Strategic Outlook(A)

All too often there is dissonance between our roles as workers, family members and owners of capital on the one hand, and our responsibilities as global citizens on the other. This tension comes to a head around the issue of economic growth. Continuous growth maintains employment levels and creates jobs for new entrants into the work force. Growth is the rising tide that can lift all boats, avoiding painful tradeoffs. Growth puts money in investors’ pockets and raises the overall standard of living.

Yet it is obvious to many of those that depend on growth for employment, wages, and investment income that the status quo is unsustainable. As China and India take baby steps toward a Western standard of living, energy prices are going through the roof and greenhouse gas emissions are rising every year. Beyond environmental risks, the constant drumbeat of economic growth crowds out other goods such as leisure, civic participation, personal development, health, sleep, hobbies and time with friends and family.

Some of the problems with growth are definitional. We manage what we measure, and GDP skews perceptions and policies by lumping together both good and bad growth. In order to isolate the positive side of growth, the non-profit group Redefining Progress estimates a “Genuine Progress Indicator,” or GPI. This measure adjusts personal consumption expenditures for income inequality, and then adds or subtracts categories of spending based on their impact on the nation’s well being, broadly defined. “Defensive household expenditures” in response to a declining quality of life are subtracted, such as money spent on pollution abatement and security systems, and adjustments are made for the depreciation of environmental assets. Time spent on parenting and volunteer work is added back in, as are the services provided by cars, refrigerators and other consumer durables previously manufactured. Not surprisingly, the GPI is rising much more slowly than the “all growth is good growth” GDP. We can only meaningfully accelerate sustainable growth if we develop widely accepted metrics that accurately track social and economic progress.

No doubt, many people in developing nations need to consume more and their economies must grow. All the more reason for us to rapidly change our measures of social success — to develop indicators that reward good growth while inhibiting harmful growth. Rather than accepting unhealthy growth as a necessary evil, investors can choose to put their money toward products and providers that support genuine progress and avoid those that generate high social costs. Since sustainable efficiency makes practical business sense, good growth can underwrite the double bottom line of financial and social return. A recent study evaluated the investment returns of companies based on their “eco-efficiency,” defined as the ratio of the value a company adds with their products and services to the waste they generate. While industries with heavy environmental impact such as oil, gas, chemicals and utilities scored badly in general, the authors identified the best-of-sector performers in each part of the economy. The “eco-efficient” portfolio created substantially better investment returns than the companies with less eco-efficiency.1

Growth can be sustainable, healthy and profitable, or it can be dangerous, destructive and self-defeating. Getting the right kind of growth requires good metrics, as well as purposeful consistency in our varied roles as consumers, workers, employers, citizens and investors.

1 Jeroen Derwall, et al., “The Eco-Efficiency Premium Puzzle,” Financial Analysts Journal, March/April 2005, pp. 51-63.

CNOOC to the Left of Me, Chevron to the Right: Stuck in the Middle (A)

When President Richard Nixon visited Beijing in 1972, he could never have dreamed the Communists would one day bid against Chevron Corporation for Unocal. It just goes to show that if you gather enough capital today (even at the expense of human rights, American national security and the environment) you can be a player in the energy business. At least that’s how Chevron and Unocal did it. The trick now is to get Fu Chengyu’s Chinese National Offshore Oil Corp. (CNOOC) to buy Chevron. Then shareholders could take the money and invest in companies that will actually help this country.

After all, what would America be losing if CNOOC succeeds in acquiring Chevron (or succeeded in buying Unocal)? It wouldn’t mean a less secure oil supply for America. CNOOC’s bid for Unocal doesn’t necessarily pass the free market sniff test, but Chevron’s bid is not about securing oil for America either. If the market for oil is better in Shanghai than Cheyenne, the oil is going to Shanghai.

In fact, a Sino-mega merger might actually hasten the end to America’s dependence on oil. Chevron and Unocal are no more interested in ending this quagmire than is CNOOC. With two fewer American oil companies to stifle policy, the markets would reach oil independence more rapidly.

It’s also not as if these companies are buffeting America’s national security efforts. Quite the contrary. From Burma to Africa to South America, Chevron and Unocal have built empires by rushing into unstable regions and getting oil or gas out as quickly as possible. This has enabled the companies to stockpile cash, but as we are finding out in these first fitful years of the 21st century, it may be at the expense of America’s national security.

In Nigeria, for example, Chevron has relied on a partnership with a violent, undemocratic regime to derive a significant share of its crude oil supply. Chevron got its oil, but it left behind no lasting democratic institutions in the county. So now, after more than a decade of producing oil, Nigeria has social unrest in the South and Sharia (the imposition of Islamic Law) in the North. This is a poisonous combination for American national security because thugs in Nigeria hijack an estimated $3 billion to $15 billion of oil each year. To Chevron, this is just the cost of doing business in Nigeria. But with the proceeds from the stolen oil almost certainly falling into the hands of anti-American interests in the region, it may be America that pays the price.

And Unocal? When Chevron CEO David Reilly wrote in a Wall Street Journal editorial on July 12th that Chevron and Unocal shared “a strong cultural affinity”, he wasn’t kidding. In the late 1990s, Unocal tried desperately to go into the oil pipeline business with the Taliban in Afghanistan, hoping to put $250 million into the hands of the Taliban pre-9/11. Now it is Unocal’s stake in pipelines just north of Iran that has attracted suitors. Protecting these assets from militants in the region won’t come cheap. And if it’s Chevron that gets Unocal, this is how it will work: American taxpayers will be stuck paying to protect pipelines in the heartland of America’s enemies (diverting resources from schools, emergency services or the development of alternative energy); Chevron will get the profits (which are then lightly taxed); and China will most likely get the oil anyway.

So you see, letting CNOOC have Unocal (and maybe Chevron too) might be good for shareholders and America. Shareholders would be ridding themselves of considerable human rights and environmental liabilities and with the subsequent recovery of billions of dollars in direct and indirect oil subsidies, America could put real resources into developing cleaner, stable sources of energy. Plenty of wealth would be created; it would just be spread among hundreds of smaller innovative companies (many in new industries) and among many more Americans.

Of course, when that happens, we won’t have Big Oil to push around any more.

New Reports from GE and Nike: A Watershed in Social Disclosure (A)

In 37 years of writing about corporate social responsibility, I have done my fair share of scolding companies. And there was never a shortage of targets. Inherent in those critiques, though, was the sense – my sense anyway – that companies could do better, that they did not have to behave like beasts in a jungle. I am looking at two reports that demonstrate that companies can change and address social issues in constructive, meaningful ways.

The reports come from companies absent from most social investment portfolios: Nike and General Electric.

GE’s 2005 Citizenship Report, “Our Actions,” is the first social responsibility report issued by the company. It provides a window into GE that we didn’t have before. Here are some nuggets:

GE has decided not to pursue business opportunities in Myanmar because of this country’s “history of human rights violations,” a sharp contrast to the actions of the big French oil company, Total.

One-third of GE’s officers and 40% of its senior executives are women, U.S. minorities and non-U.S. citizens, up from 22% and 29%, respectively, in the year 2000.

GE now compels its suppliers to be in compliance with environmental, health & safety and labor standards. Since 2002 GE has terminated 200 suppliers for their failure to improve performance.

It’s great to welcome GE to this dialogue (pace Jack Welch), but if awards are being passed out for social responsibility disclosure, the Oscar has to go to Nike. Its “Corporate Responsibility Report” is a gem.

Nike is the world’s largest supplier of athletic shoes, apparel and equipment. It makes virtually none of its products, sourcing them from contractors, mostly located overseas. The company has long been the bete noire of activists who deplored the working conditions in Asian factories. When those protests first surfaced, Nike stonewalled them. Now it has done an about-face. In its new report, it not only faces up to the responsibilities a company has when it outsources manufacturing, it sets a level of transparency for others to emulate. Nike currently has a roster of 830 approved factories in 52 countries. They employ more than 650,000 workers, the majority of them women between the ages of 19 and 25. Some 200,000 of these workers are employed at factories in China; another 84,000 work at plants in Vietnam. View the full list at Nike’s website, www.Nikeresponsibility.com, where you will see the names and addresses of 731 active contract factories. Nike hopes this disclosure will stimulate other companies to follow suit.

Nike’s Code of Conduct bars child labor, respects the right of employees to form unions and binds factory owners to provide “a safe and healthy workplace” and “to promote the health and well-being of all employees.” The report details an elaborate system of inspection and grading to insure that factories meet the standards and correct deficiencies.

An admirable feature of Nike’s report is its tone. It is modest in its appraisal, conscious of past mistakes and aware of how much still needs to be done. Nike had help from a Report Review Committee consisting of nine people from the NGO, academic, labor, investor and public interest communities. The chair was Deb Hall, director of accountability programs at CERES. Another member was Thomas Gladwin, professor at the University of Michigan business school and a Trillium Asset Management board member. The group issued its own report on Nike’s report, commending the company for its candor and suggesting ways to improve future reporting. Nike included the committee’s comments in its full report.

The message for other companies: Just Do It!

Chevron and Unocal: Two of a Kind (A)

On Wall Street, mega-mergers are usually celebrated. After all, they portend layoffs, bumped up profit margins and investment banking revenues. What’s not to like? In the case of Chevron’s proposed $16 billion acquisition of Unocal, plenty. At least if you care about national security, the environment or what the rest of the world thinks about America.

Chevron, Texaco and Unocal cut quite a swath through the 20th century. With few limits placed on their behavior they amassed both wealth and political power. But the companies also left a wake of instability that is now, in the first fitful years of this new century, crashing down on society.

Chevron, for example, is a company that has relied on a partnership with a violent, undemocratic regime in Nigeria to derive a significant share of its crude oil supply. Unfortunately, for all the billions in revenue Chevron has reaped in Nigeria, its investment in the West African country has not helped fund the institutions necessary for a democratic movement in the country. On the contrary, oil money from San Ramon has poisoned the opportunity to increase American influence in the region.

To this day, Chevron’s government partners are widely believed to tap into oil pipelines to hijack oil. The practice, called “bunkering,” provides an estimated $3 billion to $15 billion of black market currency to thugs in Nigeria and elsewhere annually. Needless to say, the proceeds from the stolen oil are not going to finance a stable democratic Nigeria. In fact, the cash is almost certainly falling into the hands of anti-American interests in the region.

In this way, Unocal is a perfect fit for Chevron. Maybe this is what Wall Street means when they talk about “synergies” in mergers. In the late 1990s, Unocal tried desperately to go into the oil pipeline business with the Taliban in Afghanistan, hoping to put $250 million into the hands of the Taliban pre-9/11. Feminists and socially responsible investors, not Wall Street, helped block that deal. Today, it is Unocal’s 10.3% stake in the Azerbaijan International Oil Consortium and its 9% stake in pipelines designed to move oil from the Baku to Turkey that enticed Chevron.

Will Chevron learn from Nigeria and take this opportunity to improve America’s influence in this critically important region? Doubtful. After all, in 1999 Chevron acquired Texaco’s horrible legacy in South America and has done nothing to improve it. The abhorrent behavior of American companies in South America fermented such opposition to American interests that Congress felt impelled to approve nearly a billion dollars to provide military protection for American pipelines in the region.

Since Unocal’s most valuable assets lie just north of Iran, you can expect to see more of these types of expenditures. The cash-strapped Bush Administration will borrow most of the money needed to protect oil installations in the former Soviet states, but will also raise some through cuts like those to the National Science Foundation ($100 million in 2005 and 2006) and the science programs at the Department of Energy. Big Oil likes this strategy because it helps them now and later. Progress on energy issues is not on their agenda.

This merger sheds light on a sad fact: influence that took a century to develop won’t end until American investors (and citizens) figure out how to turn off the spigot of money propping up Big Oil – from the gas pump and from the halls of Congress. When that happens, small, innovative energy companies will have their day and mergers like this one won’t be viable or necessary. For the markets and for America, that day can’t come soon enough.

Can Citigroup Earn $17 Billion a Year and Be a Good Guy?(A)

Citigroup, , the world’s largest financial services company, made more money last year than anyone has a right to make – $17 billion after taxes. The only U.S. company to exceed that mark was ExxonMobil – buoyed by soaring oil prices, it earned $25.3 billion. The Citigroup profit was greater than the revenues of 70 percent of the Fortune 500 companies.

Through its various arms – retail banking (Citibank), consumer and mortgage loans, corporate underwriting, asset management, merger and acquisitions advisor, brokerage (Smith Barney), private bank credit cards – Citigroup has a ubiquitous presence on the world scene.

So what’s not to like? Well, these far-flung activities, driven by an aggressive strategy to submerge competitors, have yielded not only golden profits but a fair amount of mischief.

You may have seen the photograph that ran last year in newspapers across the world showing CEO Charles Prince bowing his head in apology at a Tokyo press conference. He was apologizing for shady practices by Citigroup’s private bank, actions that led the Japanese government to close down the operation. Then there was last August’s bond trading escapade in London. A bunch of brash Citigroup bankers used the electronic trading system to unload $16 billion of bonds in two minutes. A little while later they bought back a big chunk of the bonds at much lower prices. Small dealers were ravaged by this deal; Citigroup came away with a quick profit of $30 million.

Citigroup’s 2004 profits were about $1 billion lower than the previous year because the financial behemoth had to take various charges related to inappropriate actions such as helping WorldCom and Enron issue financial statements that misled investors. To settle the WorldCom matter, the company paid a fine of $2.9 billion. They also paid a $70 million fine levied by the Federal Reserve for violating fair-lending laws.

Prince has had it with these shenanigans. In February he laid out a five-point program to beef up ethical standards in the company. The program started on March 1 with the showing of a 25-minute documentary film, “The Story of Citigroup.” The film deals with the history of the company and the “shared responsibilities” all employees have. It will be compulsory for every employee in Citigroup to see the film and to attest later that they understand the “shared responsibilities.” Other aspects of the program include:

An “ethics hotline” that will enable staff members to give anonymous feedback on managers.

Senior managers (top 3,000 officers) will gather in small groups and spend a full day each year on how they and the company can do more to live up to “our shared responsibilities.”

Every employee will receive mandatory training in ethics every year.

Prince will have a bimonthly dialogue with senior managers and will preside over a series of Town Hall meetings with employees.

An annual survey of managers on how they feel about the senior managers.

Compensation of business heads will include a significant component based on how the entire company performs, not just his or her business group.

Prince said the goals of the new program are to help Citigroup “grow responsibly” and to make it “the most respected financial services company.” Shortly thereafter Fortune issued its annual “most admired lists.” Citigroup failed to make the Top 10 and in the megabank category it slipped from first to third place behind Bank of America and Wells Fargo.

If you have any ideas on how Citigroup can become a more respected corporate citizen, send them on to Chuck Prince.

Market Outlook – 15 March 2005(A)

This past fall the price of a barrel of oil set a new record above $55, and after a brief respite we are close to those sky-high levels once again. Yet the economy is growing, and inflation is running at only 3%. For many of us who were both alive and out of diapers during the oil crises of the 1970s, this is a puzzling set of events. So what is driving the increase in energy prices, and what are the economic, social and market impacts?

Energy consumption has been rising steadily for at least 200 years, so what is perhaps most surprising was how low and stable prices were from the mid-eighties until quite recently. Then a confluence of factors sent energy costs to the stratosphere, including September 11th, the Iraq war, and global economic recovery. But perhaps the decisive factor has been the evolving nature of developing countries with large populations, most notably China.

Between 1990 and 2001, total energy use increased by 16% in industrialized countries, but by a whopping 56% in the developing world. Populous countries, including China and India, have crossed a wealth threshold that is leading to an explosion in the production and sale of consumer goods. Automobile sales in China have risen by as much as 35% in some years, reaching five million units in 2004.

Our country has gotten so rich that, for many people, the increase in energy prices just doesn’t matter that much anymore. Yes, people are spending $8 billion more a month at gas stations than they were three years ago, but at the same time overall retail spending has risen by more than double that much. Gas station sales represent only 8% of overall retail sales, even with the higher prices. Rising energy prices have had little overall impact on our affluent society, but have put yet more pressure on working people and the poor.

One would hope that rising prices would lead to more conservation, but economic and population growth is swamping the impact of more-expensive energy. Worldwide emissions of carbon dioxide, the greenhouse gas most responsible for worrisome trends in global warming, are projected to increase by over 50% between 1990 and 2025, according to estimates by our own Department of Energy. Yet the policies to control energy demand are straightforward and well within our grasp. Greg Easterbrook has estimated that five years after raising average efficiency standards for new cars and light trucks by 6 miles per gallon, we would be conserving about 850 million barrels of petroleum per year – equal to what we import from the Persian Gulf states on an annual basis.

With little overall economic cost to the run-up in energy prices, the most tangible financial market response has been to raise the value of energy-company stocks. In the last five years technology company shares have declined in value by 65%. Meanwhile, the S&P 500 energy index is up 75%. Just in the first couple months of 2005, energy stocks have risen 20% in an otherwise flat market. At Trillium Asset Management Corporation, our clients’ portfolios have participated in this price rise. While not excluding the energy sector altogether, we actively avoid the most egregious actors in the industry, and are engaged with some of the more progressive companies such as British Petroleum and Royal Dutch Shell.

Beyond the dramatic move in energy company stocks, markets have been bouncing around in 2005 with no clear direction. Given the ongoing strength of the economy, reasonable market valuations, and the lack of inflationary pressures, we expect stocks to continue their recovery and outperform bonds during the remainder of the year.

The Art of Selling(A)

Prudent investors are typically eager to know what securities they own, when they were bought and why. As investment managers, we are focused on making smart buy decisions and communicating with clients about the holdings we’ve purchased – but our job also includes making sound decisions about when to sell. Arguably, the decision to sell a stock is as important as the decision to buy.

Overall, our strategy is the proverbial “buy low, sell high.” Ideally, we aim to buy a stock when it appears undervalued, benefit from the stock’s appreciation to full market value, and then sell to capture gains when the stock has peaked. Of course, we not only want to buy winners, we also want to avoid losers. At Trillium, our sell discipline is designed to both lock in gains and minimize losses.

In the optimal case, we sell a stock after it has increased in price. When our analysis indicates a stock has reached an excessive valuation, we will sell the position in its entirety. As long-term investors, however, if a stock has reached its price target but we still see potential for further appreciation, we may trim and realize partial profits rather than sell the stock outright. We might also sell a portion if the holding or its industry has become too large relative to the overall portfolio. What this means for your portfolio is that you may see small holdings of stocks selling at relatively high valuations, but where we still see potential for growth.

But, of course, stocks don’t always go up. And here, when a stock declines in price, having a strong sell discipline is both humbling and important. At Trillium, our investment committee reviews all holdings weekly, and any stock that has declined 20% in price from its 52-week high warrants special attention. As we review stocks that have declined, the key question is: what is the best place to invest our clients’ assets now given the drop in price? There are three possible actions:

1. Sell: Our analysis indicates deterioration in company or industry fundamentals and we believe there are better investments going forward. (There is, of course, also the special case of a change in a company’s social responsibility status leading us to sell a stock.) What this means for your portfolio: you may see stocks sold at a significant loss and the proceeds invested elsewhere. For taxable accounts, this creates a realized capital loss.

2. Hold: Our analysis indicates uncertainty about a stock’s outlook, but we believe there is greater potential for upside than downside. What you may see on your portfolio appraisal in this case: stocks held in your portfolio at a significant unrealized loss – a loss we believe will be temporary.

3. Buy more: Our analysis indicates the stock is “on sale.” We liked owning the stock at a higher price and see no significant negative change in company fundamentals; we like the stock even better at its new cheaper price and decide to add to positions. What this means for your portfolio: you may see additional lots of a stock purchased at a price lower than the initial purchase price.

Our Investment Management Committee is the team charged with making both buy and sell decisions at Trillium. Decisions to add, delete or trim stocks are made by the entire committee, which meets on a weekly basis, and then implemented in client accounts by individual portfolio managers. We are confident that our team, which includes 12 portfolio managers and analysts with an average 17 years of investment experience, is among the best in the business. Of course, the markets sometimes outsmart us and we may sell a stock before a rise, or hold a stock that then declines. Our success, and your portfolio performance, is based on our team making the right decisions the majority of the time – both when buying and selling stocks.

Energy Independence:(A)

The question of energy independence dominates the lexicon of energy policy. The oil-dependent Bush Administration believes the answer lies beneath the permafrost in Alaska, the sagebrush of the Mountain West or the blue waters of the Gulf Coast. But it does not. For all its oil reserves, does Nigeria have energy independence? Does Colombia? They don’t, because true energy independence is not about the borders that surround the oil, but the boardrooms that control it.

American energy policy is now set in corporate boardrooms. A far cry from the vision of Thomas Jefferson who hoped America would “crush in its birth the aristocracy of our monied corporations.”

But there is no denying now that in the ascendancy of corporations, America has flourished. Only today we are in the nexus of the downside. The democratic ideals that once rose alongside prosperous corporations are now ebbing. Individual rights and corporate interests are diverging rapidly. Corporations have unfettered access to elected officials. Citizens do not. Nowhere is this more dangerous than in the development of our national energy policy.

At the center of this maelstrom is America’s dependence on oil, a byproduct of a century of easy oil. But this is a new century and oil is no longer easy to come by. Today, conservation, alternative energy sources and innovation should be the focus of our national energy policy.

But the Bush administration does not see it that way, despite the wars that rage in a hunt for these remaining deposits and the desperate and costly struggle to mitigate the environmental impact of oil use. In fact, the long-term costs associated with oil are now greater than the actual economic benefit of the energy itself. In a market economy, how can this happen? The answer is simple: companies don’t bear these costs. Taxpayers do.

Essentially, Americans pay a down payment of approximately $1.50-$2.00 a gallon for their gasoline. They then pay, by some estimates, an additional $3.00 per gallon through their taxes to pay for the military cost of protecting the oil supply and the environmental and health costs associated with oil’s use.

And these costs are only going to rise. For example, building more oil facilities will come with a huge price tag for security. Consider that of the 257 major oil spills in 1999, 51 were the result of terrorist attacks (according to risk analyst Cutter Information Corporation). And that was pre-9/11.

Since funds in our society are finite (like oil), Americans are basically diverting between $30-50.00 from schools, fire departments, police departments, 911 emergency response services, libraries, parks and healthcare for every tank of gas they buy. And to make matters worse, energy companies also pay perhaps the lowest tax rate of any individual or business in our society. Is it any wonder that ExxonMobil will make $17 billion in annual profits this year?

For all its keen sense of peril, the Bush Administration ignores what threatens America at every turn: poison in the air, water and food supply at risk, global warming, and a generation of America children with toxins in their blood. Although this is lost on the Bush Administration, it will not be lost on the American public indefinitely.

The Bush administration has concluded that oil dependence is not the problem, just dependence on foreign oil. But we know better. If the market for oil is better in Shanghai than Cheyenne, it won’t matter if the crude came from Alaska or Arabia. It’s going to Shanghai. That is why there can be no energy independence as long as corporations are setting energy policy. That is why continued oil dependence can no longer be passed on as solution for America’s energy needs.

Old labels die hard(A)

Old labels die hard. Those of us who have been around for more than five decades remember the Labor Party of Britain as a socialist organization with an anti-business agenda. The Labor government in power now has abandoned that mission. Instead, as I saw during a recent visit, “New Labor” is trying to establish itself as a stanch friend and supporter of business enterprise.

Gordon Brown, Chancellor of the Exchequer, published a manifesto in which he declared that “we must forever renounce those old stereotypes” and embrace a new revolution designed to “unlock entrepreneurial ability.” To that end, the Chancellor opened Britian’s first National Enterprise Week celebrating young entrepreneurs and the fastest-growing inner city start-ups.

“When I was in school,” the Chancellor said, “no business ever came near my classroom. Fellow university students shied away from commerce in favor of the professions.” That’s changing, he added, pointing out that “now half our schools teach enterprise” and beginning next year, “every secondary school will offer pupils not just work experience but education in enterprise.” Brown’s program also calls for the introduction of enterprise partnerships with the United States. He pointed out that Britain’s rate of business creation is half that of the U.S. – and that, he said, “is simply not good enough.”

In time of course Britain may be able to develop its own Enrons and WorldComs. I saw good evidence that they are already on the way. In the 1990s the German car maker BMW acquired the Rover passenger car business. Failing to make a go of it and knowing the British affection for this brand, the Germans sold the company in 2000 to four Birmingham businessmen for a token price of 10 pounds (about $20 at today’s exchange rate) along with a soft loan of 427 million pounds.

The Birmingham Four have done little to revive the brand – sales are down, profits are non-existent – but they have managed to pay themselves handsomely. In 2003, for example, they took home three million pounds apiece (roughly $6 million dollars), which was more than double the pay of management board members at BMW. In addition, they have put 16.5 million pounds into a pension trust fund for themselves. Never mind about selling cars, just go for the money.

Meanwhile, the Labor Party was trying to protect the right of some British smokers to threaten their lives with this habit. Ireland has banned smoking in all public places including bars and restaurants. Scotland plans to do the same by 2006. But the Brits are fiddling with ideas for a ban that has exceptions. For example, smoking might continue to be allowed in pubs where cooked food is not prepared. This plan unleashed the legendary British sarcasm, delivered by Alan Coren, columnist for the Times of London, who wrote:

“Smoking is to be outlawed everywhere except in public houses where food is not prepared. The only food available will be crisps, pork scratchings, nuts – anything, in short, with enough salt, fat and sugar in it to make arteries crack like pipestems. Smokers will thus be corralled into places where they can not only inhale to their hearts’ discontent, but also gorge themselves on vast intakes of alcohol and crunchy snax until the walls have to be knocked down to allow them to squeeze out again….”

“These customers… will primarily be members of that underclass who have nothing else in their lives. What, therefore, the inspired White Paper is advocating is a joyous return to the lowlife stews of yesteryear, the pothouses and shebeens and boozers ankle-deep in spit-and-strawberry slurry, good enough not merely for the likes of them, but also for the likes of their betters, tottering out of their smoke-free Connaughts and Savoys and Annabels to cab themselves to their inbred conks, to the lower depths of Whitechapel and Shoreditch for a bit of slumming and a bit of rough.”

Bring back Charles Dickens!

Market Outlook – 8 January 2005(A)

2004 started and ended with a bang, spending the intervening nine months in an extended if shallow slump. Thus did the market live up to its reputation for frustrating the largest number of people for the longest period of time. Those who took January’s gains as signs of a booming year to come–and a continuation of the heady gains of 2003–were quickly disappointed as the market topped out in February and proceeded to decline all the way into August.

This, of course, brought the naysayers out in force with predictions of both a renewed economic recession and a return of the bear market in stocks, memories of which had only started to fade. Spiking oil prices, chaos in Iraq, a tepid US employment picture and uncertainty over the presidential race all conspired to keep the market down almost to the end of October.

Only days ahead of the election, however, the markets began to stir as oil prices cracked and fell; solid 3rd quarter earnings reports rolled in; and cash sitting on the sidelines pending the election began to tiptoe into stocks. From October 25th through December 31st the S&P 500 went virtually straight up, rising 11% in nine weeks and sending the bears back to their caves.

Interest Rates and Inflation

Aiding and abetting stocks—and frustrating virtually every bond pundit in the land—long-term interest rates refused to move higher, closing the year unchanged with the 10-year US Treasury Note yielding 4.25%. The Federal Reserve did raise short-term interest rates from 1% to 2.25% during the year. But with the 10-year Treasury yield holding steady the net result was simply to “flatten the yield curve,” that is, pull short-term rates up closer to long-term levels. Such “flattening” is natural and reflects a less stimulative interest rate policy, which is appropriate now that the Fed has gotten the economy back on its feet.

This flattening of the yield curve is encouraging as it indicates a sanguine attitude about inflation on behalf of bond investors, who are notoriously sensitive on the subject. The bond market seems to understand that the Fed is raising short-term interest rates NOT to put the brakes on a runaway (inflationary) economy but rather to ease off the accelerator as the economy reaches cruising speed.

Contributing to the benign inflation outlook was the sharp drop in oil prices in late October and November, a move that reversed the upward spiral of only weeks before. This kind of nutty action has “HEDGE FUNDS” written all over it as these speculative vehicles turbo-charge the herds’ move into and out of the “hot” asset of the moment, whether oil or stocks or currencies. Long-term investors mustn’t confuse such speculative noise in the system with the true fundamentals of the situation.

World Currencies

We suspect something similar is at play in the currency markets, where the decline of the US dollar has taken the place of oil prices as the panic du jour in the press. It is a truism of markets that by the time everybody is scared about something the worst of it is usually over. We suspect this is the case with the US dollar, which is now trading at 30-year lows relative to many currencies. This puts dollar-priced assets of every stripe on a virtual fire sale to foreign buyers, which should increase foreigners’ appetite for US assets. In the debt markets the Fed’s actions last year pushed short-term US interest rates above those in Europe for the first time in over two years, which should also increase demand from foreigners for US debt instruments. Both of these factors should tend to support the US dollar, mitigating further declines.

The real dollar bears of course aren’t just grousing about another 10% decline in the dollar; they see a freefall prompted by wholesale liquidation of US assets by foreigners. This argument rests on the assumption that the largest foreign holders of US dollars–Japan and China–will seek to avoid the pain of further dollar declines by selling their US dollar holdings. As Japan’s and China’s dollar holdings are so large, however, they could sell only a small portion of their total position. That would suffice to drive down the dollar and with it the value of their remaining vast holdings. For Japan and China to sell dollars because they fear a further decline would be like pouring kerosene on a fire to put it out.

2005 Outlook

Over the coming year we expect to see the US economy grow at a moderate 3%-4% pace with inflation under control. The Fed will continue to gradually raise short-term rates to more normal levels, a process we foresee having a fairly modest impact on longer-term rates. This environment should promote continued profit growth among US corporations, though earnings are likely to grow roughly 10% in 2005 as compared to 19% in 2004.

Assuming 10% earnings growth for stocks next year and a roughly 2% dividend yield, one might conclude that stocks should return something around 12% for the year. However, as interest rates should rise, if only slightly, that’s likely to create a bit of a headwind for stocks in 2005. Adjusting for that headwind, we assume stock returns for the year will fall somewhere in the high single digits.

The upside surprise to this forecast would be if corporations begin to put their vast cash hordes to work—hiring employees, making capital investments, increasing dividends, buying back their own stock and/or buying out other companies. Any of these activities could potentially boost stock returns for the coming year. And, indeed, as 2004 ended we saw a flurry of super-sized corporate takeovers (Oracle/PeopleSoft, Sprint/Nextel) that seemed to hint at a growing confidence among corporate execs, or at least a growing impatience with sitting on cash.