| Soft Landing Wins For Now — February 2007 Last August I wrote about the soft landing/hard landing debate. Since then the market has been strong, ending the year at or near multi year highs. The US stock market is usually a good indicator of future economic activity. What has been interesting over the last six months or so has been the divergence in views. The stock market has been betting on a soft landing and the bond market, with its flat yield curve, has been betting on a hard landing. So far the stock market has been right!
The reasons for the recent strength in the stock market can be summed up simply by saying the following: Valuations were reasonable, the overall US and global economy has remained strong, corporate profits have continued to exceed expectation and investors have focused their attention on short run market fundamentals and not on the long run impending macro economic challenges. In addition, the world is a wash in liquidity (i.e. cash) and with global interest rates relatively low by historical standards, large institutional investors are allocating more of their cash to US equities.
In the last quarter of 2006 the market received two additional bonus gifts: namely declining interest rates (i.e.: 10 yr treasuries) and falling energy prices. This was unexpected, and gave equity investors some confidence that consumers would continue their spending ways; thus The Fed's "Pause" combined with the dual reality of decent job and income growth has led to a soft landing to date.
So where do we go from here and what are the themes for 2007? As I sit to write this current newsletter, fourth quarter earnings are basically in the books with an impressive 11% year-over-year gain. This continues the streak of 18 consecutive quarters of double digit earnings growth. When you drill down a bit though, we learn that of the 11% growth, 8% comes from the financial services sector alone. Put another way, the non- financial services economy only had 3% earnings growth in the fourth quarter of 2006. This is not supportive to current equity prices, but the headline number has delayed the pain of this trend should it continue into 2007. My view is that full year 2007 corporate earnings growth is likely to be about 6-8% which leaves some room for US equity prices to end this year on the plus side. That being said, I do expect a correction of sorts this year if for no other reason than history repeating itself. The S&P 500 has not had a 10% correction from peak levels in more than 4 years. With decelerating corporate profits and some considerable macro economic clouds looming, a correction is not only likely but needed to keep the markets in balance.
So what are the macro economic clouds occupying my mind? There are many, including the real estate bubble continuing to lose air, consumer debt problems due to all the funky mortgages that have been underwritten in the last few years and the resulting home foreclosures (in Massachusetts alone they increased 70% in 2006); the weaker trending dollar and the increasing risk of foreign investors becoming less willing to carry our government debt; and the various fiscal issues related to our aging population (i.e. Medicare/Social Security). These macro issues are not here and now issues, so in the age of markets dominated by hedge funds and large institutional trading desks, these don't seem to have a significant effect on market prices, but over time they will greatly influence not only our economy but the global economy. Investors are a bit complacent in my view about these macro issues and will need to increasingly watch these trends with interest.
In the meantime, economic activity is strong, employment is strong, interest rates and inflation (at least as currently measured) are favorable, corporate balance sheets are strong, consumers are still willing to spend their hard earned money and the stock markets are enjoying every bit of it. Despite the run up over the last few years, the US stock market is fairly valued in my view. The market is mature, which means that stock picking will become increasingly important as the broader indexes moderate at new highs. One of our strategies is to stay focused, stay invested, think globally and find companies that can carry momentum through a slower growth economic cycle. Another strategy is to modify risk where possible to lock in some of the gains received in the last several years. Thirdly, for new clients just beginning to build out their portfolios, caution is required. Finally, and most importantly, to keep our eyes on the storm clouds that might indicate a need to alter course.
These are interesting times, full of complexity and intrigue. The role of being a money manager has never been more challenging nor more fulfilling. I was moved recently by the movie "The Pursuit of Happyness." I highly recommend it; there are many lessons to be learned about the daily challenges that most people face just to survive juxtaposed with the topics covered here. It has gotten me thinking about how fortunate I feel to be able to make a living for myself and family doing what I love, working with you, my clients, to invest and plan wisely. Your continued trust is greatly appreciated.
|