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10 February 2003

The market continues to move sideways

Capacity utilisation rates are at 19-year lows and corporate balance sheets are not as healthy as they might be

Through the middle of January the US market rallied almost 20% from its October low but much of these gains were lost over the rest of the month.

The quarterly earnings reporting season often provides a challenging period for the market.

Investors place a lot of emphasis, arguably too much, on quarterly reports but particularly when the rate of economic growth is unclear.

Admittedly many companies have still to report but on the whole results appear slightly better than forecast, particularly in the technology sector. This has not, however, helped the market. In fact the major indices have fallen since companies started reporting during the middle of January.

At least part of this can be blamed on the notable lack of guidance provided by management teams. This is not altogether surprising given the mixed macroeconomic data. A strong third quarter GDP number and a surprise rate cut by the Federal Open Market Committee were two of the main catalysts for the positive three-month period since October. However investors need to see more consistent and convincing signs that the economy has truly turned the corner particularly with the US market trading at about 17x 2003 operating earnings.

The reality is that there is still far too much uncertainty. Geopolitical tensions remain a major problem. These include the ongoing uncertainty facing Iraq, the announcement by North Korea to reactivate nuclear reactors, and a rise in crude oil prices due to a nationwide strike in Venezuela.

The consumer has provided much needed support for the economy and accounted for 75% of GDP growth in the third quarter. More recently consumer spending has shown signs of weakness after a disappointing December, no great surprise given the unemployment rate is now at an eight-year high.

An increase in capital spending would help offset this slowdown. However, this may take time. Capacity utilisation rates are at 19 year lows and corporate balance sheets are not as healthy as they might be at this point in the cycle, suggesting only a gradual pick up in business investment.

Despite the gloomy backdrop the outlook for the economy and earnings is slowly moving in the right direction. Improving corporate earnings, a gradual recovery in capital spending, a steady consumer, and a resolution to geopolitical tensions, would enable the market to follow suit.

The Bush fiscal package, which includes a change to the double taxation of dividends, will help, but is likely to have a greater impact in 2004. The recent rally was led largely by technology and lower quality, high beta names.

Typically these types of companies only benefit from a robust economic recovery whereas we feel it will be more gradual. We intend to move money into more economically sensitive stocks over the next few months but will continue to focus on companies with a proven track record and solid free cashflow.

James Kinghorn
Investment Manager
The Scottish Investment Trust