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First quarter 2013 Commentary

“October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.”

Mark Twain
Notoriously Awful Investor

Here in the first quarter of 2013, we are witnessing a federal government tangled up trying to deal with the competing vices that emanate from capitalism and big government. We now have legislation that presumably has made permanent the tax rate structure under which we all must live, providing at least some clarity on the rules of engagement. Next comes the gun fight about federal spending for social programs and the deficit to finance them, which promises alarming headlines and stock market volatility but probably ends only with agreements to cut spending in the out years. Beyond that, I expect entitlement reform will be minimal as it is clear that the electorate on the receiving end does not want change. However, the strong stock market here at the start of the year presumably is saying that contained tax increases and likely modest spending changes mean that the US economy can continue to move forward at its tepid pace without the risk of a government induced recession.

Last year turned out to be a decent year for the economy and the stock market in spite of the worrisome issues surrounding the election, Europe’s banking crisis, and the fits and starts in the US and overseas economies. According to Bloomberg, the S&P500 increased over 15% while the Dow Jones Average rose over 7%, and most equity managers produced results somewhere between the two. The S&P500 was led particularly by the high weighting of broken financial stocks that blasted off in the fourth quarter and rose over 26% for the year.

Looking ahead into 2013, I am in the consensus camp that anticipates 2+% growth in real US GDP, with somewhat stronger growth in the private sector held back by continued slower spending at the federal, state, and local government levels. Without too much negative drag from the tax and spending moves in Washington, this forecast seems reasonably attainable. In that context, I see corporate profits advancing at a high single digit rate and stock prices following earnings up, albeit in a volatile fashion.

Rather than try to build a detailed case for an improving economy and stock price outlook as I have in past reports, I will use this quarter’s Commentary to point out some exciting parts of the US economy that promise real opportunity and prospects for hope. The US system of free markets and business innovation is alive and well and there are important developments underway. Here I list four of the most potentially impactful on the economy.


By now most observers are aware of the energy boom in the US. Once oil prices in 2008 hit $140 per barrel and natural gas prices exceeded $10 a mcf, the principle that “high prices kill high prices” took effect. Newer, costly exploration technologies – most notably, horizontal drilling – that higher prices made affordable have led to massive gas discoveries in shale rock across the US and are leading to rapid expansion of oil production as well. Higher production, in turn has brought down the price levels of these products. According to CNN Money, the US now has excess reserves in gas and some say our oil production will double from 5 million barrels daily rate in 2011 to over 10 million by 2020. Considerable investment will be required to reach these levels and will benefit a number of regions across the US as well as those companies both that drive the development and that use the output.

High on the list of industries benefiting from energy expansion are the oil field service, drilling and equipment companies, as well as pipelines (mostly master limited partnerships) that move the oil and gas. Additionally, the power and utility companies who are large users of energy will see lower costs and provide bill reductions for their customers. The steel industry will benefit in switching to gas from coal in its production, as will the chemical industry in its production of core products like ethylene. Nitrogen fertilizer producer margins are already improving from a switch to gas and leading transportation equipment manufacturers are developing natural gas engines for use in fleet vehicles. Finally, capital equipment companies providing products and services to build the energy infrastructure include firms in engineering and construction, automation, electrical components, pressure pumping, gas turbines, and flow instruments. These benefits promise a revitalization of industrial manufacturing in the United States.

Housing and Autos

These two industries were severely victimized by the recent financial crisis and recession and only now are showing signs of new life. In housing, The National Association of Home Builders state that the rapid decline in house prices and current low level of mortgage rates now yield a monthly mortgage payment on a median priced home that is 12% of the median income, compared to the long-term average of 20%. Further, the supply of homes for sale has declined to 5.4 months of average sales, which is a normal historical level. The Case-Shiller home Index has now risen for eight straight months and the number of buyers is increasing. Bloomberg reports that new housing starts increased 20% in 2012 and could grow at that rate for several years to get back to the 1.6 million rate that economists consider necessary to satisfy new household formations and replacements. Beneficiaries of such growth would be the home builders and brokers, the wholesale and retail building supply companies, and the banking industry players who have a meaningful mortgage origination business.

I highlighted the auto industry in my 2012 letter to investors which is also coming off the bottom of 10.4 million vehicles sold in 2009 compared to a current run rate of 15+ million. Consumer credit is readily available at low rates and the US auto fleet average age is at record highs. US auto companies and foreign auto transplants have a number of new offerings in cars and trucks that include more technology and better gas mileage, and those products should appeal to consumers as the economy and job prospects hold together. OEM producers, suppliers, distributors, retailers and financing firms will benefit from a stronger auto market.


No matter what your view is of Obamacare, it is here to stay. Its implementation takes effect in 2014 but this year will see both confusion and opportunity as the medical industry players position for the greatest change in healthcare since the enactment of Medicare in 1965. It seems clear to me that spending on healthcare in the US will continue to increase as a share of GDP and that government funding will grow at the expense of other federal programs.

The number one objective of Obamacare is to provide medical insurance for those uncovered. The mechanisms to effect this goal via exchanges, subsidies, and mandates are yet to be clearly determined, as are the costs and benefits for both the insured and the providers. Both will experience cost pressures – whether in premiums or fees – and patients and companies will be challenged to find acceptable outcomes. That said, however, estimates by the Heritage Foundation are that 30 to 40 million new entrants will enter the health care system, in addition to the 10,000 seniors who age-in Medicare each day! The numbers provide a vast opportunity for health care companies to increase sales of products and services.

This industry growth under an evolving system will require companies to design profitable business solutions. The managed care insurance companies stand to benefit the most from providing coverage of the previously uninsured, from growing sales of their supplemental Medicare Advantage plans, and from the opportunities to administer state Medicare programs. Pharmaceutical firms benefit from patient growth and from their new product development (especially in the growing bioscience, genomic area) but they will experience continued pressure on prices. Pharmacy benefit managers, drug distributors, and the independent laboratory companies will have a tailwind from patient growth, new products and scale of operations. In addition, many hospitals and service providers stand to benefit from reduced bad debt expense since they were obliged to treat patients even knowing that were uninsured. All in all, as healthcare grows faster than the overall economy, smart companies will benefit.


My take on the opportunities in technology revolves more around the user than the provider. The large, well known technology companies such as IBM, Intel and Microsoft have driven the industry for years with advanced products in the hardware and software realm. Now the focus is on how to use the data that these systems provide in a productive way. When I look only at how technology can help drive the revenue line, it is hard for the neophyte to imagine how much data a company must warehouse about customers from the billions of interactions from point-of-sale transactions, web hits, call centers, news feeds, social media, emails, and so forth. Then, with this information, the company must analyze the data on a real time basis to assess customer sentiment about the organization, its products, buying patterns, supply chains requirements, reaction to promotions, competitor comparisons, and many other variables. Today, firms see these activities as competitive advantages that can provide the customer what he wants, where he wants it, at what prices, delivered how and when he wants it, and in a way that grows the business. Beneficiaries will be those companies providing data warehouse and analytics software, equipment for storage and processing, consulting services around implementation and utilization, e-commerce operators who have scale and expertise, advertisers who use data to provide targeted messages, retailers who present a more relevant and personalized shopping experience.

I have used this report to comment on positive themes that simply say there are reasons for the investor to be hopeful, where growth and change offer investment opportunity. I am, of course, mindful that the political road ahead will be very bumpy, but the US economy is bigger than our elected officials. As long as they do not make it worse, some progress will be made and certain areas will do well. I believe this is an environment where money can be made in equities. Bonds remain at risk given the historic low levels of interest rates and the prospects for eventual rate increases from a stronger demand for money and less accommodative Federal Reserve. However, the economy will have to see growth faster than I forecast for those risks to materialize, so I remain committed to fixed income where appropriate in client portfolios.

As always, I thank you for your business and trust you have placed in me.

Jeff Bogosian
Branch Manager
1st Discount Brokerage, Inc.