Higher-than-expected company profits help economic picture remain positive

By Norman F. Klopp, Jr., CFA, Partner

Coming on the heals of rapidly increasing oil and gas prices, this hurricane struck at the heart of the U.S. domestic energy production and refining complex and exacerbated the turmoil in the energy markets.

We were surprised at how quickly much of the oil and gas production was restored after Katrina struck and the speed that a significant amount of refining capacity was restored. It appears likely, however, that the Gulf Coast region could continue to be threatened until the hurricane season ends.

We would like to believe that one positive that will come from this disaster and its sharp focus on our vulnerability is a more sustained, broadly-supported and effective energy policy for our country.

Modestly negative event

Hurricane Katrina will likely have a modest negative impact on GDP growth for the next few months. Beyond that, the massive recovery and rebuilding effort will provide a modest positive business stimulus late this year and well into 2006.

The resiliency of the stock market was a positive sign during the third quarter, despite these negative events:

• Soaring energy costs;
• The sudden devastation of Katrina;
• Continuing mixed messages from Iraq;
• A flattening of the yield curve as short rates continued their upward swing and long rates remained relatively stable.

The message we glean from this market resiliency has two parts:

1). The stock market is not overvalued and, by some measures, is significantly undervalued.

2). The economy continues to do very well after 10 quarters of GDP growth and strong corporate profits.

Had the events of the third quarter taken place with an overvalued market and an extended, tenuous economy, the market reaction could have been dramatically negative. Economic news in the third quarter continued to be positive.

Building product prices

The Federal Reserve Board held to its “measured” course of increasing the federal funds rate 25 basis points per meeting when it convened on September 20th. Some people had speculated that the Fed might forego the rate increase, due to the widespread damage caused by Hurricane Katrina. However, a more balanced view of the impact that the hurricane had on the economy emerged as examples of Katrina-related inflation, in such things as lumber and building products, became apparent.

The U.S. economy, measured in terms of GDP change, has grown at a 3% or better rate for ten consecutive quarters. This growth has been translated into record levels of corporate profits when measured as a percent of GDP. Aggregate earnings-per-share estimates for the market, defined as the Standard & Poors 500 Index, for both 2005 and 2006, have continued to be revised upward throughout this year. This continues the trend of the last 13 quarters in which reported earnings have exceeded expectations, growing at double-digit rates.

Consumer spending

Consumers continued to show resiliency, as demonstrated by retail sales reports (excluding autos and gasoline), which increased 0.5% in August. Disruptions from Katrina negatively impacted retail sales in the Gulf Region, but that situation should reverse once the commerce infrastructure recovers. Higher gasoline prices, and the near certainty of higher home heating costs this winter, could slow retail sales growth in the next few quarters. We saw some signs of this potential impact when August retail sales reports showed strength in staple (essential) sales versus discretionary (luxury) sales.

Corporate spending

Reflecting strong corporate earnings and cash flow, capital spending was up 13.6% in 2004. It should be up in excess of 13% this year, and grow at double-digit rates again in 2006. The need for additional capacity in some industries, and the near universal need to maintain productivity improvements, are driving spending levels. Productivity becomes particularly important to companies that are facing commodity and other cost increases, but are unable to get any price increases, or sufficient increases to offset these costs.

There’s an old saying in the investment business: “Bull markets have to climb a wall of worry.” Think about this “wall of worry”:

• Record-high energy prices;
• Rising interest rates;
• The most devastating natural disaster in U.S. history;
• A huge new federal government spending burden;
• Continued concerns about Iraq;
• A “stretched” consumer.

Yet despite these problems, the stock market has been surprisingly stable this year. Volatile? Yes. But stable. And through it all, economic growth and corporate profit growth have exceeded expectations.

What counts?

In the end, what counts for the stock market is growth in corporate profits and cash flow. In the current business environment, growth will be less universal and focused increasingly on a company-by-company basis.

At Midwest Investment Management, we believe our investment process and disciplines are well-suited to this type of investment environment.

• • •

If you are not currently a Midwest Investment Management client, let Norm Klopp help you implement an investment program that can position your portfolio for sustained, long-term growth. To get started, contact Norm at (216) 830-1135 or e-mail: nfk@mimllc.com