January 2006
The stock market rally that began in mid-October failed to live up to expectations and fizzled out two weeks before the end of year. The Dow Jones Industrial Average ended the year slightly below where it began while broader indices showed small gains. Investors were scared off by the ominous sign of the dreaded inverted yield curve, which has historically predicted an economic recession. We do not see a recession in 2006 but we worry about other things like higher inflation and slowing corporate earnings growth that may keep a lid on investment returns in 2006 despite the good start to the New Year.
There is tendency in our industry to put forth optimistic outlooks in January and get clients excited about the prospects for the New Year. While we are long-term optimists for American capitalism, we try to maintain a more balanced approach in our annual forecasts and focus as much on the risks as the opportunities. In that way, we do not get mentally trapped into defending a position and we are better able to change our views based on new information.
2005 Was Actually a Good Year
We have been very impressed with the strength of the U.S. economy over the past three years and even a little surprised in 2005. This mature economy was able to maintain above average growth despite the challenges it faced. It is interesting to note, however, that a large percentage of the population, especially in manufacturing states like Michigan, believed the economy was in a recession in 2005. Media reports of large layoffs in industries like automobile manufacturing and the major airlines may have distorted reality to some extent.
In fact, the U.S. economy showed the world in 2005 that, like a Timex watch; it can "take a licking and keep on ticking". Soaring energy prices and a record number of hurricanes were not enough to stop Americans this past holiday season from doing what they do best... Shopping! Consumer confidence has improved to levels seen prior to the hurricanes and part of the reason for this is the better job market (at least in most states).
Reasons for Optimism in 2006
Corporate America is starting to spend and invest that hoard of cash it has been stockpiling over the last couple of years. Many companies have indicated that they are hiring again and will be adding even more to their payrolls in 2006. With the unemployment rate already at a relatively low 5.0%, companies in certain industries may find that they will have to pay more for these future hires and some of that "generosity" might even trickle down to other employees. Paychecks could get a bigger boost this year.
The global economy has also been looking better as the demographically aged economies in Europe and Japan recently got some spring back in their step and showed some growth based on their own consumer spending and not just exporting their goods to others. U.S. exports will benefit from this in addition to the continued strong growth in China and India. U.S. companies, on average, have been achieving much better than expected earnings growth over the past three years. In fact, corporate earnings are now significantly above the 6.5% per year long-term growth trend line. In 2005 alone, operating profits for the S&P 500 companies were up an estimated 14% and are expected to be up another 11% this year.
If the U.S. and global economies are looking so strong going into 2006, one would think that investment returns would be pretty good this year or at least better than the paltry results earned in 2005. After being so cautious in our 2004 and 2005 outlooks we would love to be unabashedly bullish about stocks and bonds in 2006. We are not pessimists by nature, really. However, with investors' expectations for the economy and investment returns already elevated, we once again feel compelled to look at what could go wrong.
What We Worry About
To begin with, the growing consumer optimism that we discussed above could be short-lived as people continue to turn down their thermostats to try to limit the financial pain of the inevitable higher heating bills this winter. Gasoline prices have also ticked up again. In addition many people will continue to have to deal with higher mortgage payments from their adjustable rate mortgages as short-term interest rates continue to move up. Consumer spending will suffer.
In fact, the major risk to the economy and financial markets, in our opinion, is the direction of interest rates. Recent statements by the Federal Reserve have most investors believing that the Fed has only one or two more "measured" increases in interest rates in its play book. And if that is true then they surmise that the Fed will be cutting short-term interest rates by summer or fall and the markets will rally. That is a nice thought but we do not think it will happen like that. We believe interest rates could rise more than expected in 2006, which will slow future economic growth and be a serious headwind for the markets.
We worry about higher interest rates because we worry about rising inflation. While the jump in energy prices has not yet caused a broader increase in consumer prices, we think that the possibility still exists that it will. Businesses are being squeezed by rising material prices as well as healthcare costs for their employees. Despite competitive concerns, we may see more companies raising prices for their goods and services in 2006 even if the economy slows. The rally in gold prices and our long-term outlook for a weaker dollar also support our view for higher inflation.
The bond market does not seem to agree with our position. The U.S. Treasury yield curve, which shows the yields currently earned from Treasury bills, notes, and bonds with maturities ranging from 3 months to 30 years, recently inverted for the first time in years. The yield on the 10-year Treasury note was slightly below the yield on the 2-year note for a few days. This caused concern among the investing community that a recession is in the offing because the yield curve has almost always been inverted prior to a recession. If the bond market was worried about higher inflation in the future the longer-term bonds would have much higher yields than shorter-term bonds to compensate for the risk.
As we mentioned, corporate earnings have risen substantially above the long-term trend line so we worry that the time has come that earnings will begin to revert back towards that trend line. If competitive forces prevent companies from raising prices to cover higher costs then profit margins will suffer. Corporate earnings growth could begin to disappoint investors.
Other risks to the stock market include political risks such as mid-term congressional election results this year and the possibility that the 15% tax rate on dividends will be allowed to expire in January of 2008. The low public opinion of the Bush Administration as well as the U.S. Congress could mean there will be big changes in November.
What could go right for the economy and markets that would make us become more optimistic? That is easy; significantly lower energy prices. If oil prices were to fall by $15-20 a barrel we would be much more optimistic about the economy and the markets in 2006. We would also be pleased to be wrong again about inflation and see it trend down instead of up so the Fed could cut rates if they had to.
Focusing on the Micro Instead of the Macro
Fortunately for our clients their investment results have not depended on the accuracy of our annual economic and market outlooks. To be honest, we are only average prognosticators on macro views of the world. We go through this exercise to identify potential investment risks.
We get paid to focus more on micro issues like specific investment opportunities that are less depended on the economy than company-specific events. And when we cannot find these gems we are responsible for protecting our clients' money until another idea comes along.
John W. Gudritz, CFA
john@frontstreet.com