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Overall Market Outlook
Finally, we had a positive quarter, quite amazing given such major hinders as continued rally in energy prices, one of the worst hurricanes in US history and Fed's insistence on keeping notorious "measured pace" language in their monetary policy (more on this later). Those who spent time analyzing the state of the economy during the first three quarters of the year or, much less time consuming, read my previous commentary, might not be as surprised, however, as not much changed in the economic landscape. The corporate earnings are still as robust as ever, and while GDP grew only at 3.3% in Q2, if one looks a bit deeper, he'll see that some of the growth actually was not counted as it resided in inventory sales. If you discount those inventories, you would see ex-inventories GDP growth (a.k.a. "final sales") of 5.4%—level last seen over two years ago. Yet there are risks in the market that are of great concerns to us, and these are not oil prices or hurricanes.
Which brings us back to the questions of why do the Federal Open Market Committee statements still read as cautionary tales, and why do we hear some hawkish statements from at least three Fed presidents (Moskow, Santomero and, most recently, Fisher). The answer is the inflation. Indeed, driven by energy prices, the inflation measured by PPI is now at 15-year high at over 5% year-on-year. And even if we brush off food and energy from our inflation analysis, core PPI is now over 2.5%, and the core-PCE (Personal Consumption Expenditures) registered 1.8% year-on-year in September, which Mr. Moskow characterized as approaching the upper on of Fed's tolerance corridor. Nobody knows what the real tolerance of Fed towards inflation is, but given the above characterization, I would suspect that prolonged periods of core inflation (as measured by PCE increase) over 2% will not be tolerated and the policy will shift from neutral to restrictive, which would be good (stabilizing) for the economy, but not so good for the stock market. Fortunately, we won't have to worry about it until at least the beginning of the next year, as the next two rate hikes by Fed are already priced in (see further thoughts on interest rates in my fixed income commentary).
Now that we have inflation identified as the major culprit of the current economic market, and mentioned FOMC a few times as the stabilizing economic force, let me jump right into an important question of what FOMC cannot mitigate? Interestingly enough, in the most recent commentary (Sep 27 remarks for the National Association for Business Economics) Mr. Greenspan implied that FOMC couldn't mitigate its own success. Paradoxical, isn't it? What Mr. Greenspan means is that the successful monetary policy and precise control the government exercises on the economy lead to such a low variability in economic conditions that the perceived credit risk and interest rate term premiums are now the lowest in the history of mankind. Chairman Greenspan proceeded to explain (complain?) that the market ignored Fed tightening of the late 1990 and suggested that such ignorance actually exacerbated the tech bubble. Now, the commentary in itself is rather academic, but its timing, which was the next day after chairman's speech for speech for American Bankers Association should be perceived as a dire warning. In that Sep 26 speech, Mr. Greenspan contemplated a steep decline in consumer spending (which so far carried US economy afloat during such shocks as Sep 11, sky-rocketing fuel prices, hurricanes, etc.) that would be caused by imminent increase in mortgage rates, and proceeds to state that he is uncertain at how disruptive this would be to the economy as whole (though his hopes are rather high). And that uncertainty is yet another major risk that can affect equity prices in the 4th quarter.
Other than those risks, the 4th quarter is seasonally strong for the stock market; the earnings still look good (most economists expect 15% increase in S&P earnings in Q4). So, if the market can overcome the higher interest rates and energy prices (which it did so far), the prospects for the equity prices are rather optimistic.
Second Quarter Performance Review
The market's 2nd quarter gain again fell short of erasing its earlier losses. For the year only the S&P 500 index is slightly positive (+1.4%), while Dow and Nasdaq are still in the red at -2% and -1.1% respectively. Vega Equity*™ and Vega Equity+™ accounts, on the other hand posted higher gains of 4.8% and 5.1% respectively during the 3rd quarter, and are now positive 7.0% and 7.7% for the year
| 3rd Quarter
2005 | Year-to-date 2005 | Year
2004 | Year
2003 | Annualized
Since Inception * |
|---|
| Vega Equity+™ | +4.80% | +7.00% | +12.00% | +40.00% | +18.60 |
| Vega Equity*™ | +5.10% | +7.70% | +17.60% | +42.70% | +24.00 |
| S&P 500 | +3.10% | +1.40% | +9.00% | +26.40% | +12.90 |
| NASDAQ | +4.60% | -1.10% | +8.60% | +50.00% | +18.90 |
| Dow Jones | +2.90% | -2.00% | +3.10% | +25.30% | +8.60 |
Strategic Direction for the 4th quarter of 2005
Not much changed since my previous newsletter where I emphasized balancing of portfolio exposure to risk factors that are of most concerns at the moment, such as energy prices and interest rates. We still keep our exposure balanced in that regards. What has changed, however, is the additional concern of inflationary pressures. Under such conditions, more exposure to risk factors that anti-correlate with inflation is warranted, such as exposure to gold and other commodity prices. We are still cautiously optimistic on the stock market, although given the gains of 3rd quarter the market is now fairly priced in our opinion, and we are not expecting anything more that a few percent gain in Q4 of 2005, in line with historic stock market returns.
Vega Fixed Income Strategy Update
The overnight Fed funds rate after September 20 hike by 25 basis points now stands at 3.75%, which is just one 25 bps hike away from 4% which market just a month ago perceived as Fed's target, or "neutral" policy. Yet the September 20 came and went and the "measured pace" language is still in the FOMC directive, which to me means that Mr. Greenspan is eying at least 4.25% as target rate. The market apparently agrees as it now prices in two more rate hikes, albeit with a one FOMC meeting pause in December (hoping, I guess, for a Christmas present). Yet the 5- and 10-year T-Note rates as I write this newsletter stand correspondingly at 4.2 and at 4.35%, which means that these are bound to increase by January by quite a bit, taking the rates of corporate bonds, mortgages, and various collaterized obligations alone for the ride.
An interesting back-of-the envelope computation shows just how tight the bond market has become. If one looks at the so-called implied forward rates on treasury securities (that is the yields one can lock by creating a rather involved synthetic positions in various US treasury bonds, bills or notes), he will see that the market currently prices 1.5-year yield in April of next year at 4.21%, which is below the market's own opinion of 4.25% January Fed funds rate. Does that mean that the market is confused? Not quite, as the 0.04% is about equal to the cost of implementing the said synthetic position; instead what it really mean is that the market is very tight, and the spreads (that is the premiums in yield one receives for taking risk) are virtually nonexistent.
Which brings us to the strategic direction in our fixed income policy for the next quarter, which is to stay on the sidelines, investing the bulk of the assets into short-term liquid instruments for the investment grade accounts, and limiting our interest rate risk to the bare minimum in high-yield accounts.
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
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