What’s In Store For 2007?
by Paul J Nolte CFA, Dearborn Partners. January 12, 2007
The New Year has become old very quickly, especially for those trading the commodity complexes, while stock investors - after a rough start have hit their pre-New Year stride. Economically speaking, do the financial markets still believe that goldilocks is still rummaging around the house - or are the three bears just about to enter stage left?
The figures that we have focused upon over the past couple of years to assist us in determining the strength of the economy are the ISM figures - both for manufacturing and the services. While manufacturing dipped below 50 in December (causing a commotion among economists), it quickly reverted back to above 50 with the most recent figures and with a lower price component to boot. The service side, which accounts for somewhere between 60-80% of the economy depending upon who is talking, remains well above the magic 50 number that indicates an expansion in that part of the economy. Pile upon the ISM figures a bounce in the housing figures (refinance and new mortgage activity) and we may be seeing the early stages of a growth spurt - not unlike one that many of our children occasionally experience! Today's retail sales figures translate to a 4% spending rate and will boost GDP for the fourth quarter – now estimated at 3%, up from a relatively mild 2.6% before these reports. Confirmation of a strong economy is best seen in the bond market, where rates have backed up to over 4.75% from nearly 4.5% just a couple of weeks ago. In fact, little discussion has been heard about a Fed cut during the first quarter that was rampant around Thanksgiving.
Equity investors have been looking at historical trends and seasonal factors to help guide them through this year's markets. Whether the third year of a presidential cycle or the fact that the market has increased four consecutive years bolsters either the bullish or bearish case respectively. What tends to get ignored is a hard look at valuation levels of the markets. True, earnings have been growing at double digit rates for as long as many analysts can remember (ok, so they are a bit young!), and are scheduled to slow a bit to somewhere around 6-8% - still well above the GDP rate of the economy. The market multiple based upon guesstimate earnings (i.e., forward EPS) is somewhere in the 14-15x camp, with the more reliable (and more robust historically) trailing EPS of 18+x. While it is true that these multiples are the lowest in nearly 10 years, they are nowhere near to low (let alone lowest) over the past 25, 50 or 100 years. The US equity market remains expensive by most measures and a reversion to the mean (of 14-15x TRAILING) is likely to occur AT SOME POINT. However, since the markets can remain irrational longer than we can remain solvent, what are investors to do? Many individual investors take an all or nothing view of stocks - either we buy or sell. However, a better alternative is to begin shaving positions in areas that have run and rotate the money into areas that have been dormant.
We have a couple of rules when looking at the various industry groups. First, they need to be out of favor for more than a week or two - to avoid the initial visit (that turns into a interminable stay) of groups in the bottom of our rankings. Second, we must see some improvement in the relative rankings by the group that is lead by more than one or two stocks (easier to pick winners when everyone is going the same way). And finally, the stocks within the group need to demonstrate some technical strength - meaning a reversal in price, breaking downtrends etc. before we get interested in actually putting money into a group. The only real trouble in today's market is that there has not been a group that has really moved to lower levels in absolute terms, although many have in relative terms. For example, the decline in drug stores due to Wal-Mart's decision to cut pharmacy prices has pushed the group to the bottom of our sector work, however the decline was relatively minor when viewed over a weekly or monthly chart. So while we believe the markets can move higher over the coming weeks/months – there are, in our view, only stocks worth buying for relative performance, not absolute. Even in 2000, there were plenty of groups that were worth buying for absolute performance as they had declined for so long and were so out of favor that the pickings were easy. Today, with nearly every group participating in the rally, it is increasingly hard to find groups that are truly out of favor and worth loading up on at current levels.
The first rule of investing is to follow the trend – and the trend has been going higher for stocks and lower for commodities for some time now. The gold index (XAU) topped out in April 2006 and has had a series of lower highs and lower lows – not a great configuration for long-term gains. The oil index has been volatile since that same time, even though it made new highs, momentum has been coming out of that market and the early year decline was inevitable. But if stocks are going higher purely on momentum, is today a good day to commit dollars? Yes – but not your last one and not all domestic. Looking at the relationship between normally non-correlated assets (bonds, stocks, commodities, real estate, foreign and emerging markets), bonds and commodities are at the bottom of the stack while REITs and emerging markets are at the top. Bonds have struggled to consistently beat any asset class since the market decline of '00-'02 and commodities have moved violently from in to out of favor over the past year after consistently beating the other groups (again, since 2000). The favorable sectors have been in favor for a long time, much longer than we would have thought given the interest rate environment and the attempt to slow at least the US economy. REITs have remained strong in the face of the housing decline as corporations continue to take up space at the expense of individuals. Emerging markets are a play on both a lower dollar and a willingness to take on risks. Given that risk premiums are low across the board, it makes sense that investors are making these investments.
Since risk levels are low in equities (see the VIX, exploding foreign markets) and in bonds (spread between junk and governments) investors are investing without regard to a change in the overall risk levels in the markets. Again, it is not a matter of if that change occurs, but when – and that answer remains "sometime in the future." Our focus has been on the long-term trends in the markets; that is why we tend to look at weekly or even monthly charts that usually take months to shift. But once they shift, they will stay on the new track for years instead of hours or days. If we are to assume that the worst will be first in our non-correlated asset classes, then investors should be looking at bonds (out of favor since '02) and surprisingly the S&P500 (which has been around the bottom of the group since 2000). While these may not be "winning" trades in absolute terms (save for maybe bonds), they should hold up better than the other asset classes who have already had their time in the sun.
Today, the continued stream of good news regarding the economy heartened the equity markets and the normal relationships existed (stocks up, bonds down) in the financial markets. While a correction in the equity market is expected (bonds are going through theirs now), it may not begin until after the growth spurt winds down some time late in the first quarter. Today's closing numbers: the Dow gained 41.10 points to close at 12556.08, the S&P 500 was up 6.91 points to close at 1430.73, and the NASDAQ gained almost 18 points, closing at 2502.82.
© 2006 Paul Nolte