January 2007
The stock market rallied for a fourth straight year in the face of a housing slump, a slowdown in manufacturing, and an inverted yield curve. This is not how the market normally reacts to this kind of economic environment but then maybe "this time it is different". While we are aware of reasons that this market can go higher in 2007 we are worried about the complacency among investors that now permeates the global financial markets at a time of so much economic uncertainty. We think there is still too much risk to ignore.
As we learned in 2000, "this time it's different" are scary words and have, in the past, decimated investment portfolios of the believers because it is a rationalization for irrational behavior. Investors' greed overcomes their sense of prudence.
While we hope for a continuation of this bull market in 2007 and will look for stocks to participate in it in case it does, we expect that most investors will be disappointed as they discover that risk is still alive and well in the financial markets. We feel very confident that no matter where the stock market ends the year it will be a much bumpier ride than in 2006. In the past, complacency has eventually led to volatility.
Recent polls of professional investment managers and Wall Street strategists show that very few of them think that the stock market will be down in 2007. No expert in the recent Barron's poll forecasts negative returns this year. They see the Federal Reserve lowering short-term interest rates and corporate earnings growth in the high single digits; the perfect ingredients for the continuation of the bull market. Unfortunately, historical precedence leads us to another outlook.
We still think that there is a good possibility that the declining housing and auto manufacturing sectors will slow the economy more than expected in 2007. It has always happened in the past when these sectors have fallen as much as they already have. One can argue that the U.S. economy is different than it once was with much less dependency on construction and manufacturing and more on services and trade. We still think that, on the margin, these two sectors still have a significant effect on economic growth.
The strength of the economies overseas may actually hurt as much as help us in the next few quarters by keeping inflation higher than one would expect during an economic slowdown in the U.S. Energy and other commodity prices will probably stay elevated as overseas demand in faster growing countries continues to prop them up. That is unless the slower U.S. economy has a dampening effect on their growth.
In addition, we expect labor costs to continue to rise and put upward pressure on overall prices or downward pressure on profit margins. Wages and salaries have not kept up with productivity gains in recent years and workers are starting to demand more, especially with the unemployment rate as low as it is.
All of these rising costs should bring historically high profit margins down to more normal levels. This should cause corporate earnings to be less than expected in 2007.
If it turns out that inflation remains near current levels or higher because of these higher costs then it is doubtful that the Federal Reserve will be able to cut short-term interest rates as is also expected by the market. Fed Chairman Ben Bernanke would prefer inflation under 2% before he thinks about lowering interest rates. The stock market has already discounted a rate cut and will be disappointed if it does not get it.
While the economic fundamentals under this forecast should lead to a significant correction in the stock market, we would not bet the farm that it would happen soon or quickly. That is because there is still so much money in private equity funds looking for acquisitions and this tends to put a floor on stock prices.
In 2006 there were $1.76 trillion in mergers and acquisitions in the U.S., which broke the record set in 2000. Stocks from some large companies like HCA (hospital), Equity Office Properties (office REIT), Clear Channel Communications (radio and billboards), Michael Stores (craft supplies), and OSI Restaurant Partners (Outback Steakhouse) are disappearing from the stock market. Globally the amount of mergers and acquisitions was closer to $4 trillion. There is still billions of cash out there that needs to be used to buy companies.
In addition to acquisitions, companies are buying back their own stock trying to bolster their stock price to ward off these private equity "vultures". In 2006 companies repurchased $632 billion in stock. According to Standard & Poor's, more than half of the companies in the S&P 500 Index have fewer shares outstanding now than they did two years ago.
While many investors see this environment of a shrinking supply of stock and a growing demand as a reason to be bullish, we see at as an indication of an aging bull market. In the past, these events tend to happen just before the end of an extended bull market.
The fact is no one knows for sure if the stock market will be up or down in 2007. However, with the vast majority of investors expecting a continuation of the bull market for the New Year, we are naturally skeptical. We also believe that this one-sided view will cause a tremendous amount of volatility in the market as news and economic reports make investors question the consensus view.
In 2007 we plan to continue our defensive strategy in order to hold onto the decent returns we have earned over the last four years. We will incorporate it with our continued effort to find stocks that can perform well in this risky market environment. This approach may cause our clients' portfolios to lag the market indices if this rally continues unabated and our stock picks do not outperform the market. However, we will not ignore the risks that we see and leave these portfolios unprotected.
We think there will be an opportunity to buy stocks cheaper than they are today and we have some cash on hand in preparation. If handled correctly market volatility can be our friend over time and help us earn better than average returns. So we will buckle up our clients' portfolios and enjoy the ride.
John W. Gudritz, CFA
john@frontstreet.com