Overall Market Outlook

In our previous newsletter we alluded to 3 dangers that may impede the robustness of US economy, in order of importance: rising cost of labor, over investment into housing sector, and rising energy costs. Of these three only the least important danger has materialized in form of $50 per barrel oil prices. Quite unfortunately, despite being in our opinion the least important, it is also the most conspicuous, giving the market unwelcome jitters. So the market stumbled, while investors went through the period of reconciliation with higher oil prices.

So did we, and came to a surprising conclusion. Despite the obvious initial reaction, we now find that high oil prices may not be as bad for the global economy prospects as some pundits would like us to believe. Without being bogged down in dull economic computations, let me give you a brief overview of our thinking. First, mentally separate the oil economy from the rest of the world economy, and try to look at it as an exogenous factor. Then, investment into oil economy may be viewed as a dampening mechanism not unlike that of a Federal Reserve’s manipulation of interest rates. Indeed, high oil prices means more incentive for investment into oil economy, resulting in money flowing from the world’s economy into oil economy. The same happens when Fed raises interest rates—more money are flowing from US economy into the US Treasury. Unlike interest rates manipulation, oil prices and thus, money flow from world’s economy into oil economy is not easily controlled. However, in our current situation, rising oil prices are doing exactly what a sound policymaker would do for an accelerating world economy: decreasing money supply, thus putting a damper on an economic train that is about to exceed safe speed limit. Our calculations show that in fact, even increasing oil prices to $60 (from current $50) would still amount for a relatively minor damper—similar to a further increase in Fed Funds rate by a mere 0.5%. To avoid vehement counterarguments, I admit, the analogy is not perfect; but it makes for a good illustration of what kind of impact should we expect from imminent energy cost increase.

Outside of the oil sector concerns, the US economy is quite robust. The labor cost is well contained, the housing sector just keeps booming, and the inflation is about as tame as it ever gets (so far this year the core inflation is running at an annual rate of well under 2%). The GDP is growing at an annual rate of well over 4% (real terms), and the long-term interest rates actually fell (with 10-years Treasury yield at times falling below 4%). The corporate earnings are strong, with most economists expecting double-digit earnings growth over the next few quarters. Moreover, S&P already yielding over 5% in earnings (P/E of 20), making stocks quite attractive compared to other classes of investments.

So, why did the stock market not rally this summer? I can suggest several possible explanations, such as geopolitical concerns or upcoming elections (economy does not like major changes in policies, and Kerry is certainly quite far from Bush in economic policy). However, these concerns are bound to be subsided over next several months as US presidential race is put behind us and Iraq’s insurgence becomes a more local issue after planned January election. Barring major unforeseeable events, once those concerns are addressed, we see S&P 500 index reaching 1300, at which level it will become fairly priced. Whether this happens before the end of this quarter or soon after, we are not sure, but until then our stance on the market is bullish.

VEGA EQUITY STRATEGY UPDATE

Second Quarter Performance Review

We entered third quarter of 2004 with a bullish stance. Our target beta for equity portfolio was set to 1.0 ЁC we were "fully invested." Yet, the stock market chose a different path over the summer with negative performance for all major indices (S&P 500: -2.4%, Dow Jones: -3.4%, Nasdaq Composite: -7.4%). Our equity programs, Vega Equity+. and Vega Equity*™. outperformed the market, with Vega Equity+. registering a fractional loss of -0.28% and Vega Equity*™. actually gaining +0.35%¹.

	YTD as of 10/1/2004	Year 2003	Annualized Rate of Return	Max Drawdown	Return/Risk Ratio	Beta	Excess Return (α)
Vega Equity+™	+3.8%	+38.0%	+23.0%	-3.6%	6.4	1.1	+5.6%
Vega Equity*™	+6.4%	+40.1%	+27.9%	-5.1%	5.5	1.3	+8.0%
S&P 500	+0.2%	+26.4%	+17.4%	-10.2%	1.7	1	0.0%
NASDAQ	-5.3%	+50.0%	+29.1%	-10.7%	2.7	1.8	-0.6%
Dow Jones	-3.6%	+25.3%	+16.4%	-11.3%	1.5	1.2	-5.2%

Strategic Direction for the Remaining part of 2004

This summer proved to be slow for the stock market, and it is reasonable to say that not much changed on the economic front. Indeed, we still expect double-digit earning growth for S&P 500 companies in the next two quarters, and our models still predict S&P 500 to be between 1230 and 1340 by January. In line with this forecast, we are keeping our portfolios fully invested (target beta of 1.0).

We used summer pullbacks to pick up several technology names that we view as good value at current prices, such as software vendors Wind River Systems (Nasdaq: WIND) and Mentor Graphics (MENT). We have also increased our exposure to the oil services sector. Now, the oil services sector had been under-performing lately, at least compared with large cap integrated oil names such as Conoco Philips and Exxon Mobile. Yet, the increased gap between supply and demand, and more than healthy profits of integrated oil companies will almost certainly mean higher investment into new oil field development, and this is exactly where we see the most of the oil-related upside. The few names we bought are: Core Laboratories (NYSE:CLB), Noble Corp (NYSE:NE), Ensco International (NYSE:ESV) and Hornbeck Offshore Services (NYSE:HOS).

Just as important as decisions to invest in a sector are decisions to stay away from particular group of stocks. And today one of such groups, in our opinion, is financial sector. The reasons are many: relative out-performance during the first part of the year, long history of under-performance during Fed tightening cycle, rising concerns about sustainability of the housing boom (and, thus, mortgage business). These factors lead us to believe that the propensity of financial sector to lead the market may not realize this fall.

Vega Fixed Income Strategy Update

Fixed income climate is about to improve. The yield curve recently gotten so flat that almost any increase in short-term interest rates is bound to cause corresponding increase in long-term rates (and thus, yields on bonds). On the other hand, the quality spreads are getting tighter as the overall economy improves. Under these circumstances we see any rises in longer-term yields as buying opportunities, especially in the realm of shorter duration, lower quality corporate bonds. The average yields in our Vega Safety™ and Vega Wise™ programs remained steady during the last quarter, at 3.4% and 5.9% correspondingly¹.

Vega Alternative Strategy Update

For the information on performance of our hedge fund products please contact us directly as by SEC rules we are not allowed to make such information publicly available. In general, however, our hedge fund strategy follows the same guidelines as our equity portfolios enhanced with additional instruments such as short positions and derivatives.

Yuri Drozd, Chief Investment Officer
Dr. Vladimir Naroditsky, CFA, Head of Research

¹Vega Capital Group LLC ("Vega") is an independent adviser registered with the Securities & Exchange Commission. The performance shown reflects actual performance for representative accounts. One representative account is selected for each strategy. The selection of representative account is based on the following factors: cash flows into or out of account for the reporting period, size of account sufficient to be representative of the strategy, average trading expenses. Performance of other accounts managed under the same strategy may vary. The firm maintains a complete list of its' accounts performance, which is available upon request. Past performance is not indicative of future results. Accounts under Vega's management are not insured against loss of principal, and may loose value. The U.S. Dollar is the currency used to express performance. Returns are presented net of management fees and include the reinvestment of all income. In addition to an advisory fee, performance shown includes any additional custodial or service fees. The advisory fees are calculated as follows: for Vega Equity Plus accounts, the fee of 0.5% per quarter is charged quarterly, in advance, based on the closing balance on the last date of the previous quarter; for Vega Equity Star accounts the quarterly fees consists of management fee of 0.375% per quarter charged in advance, based on the closing balance on the last date of the previous quarter plus performance fee, charged in arrears equal to the 10% of investment gain for the quarter above all relevant watermarks and hurdle rates for the account. Vega's schedule of advisory fees vary based on product and type of client and is contained in Form ADV-II. Additional information regarding the policies for calculating and reporting returns is available upon request.