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  by Dennis M.
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Past Commentaries

Current Commentary, Review and Outlook
September 22nd, 2004

To My Clients, Friends & Observers:

Corporate earnings momentum peaked in the third quarter of '03. That means that earnings growth stopped accelerating. Earnings grew right through the first quarter '04, but at a slower pace. Second quarter has been a mixed bag but with one clear tendency in evidence: top line (sales) growth has stalled, particularly in tech companies.

Corporate balance sheets at year-end were in the best shape since 1992. Aging tech equipment needed cyclical replacement at least and there was the consensus and the wherewithal for aggressive capital spending in 2005, necessary to enhance productivity.

Job growth in July came in at around 35,000, a mere 200,000 less than was expected for this stage in an economic recovery. Capacity utilization in manufacturing is at 77%, obviating any pressing need for new capital equipment.

Because we are now putting an additional $40 a week into our cars instead of our shopping centers sales growth is stalled and revenues will eventually decline if oil continues to price at these levels. Oil hit a 21 year high of $47.65 today. It has thrown the global economy out of equilibrium.

This is a time when prudent corporate managers circle the wagons and preserve cash. New capital spending decisions are postponed pending some substantial shifts in the economic landscape. The capital spending cycle that would have done so much for earnings and investment has been put on hold indefinitely. This will be felt hardest in the U.S., to the glee of every other nation on earth. Europe has lagged so much that any growth is an improvement. Growth in China is practically incendiary by comparison. Chinese demand for oil has increased 40% year over year, compared to 3.4% for the U.S. Other Asian economies benefit from their correspondence with China.

That oil would increase 30% in the last six weeks and revenue growth in tech companies would stall so abruptly was not foreseeable. Several things are crystalline now. Inflation is most commonly quoted "ex-housing" and "ex-energy" because housing inflation is immaterial to all except new builders and first-time owners and energy costs are readily reflected in the increased cost of every good and service that uses energy. Longer term, everybody becomes a new home owner. And because energy is a factor of every single economic transaction it should be easy to understand that energy costs that have increased 400% since 1999 are the most significant factor in crippling an economic recovery that looked so promising only 8 months ago. Inflation in the face of a slowing economy is stagflation, a truly gritty prospect.

In light of this the bond market looks more constructive than it has though corporate spreads to treasuries are skinny thanks to the present outlook for equities. Despite the media's attention to the Fed raising rates the market has acted quite differently. Treasury yields have fallen approximately 50 basis points across the curve since June. We currently position four to seven year maturities depending on the client portfolio.


Two securities we positioned earlier this year will serve to emphasize the caution the market demands. Emulex dominates the market for fiber channel host bus adapters (HBA's), uses its excessive cash balances to integrate by acquisition, and returns in excess of 20%. QAD, Inc. is an example of a company that would best benefit from a cycle of capital spending expansion. They provide productivity software solutions for small to mid-sized manufacturers. QADI has an excellent product, good margins, barriers to entry in their niche, double digit bottom line. Both companies met all our screens and had favorable outside research as well. Both companies face top-line shortfalls resulting from the capital investment cycle that has failed to materialize. Both companies dropped 25% of their share value in a matter of a few trading sessions. As good as they are, they are now simply out of favor, as are most small and midcaps.

The investing public cannot appreciate how strong is the demand that holds the market up. When there is no bid, there is no bottom. Cash flow and reliable growth attract us to quality utilities like FPL Group, Pepco, Vectren and WGL Holdings. Arch Capital (ACGL) is attractive in the insurance sector.

Best regards,

Dennis O'Connor