest rates on bonds on a rapid upward trajectory. Over the last eighteen months, as we have pointed out several times, the price of a barrel of oil has risen over 50% and the interest rate on the ten year treasury note has declined by one half of one percentage point. Alan Greenspan was moved to pronounce this a “conundrum,” which it obviously is, and he was also moved to try “jawboning” up long-term rates. This is an interesting reversal of roles. In the early nineties Greenspan was the target of members of the first Bush administration who felt he was keeping short term rates too high. It was frequently reported that the Treasury Secretary was trying to jawbone lower interest rates. Eventually rates came down, but too late for George H.W. Bush’s reelection.

We now have the unusual situation of the head of the Federal Reserve trying to get the bond market, over which he has no direct influence, to allow higher interest rates. As the Fed raises short-term rates to try to slow the economy, the decline in long-term rates keeps stimulating an important piece of the economy: the housing market. This is great for certain segments of the economy, but it makes it harder to determine when the Federal Reserve will stop raising rates. We believe the Fed is almost done, but we will only know this when they meet and do not make any changes to the Fed Funds rate. This could happen in August or September.

Parts of the global economy are slowing. Several European economies, affected by the strength of their currencies are slowing down. The Bank of England has recently cut its interest rates and there is some evidence that the British economy is slowing as housing prices have cooled off. There is also increasing pressure on the European Central Bank (for the Euro zone countries) to cut their rates. This will have the effect of making U.S. debt, which carries a higher yield, more attractive and help keep a lid on our long term rates.

In the face of much higher than expected oil prices the domestic economy continues to behave well and inflation, while a little higher than a year ago, is pretty well under control. Corporate profits may be in a slowing phase, but should remain solid this quarter. As profit growth slows, growth stocks with predictable earnings should gain in attractiveness. One of the beneficial by-products of the decline in long-term interest rates is the more favorable relative valuation given to equities in relation to bonds. The earnings yield, which is the inverse of the P/E, is currently around 6.5%. This compares quite favorably to the ten year Treasury yield of around 4%. As long as the earnings yield stays above the Treasury yield stocks will remain attractive. Specifically, the P/E on growth stocks is at its lowest point in almost a decade, which reinforces our belief that growth could have a solid second half rally.



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