Sincerely,

BlueLake Partners, LLC

3.5% GDP growth, and this time we mean it!
For the past two years, many economists have been forecasting that the economy will grow at 3.5%. We all know it hasn’t. However, the magic of that number is that it is the average rate at which the U.S. Gross Domestic Product has been growing since 1930. Referred to as the “long run growth trend,” it is the growth rate to which the economy should inevitably return and is also the rate that most economists think is required to keep unemployment from rising. While this year’s first and second quarters grew at a rather anemic 1.4% and 1.0%, respectively, the latest WSJ survey of 54 economists predicted a return to 3.5% for this quarter and improvement from there for the rest of this year and next. As one economist put it, “The economy doesn’t grow at 1.5% forever. It grows at trend.”

If the economy doesn’t pick up, it won’t be for lack of stimulus. Our monetary and fiscal policies couldn’t be more generous: three rounds of Bush tax cuts, 13 interest rate reductions from the Fed and six waves of mortgage refinancings. A 1% to 2% economic pace is not much to show for all that help. Admittedly, there have been shocks along the way, like “9/11”, the War on Terrorism, SARS and high energy prices, but as Alan Sinai, chief economist at Decision Economics Inc., put it, “We’re force feeding the private sector with a lot of money. If we swallow that stuff and don’t spend, we are indeed in big trouble.”

The U.S. manufacturing sector is not helping. It contracted for the fourth consecutive month in June and is operating at about 72% plant utilization. With that kind of idle plant capacity, even the enticement of low interest rates won’t increase capital spending. In addition, most of the recent improvement in corporate profits has been driven by cost cutting, not by additional demand. Unfortunately, low demand leads to more cost reduction, not higher selling prices or the need for new facilities. A buildup in manufacturing inventories is usually a sign that a business pickup is expected; inventories were down in June.

On the other hand (had to use the economist’s favorite phrase once), employment, though weak, seems to be stabilizing and may God bless the consumer! Consumer spending, which accounts for two-thirds of all economic activity in the United States, has been driving the economy for some time. But with unemployment high and wages flat at best, where did the money for the spending binges come from? The answer is no surprise: low mortgage rates and home equity. In fact, homeowners have taken $200 billion out of the equity in their homes during 2002 and an estimated $300 billion during the past twelve months. Virtually everyone who intended to refinance their mortgage has already done so at least once (I’m on my third in under a year), so the obvious question is, “How long can it continue?”, especially with rates where they are. (More about rates in a minute.)

Remember when we used to fear inflation? Now it’s our friend. Ask Alan Greenspan. He would like nothing more than a little inflation right now, if for no other reason than to put a spike through the heart of its feared counterpart: deflation. All except the very young remember the days of double-digit inflation that ravaged the financial health of many, especially those on fixed incomes. By show of hands, how many of you have gone through a period of deflation? (Sorry, Japanese readers can’t participate in this one.) I don’t see many hands as the last one here was in the 1930’s, after the depression. While everyone seems careful to qualify the word deflation with words like “unlikely,” “minor risk of” or “remotely possible,” the Fed has said that it is more concerned right now about deflation than inflation. The fear is heightened by the fact that our arsenal of weapons to fight it (e.g., generous monetary and fiscal policies) has already been employed without much success. Also not comforting is the fact that our friends in Japan have been fighting deflation (and losing) for more than a decade, even with several years of interest rates near zero. One could probably argue successfully that there are political, structural and transparency issues in the Japanese situation, any of which make the analogy imperfect.

Let’s make things simple for a minute. Operating in a growing economy of modest inflation, say 5%, is relatively easy to imagine. Annual selling price increases generate enough excess cash to maintain employment levels and give annual wage increases. Employees borrow money and buy things, like houses, and eventually are able to repay the loans with slightly cheaper dollars. Why do Ozzie and Harriett, or Leave It To Beaver for the post boomer generation, come to mind?

Now let’s imagine the opposite. Prices don’t increase, in fact, they decrease. Companies make less money on every product they sell and obviously can’t give the employees a raise. Some people have to be laid off. Those that are still working make (and therefore spend) less. Those that are unemployed have nothing to spend. Aggregate spending and demand is down, so companies don’t need to build new plants. All debts, personal and corporate, must now be paid back in more expensive dollars, if they can be repaid at all. Now I’m picturing George Bailey (Jimmy Stewart) standing on the bridge in It’s a Wonderful Life.

Obviously, Congress and the Fed will do everything they can, first to prevent the latter scenario, and failing that, to reverse it. The “tax cut” bullet has already been fired; additional government spending is possible but must be balanced with ever-mounting deficits; and the Fed funds rate, at 1%, is already at its lowest level since the year Arthur Godfrey’s Talent Scouts left the air and the Hula Hoop was invented. (The year is at the end of the newsletter.) Funny things happen to our short-term financial markets when rates get below 0.75%, but the Fed chairman has said he will take it to zero if need be. There are other less conventional things that the Fed can do to keep yields low, like pumping money into the system by buying back U.S. Bonds or by publicly committing itself to keeping rates at a particularly low level for a specific period of time, but the effects of these policies are even less predictable. It’s not sufficient by itself, but the weakening dollar should help in the deflation fight.

For the past seven years the U.S. inflation rate has hovered between 2% and 3%. Since last fall, excluding volatile food and energy prices, prices have increased by just over 1%. To say that the next several quarters will be interesting is like saying Marv Albert has made some poor career moves.

Is the Bear dead or just wounded?

Let me try to make two compelling cases. The first is that the bear market is over. The stock market numbers since last fall have been fabulous. While acknowledging that growth from a low base is easier, the DJIA was up 24% from last October through the end of the second quarter, up 12 % in the second quarter alone, and the 7.7% first half gain was the first since 1999. Not to be outdone, the S&P 500 was up 15% in the second quarter just ended and 11% for the year so far. But - what about technology stocks? The Nasdaq Composite was up 46% since October of last year and 22% for the 6 months ended June 30. Who would be surprised that “bearish” sentiment is at its lowest since 1987? But that’s a bad thing. Which brings us to the second case.

If nobody is bearish, who will lead the next round of buying? This shift in sentiment, in conjunction with substantial funds flowing back into mutual funds, a spike upward in margin debt and corporate profits not expected to grow rapidly until next year, are classic signs of a market top. The fear is that the market may have gotten ahead of itself and still be overvalued, especially in the technology sector. Multiples are still high by historic standards. That 46% Nasdaq Composite run-up was exhilarating, but some analysts fear a “false start” when anticipated earnings don’t materialize.

We’ll see who is right, but there seems to be a consensus that the nice market run was based on belief in an improved economy in the second half of '03, with its accompanying pickup in demand and profits. Eventually the results on the economic and corporate fronts need to be delivered for the market performance to be sustained.

What to do?

You decide whether you think the economy will improve or not, whether we’ll have inflation or deflation and whether the stock market run is for real or a set up. Unfortunately, even BlueLake doesn’t know those answers. In any case, here are some things to think about:

• With interest rates at historic lows (and to a lesser extent with stock prices improving), now may be a good time to “clean up” your balance sheet if you haven’t already done so;
  
• The time to borrow money, or to put the credit facility in place for future use, is when you can and when it’s cheap, not when you need it;
  
• If you believe that markets are on their way north again, at the risk of citing the obvious, valuations for a potential acquisition will only get dearer. The re-emergence of hostile takeovers is viewed by some as an indicator of improving CEO confidence;
  
• If you are in the optimistic camp, you might be tempted to do some financial engineering and buy back stock with cheap debt. A word of caution: BlueLake’s view is that more tech companies have gotten themselves in trouble than helped themselves with this one;
  
• The “glass half full” folks might also consider a convertible debt offering to take advantage of the cheap debt and undervalued equity;
  
• If you think the stock market is heading south and you have been considering raising equity or selling your company, again, not profound advice just a reminder, the timing might be propitious; and
  
• Lastly, if we get down to “rubbing his head” and we’re heading for a period of deflation, cash will be “king”, and now might be the time to generate some by divesting non-strategic businesses.
  

Note: Arthur Godfrey went off the air and the Hula Hoop was invented in 1958, not that there’s any discernable relationship between the two.

— William Luke, Margaret Johns, Peter Miller, Ron Rossetti, Saket Puri

If you have any comments or observations, we are very interested in hearing from you at Newsletter@BlueLakePartners.com.