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Edgewood Management Company

VIEW FROM EDGEWOOD



ECONOMENTS

Edgewood Management Company
October 4, 2004

The View from Edgewood

After the flat market of the first half of the year, the equity markets suddenly fell off a cliff as July began. An increase in violence in Iraq and the steep rise in the price of oil along with an earnings season that produced some negative surprises seemed to be the most immediate reasons. Just as suddenly, as August progressed, with oil still rising and Iraqi violence in the news every day, the market turned around and began a rally that lasted through late September.

Oil prices were expected to decline after the invasion of Iraq . Instead, as is well known they stayed above $30/barrel in 2003 and flew past the $40/barrel level in June. However, unlike the 1970's oil has had a minimally inflationary effect. The higher prices seem to be acting like a consumption tax, cutting into consumer spending, and contributing to a slowing in the economy. GDP growth may be closer to 3.5% than 4%. This is having the totally unexpected effect of allowing long-term interest rates to fall. At the beginning of 2004 it was almost unanimously agreed that the ten year Treasury note rate, against which mortgage rates are pegged, would be at 5% or higher by this time of the year. Instead by late September the ten year note briefly dropped under 4% and ended the quarter at 4.1%. This will keep the housing market stronger than most expected and it will give another leg to mortgage refinancing activity.

We have two competing forces at work: higher oil prices acting as enough of a tax to slow the economy enough to allow long term interest rates to decline, which will prolong economic growth through most of 2005. As we stated last time, we believe the Federal Reserve will not raise rates much past 3%. With short and long-term interest rates staying low, this will support higher P/E's in the stock market, which will be important because earnings growth rates will start to slow as the economic expansion matures. However, a slowing rate of growth in earnings is very different from a decline in earnings. Instead of advancing at above a 20% rate as they did the last four quarters, it looks like earnings will grow at around 15% over the next four quarters. ISI Group has pointed out that, at the end of third quarter, the S&P 500 is at almost the same place it was at the same time in 1998. The ten year Treasury note yield is 1.4 percentage points lower, Fed funds are 4 percentage points lower, the GDP is 35 percent larger and corporate profits are 43 percent larger. While 1998 was the early stage of the bubble market and we don't see that developing again, today's conditions are highly favorable for the current levels of the market, even with oil three times as expensive.

The fourth quarter should be good for the markets as the uncertainty about the election is lifted (assuming there is a clear winner on November 2) and earnings should come in as good as or perhaps a bit stronger than current expectations. If oil stabilizes or declines slightly in price from these levels that will only add to a year-end rally.


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