Entering 2007, the stock market is benefiting from high and rising profit margins, merger & acquisition activity that continues to shrink the equity supply, and investor confidence that the Fed is pulling off an economic soft landing.
But we are keeping an eye on possible influences that could cloud this positive picture, such as a reassertive uptrend in oil prices, decisive depreciation of the U.S. dollar, continued weakness in the housing market, and a sharper-than-expected contraction in earnings growth. And we are recognizing the secular risks, such as the debt increase accompanying the supply reduction as well as long-term valuation perspectives showing that the market is still relatively expensive.
The S&P 500 would be overvalued around 1550 and fairly valued around 1150. Cycle composites warn that the year will include a stiff decline.
Our expectations for slowing economic growth, mid-year interest rate cut, relatively weak consumer spending versus business spending, and first half dollar weakness are all factors likely to affect sector performance – as are mean reversion potential, relative forward P/Es, and forward earnings estimate momentum. We are currently expecting the Health Care, Consumer Staples, and Energy sectors to outperform, and the Consumer Discretionary, Financials, and Telecommunications Services sectors to underperform.
Also entering 2007, the global commodity demand theme is well intact. Barring a global economic contraction or bear market, we will continue to give the benefit of the doubt to the long-term uptrends in commodities, gold, and the relative strength of resource stocks and resource-based markets.
The biggest asset allocation move in 2007 could be based on if the U.S. economy continues to slow into the first half of the year, moving the Fed to cut rates. Not only would bonds mostly probably outperform stocks in that environment, but bonds would be likely to outperform cash.
Last year at about this time, we noted that the twelve-month average net inflows to stock and bonds remained well below their respective peaks reached in 2000 and 2003. At the same time money market fun inflows had started to surpass the stock and bond inflows.
Now, a year later, the twelve-month moving average of money market fund inflows stands at $25 billion, the highest in more than four-and-a-half years. The average monthly bond inflow has risen slightly to $3 billion, while the average equity inflow has dropped to just $2 billion.
These trends reflect current secular trends – the secular bear in equities spawned by the bubble of 2000, and the secular bull market in commodities fueled by the Fed’s 2001-2002 liquidity infusion that arguably brought bond prices to a secular peak and cash yields to a secular trough. That’s when the disinflation theme that prevailed in the 1980s and 1990s gave way to the China-driven commodity demand theme that has brought about reflationary conditions with more similarity to the inflationary 1970s, when commodities previously enjoyed a secular bear market.
Also in the 1970s, flat or inverted yield curves were more common than they were during the stock and bond friendly disinflation environment that followed. Historical charts suggest that if the yield curve’s current inverted status remains and becomes less unusual in the years ahead, the implications will remain favorable not only for commodities, but also for cash relative to bonds and especially to stocks.
Bonds & the Economy
Our models project 3.0% economic growth, slightly above the consensus of 2.8%, although we think the risk is to the downside, closer to 2.5%. For 2007 we have estimated top-down growth from two top-down perspectives (tables follow). Using our projected ranges for six key indicators, our first top-down forecast provides an estimate using the full range of each indicator. The second top-down forecast uses just the past ten years of data. Although the results for the individual indicators are quite different in some cases, the overall forecasts are identical.
Outside the non-economic risks such as terrorism, the Iraq War, and other geopolitical threats, there are a number of risks to our forecast: 1) the housing market; 2) Fed policy; 3) capital spending; 4) foreign economies and the value of the U.S. dollar.
We’re expecting continued moderation in the rate of decline in the housing market in the first half of 2007, before growth turns slightly positive in the second half. We anticipate refinancing activity will remain relatively high. Growth in corporate capital expenditures should reaccelerate in 2007. Therefore, business spending should, once again, outpace consumer spending. Finally, if foreign economies hold up, we may see continued weakness in the U.S. dollar, which should help exports, limit imports, and support profits.
For 2007 we have estimated the CPI inflation rate to be 2.2% (below the consensus of 2.5%). However, we see the CPI core rate (excluding food and energy) remaining relatively high at 2.5% (slightly above the consensus of 2.4%), as rent trends continue to drift higher in the first half of the year. But I see a potential for both upside and downside risks to these forecasts. Energy prices, for example, could be either higher on renewed geopolitical worries, or lower on softer global demand. A resumption of the dollar downtrend could keep pressure on prices. And faltering economic growth presents a downside risk.
For 2007 we are forecasting a range of 3-7/8% to 5-18% on the ten-year Treasury. Currently we consider the ten-year Treasury fairly valued around 5.00%. But with the economy at risk of slowing more than we expect, we have a hard time seeing yields climb much above fair value. If we are right about the economic and inflation outlooks, the Fed could remain on hold well into 2007. If so, the yield curve will likely remain trapped in a trading range with a slight downward bias until the Fed eases, at which time the yield curve should steepen.
Stock Market & Style Allocation
The economy’s leverage is excessive, and that supports the possibility that the current cyclical bull market has been occurring within a secular bear market. I continue to follow the evidence which suggests that stocks are in a secular bear market. Yes, the Dow Jones Industrial Average (DJIA) has returned to new highs in nominal terms, but it has not done so on an inflationary adjusted basis. During the secular bear of 1966-1982, the DJIA likewise returned to record highs but failed to do so in real (inflation adjusted) terms, with the 1973 peak occurring close to seven years after the secular top in February 1966, and with the DJIA 5.7% above the previous high.
The DJIA’s latest high has occurred close to seven years after the secular top in January 2000, with the DJIA 5.9% above the previous high. When the peak was reached in 1973, the DJIA needed to rise another 26% to exceed its 1966 high, a milestone it finally passed in September 1995. To surpass the 2000 high, the real DJIA must rise another 14%. Until it does, the secular bear description will remain operable.
Also supporting the secular bear description are valuation indicators showing that despite the improvements since 2000, the valuation excesses that led to the secular peak have yet to be fully corrected. Although the earnings yield (earnings divided by price) and the dividend yield (dividends divided by price) have both been trending higher since 2000 (higher is better), both measurements remain far below the levels reached at the secular lows in 1942 and 1982. And they are also below their historical norms of 7.4% for the earnings yield (currently 5.9%) and 4.1% for the dividend yield (currently 1.8%). In fact, the valuation improvement we have seen so far is normal for a secular bear market as they are consistent with the previous two. Now that dividend and earnings growth are slowing, much lower stock prices (i.e. a cyclical bear) may be needed for the market to appear cheap again from a long-term perspective.
Through the third quarter, the year-to-year change of S&P 500 12-month generally accepted accounting principal (GAAP) earnings stood at 18%, down from a record high of 77% at the end of 2003. Using the current consensus estimates, GAAP earnings growth will be 15% when the year-end numbers are reported and 8% by the third quarter of 2007. For stock prices, the question is how expectations would be affected by a worsening earnings environment. Thanks to persistent earnings growth, actual operating earnings have been exceeding the consensus year-ahead operating earnings estimates of a year earlier. Now that actual earnings have exceeded the expectations for twelve straight quarters, has complacency set it?
The risk for the stock market is that with the earnings outlook deteriorating, the estimates will go from “too low” to “too high” and create an earnings disappointment which could be a significant bearish influence that has largely priced in an unsustainable pace of earnings growth.
For 2007 we estimate that the S&P 500 would be overvalued at 1567 points (a 10.5% rise from the year’s close) and fairly valued at 1,156 (an 18.5% decline from the year’s close). If the earnings slowdown proves to be moderate within an economic soft landing, then the S&P shouldn’t have trouble reaching the reward level. But if earnings disappoint with a relatively hard landing in progress, the S&P could tumble to the risk level, experiencing its first double-digit drop since 2002.
Last year at this time we combined the pattern of the four-year Presidential cycle with the one-year seasonal cycle and the ten-year decennial cycle. The DJIA held to the pattern for the first four months and the fourth quarter, but it was way out of sync in between. For 2007, the pattern shows the DJIA strong into the third quarter but then giving back all of its gains into a fourth quarter low. Since that particular pattern looks a lot like 1987, both a seventh year and a pre-election year, we removed 1987 from the calculation to see if the pattern would change, but it remained very similar.
All three cycles (one, four, and ten) show weakness in the fall. The S&P has declined over the course of half of the twelve years ending in “7”. But pre-election years tend to be the best of the cycle’s four years. Usually boosted by rising liquidity, the S&P 500 has gained a median of 17% in pre-election years, down in only five of the 29 years. Unfortunately there is not a lot of additional monetary or fiscal liquidity to be offered.
Along with the low and receding volume and the low and dropping volatility, compressed returns have been a characteristic of 2006. It has been nearly two-and-a-half years since we have seen such a narrow spread between the best and the worst performing asset classes (large-, mid-, small-cap; value & growth) over the preceding six months. Currently, models regarding asset classes are very mixed. I must remain neutral on convincingly answering the question as to which asset classes to most heavily utilize until clear separation starts to become evident. Since the compression itself tells us little about what will emerge as the next winning style, what we will need to do to watch is whether our indicators start lining up on the side of a particular style, market capitalization, or combination of the two.
Growth stocks would stand to benefit if an economic soft landing would send the yield curve to moderately steep levels at which the ten-year Treasury would be no more than twice the Treasury Bill yield. Value has tended to outpace Growth when low VIX readings have reflected a high-risk market environment. But the high-beta tendencies of small-caps have tended to make them vulnerable when volatility has been low – usually when volatility is low and picks up, small-caps move to the downside.
2007 Industry Leadership Outlook
Using a top-down approach to see how macro forces may be influencing industry leadership, we have combined several key historical macro economic and industry specific studies to derive our sector expectations. This model provides an objective “base case” scenario for our 2007 industry outlook. The table bellows ranks the sectors in descending order
2007 Sector Outlook
Full Year 2007 First Half 2007 Second Half 2007
S&P 500 Sector S&P 500 Sector S&P 500 Sector
Health Care Health Care Health Care
Consumer Staples Consumer Staples Energy
Energy Energy Materials
Materials Materials Consumer Staples
Industrials Financials Industrials
Information Technology Utilities Consumer Discretionary
Utilities Telecommunication Svcs Information Technology
Telecommunication Svcs Information Technology Telecommunication Svcs
Financials Industrials Utilities
Consumer Discretionary Consumer Discretionary Financials
To derive our outlook, the economic inputs to this model are: 1) real GDP growth (between 2% and 3%), 2) Fed policy (first half: last hike to 1st cut; second half: post 1st cut), 3) business spending over consumer spending, 4) US dollar weakness (first half), 5) mean reversion potential (1 year + 3 year), 6) relative forward P/E, and 7) the 26-week point change in year-to-year forward earnings estimates.
While we think this model helps to identify headwind and tailwind pressures on industry leadership, we are under no illusions that some factors such as global demand, global liquidity, and M&A activity may not be fully taken into account. Moreover, changes to our economic, geo-political outlook, and other industry specific forces will also likely alter this base case scenario as the year progresses. As a result, in the year ahead, our emphasis will continue to be on trend-sensitive indicators, supplemented by our mean reversion, sentiment and other industry specific economic factors. Following we examine the influence of the factors that went into our outlook.
- Slow Economic Growth. We expect the pace of real economic growth to slow next year (although we are not currently expecting a recession). Hence, to factor in the effect of slow economic growth on sector leadership, we are using an annualized GDP growth between 2% and 3% for the next year per the range of our economics team’s forecasts. The slow growth rate most benefits the Health Care and Consumer Staples sectors.
- Fed Policy. The Fed often writes the script for the economy, and so we have placed a double weight on this factor. While the timing of this factor may be debatable, our best guess is that the Fed may begin to cut rates around mid-year. So in our models we have included 1) the historical sector leadership from the Fed’s final rate hike to the first cut and 2) then used the historical leadership 126 days following the first Fed rate cut for the second half of the year. According to past data, rate-sensitive and market-defensive sectors have tended to dominate between the final hike and the first cut. This includes Financials, Consumers Staples, and Health Care. Following the first cut, however, rate sensitives (particularly Financials) have tended to exhibit a “sell on the news’ patter, while cyclical sectors such as Consumer Discretionary and Industrials have tended to gain strength.
- Business spending Over Consumer Spending. We are expecting business (i.e. capital) spending to continue to outpace consumer spending. Consequently, among cyclicals we prefer Industrials over Consumer Discretionary.
- US Dollar Weakness. We have long believed that the U.S. dollar will remain under long-term pressure. And currently, with the vast majority of our dollar models on sell signals we have included this factor in our model for the first half of 2007. But we have removed dollar weakness for the second half of the year as renewed Fed loosening may cause a “sell on the rumor, buy on the news” situation. Leadership from a weaker dollar tends to favor commodities and Energy (as well as foreign investments held in sovereign currencies). Groups under stress tend to be Retail related, which suffer from the resulting higher import prices.
- Mean Reversion Potential. Macro factors help to take into account the economic headwinds and tailwinds on industry leadership, but have these effects already been factored into the industry stock prices? To help ensure we may not be buying sectors that have already been stretched, we have included or mean reversion indicators (combining both one-year and three-year). The two top sectors with the most upside mean reversion potential tend to be market-defensive oriented, while the top four have a Growth-orientation (Health Care, Consumer Staples, Information Technology, and Consumer Discretionary). For downside mean reversion potential, Utilities, Telecommunications Services and Energy appear to be the most at risk. Be aware, however, that these effects have sometimes taken years to be realized – another good reason to wait for confirmation from our trend sensitive indicators.
- Relative Forward P/E. To take into account the effects of relative valuation and expected earnings growth, we use the forward P/E ratio relative to the S&P 500 and measures how many standard deviations each sector is out of line with its 15-year norm. The results show Energy the most undervalued, while Utilities and Financials are the most overvalued.
- Earnings Estimate Acceleration. Further refining our forward earnings analysis we factor in the effect of earnings acceleration (i.e. the change in the rate of change) by taking the 26-week point change in the year-to-year estimated earnings growth rate for each sector. Using aggregate forward earnings estimates for the sectors, results show a strong divergence between commodity-based sectors, with Materials showing growth accelerating and Energy decelerating.