Insights & Advice


Questions for Q2 2007

April 10 , 2007

Going into this year we identified market-defensive sectors (Health Care, Consumer Staples, etc.) as potential leaders for the first half of the year.  Given that those themes trended in that direction for the first quarter of 2007, we find little reason to adjust that part of our models.

If that’s the good news, then the bad new is that there has been little dispersion of sector returns.  Yes, almost by definition there has been some level of beating the market, and some level of underperforming the market – but there have been no spreads so alarmingly wide (at least on a historical basis) that some type of extrapolation can be accurately assessed. 

Sure, Consumer Discretionary and Information Technology were relatively sour, and Utilities and Materials were relatively sweet, but that dispersion of returns only began to occur in recent weeks – not enough time to call a real trend for the strong or for the weak.  What that means is that any current (and mild) sector overweights or underweights should stay about the same for the time being.

More broadly speaking (i.e. the stock market in general), my greatest concerns remains a topping process.  No, I’m not worried about the type of correction we went through in February and March – that type of risk/volatility is typical and ordinary and, ultimately, why we have the potential to experience gains in the stock market.  I certainly am not ruling out the possibility of an advance (perhaps all the way up to our previously mentioned 20007 reward level of 1,550 points on the S&P 500), but I am greatly concerned about the sustainability of any advances. 

After every stock market correction since 2002, the market has bounced back to new recent highs – and as I write this report the S&P 500 is trading above its high for the year, so it looks as if that scenario has returned.  But for that happy outcome to recur (and maybe hit 1,550 points) there are some things that have to happen – if not all, then some combination thereof.

One of the things the market would like continue is merger and acquisition activity – with both the public and the private sectors buying up public companies (thus keeping supply low).  Along the same line of managing the supply/demand ratio the market would like to see more public stock being retired.

Some containment of the housing recession goes without saying (see the “Subprime Mortgages” report).

Earnings are a big question mark – and we are in earnings season so we should start getting some answers soon.  Companies in the S&P 500 index have aggregately been increasing year-over-year profits at a double digit rate every quarter for more than four years.  Unfortunately the Wall Street consensus is that this quarter earnings will “only” rise 5.1% this quarter.  While that’s still pretty good growth, the bad news is that the lower profit growth will slow domestic economic growth and net-net push down stock prices.

These aforementioned “questions” will affect the next query – will inflation and interest rates become negative influences?  For a while now investors have viewed this duo as perfect, but if global inflationary pressures continue and domestic economic growth slows, then the Fed is going to have a tough time balancing these issues.  With the Dow Jones commodity index on the rise and with G-7 GDP growth running higher than G-7 GDP bond yields (an inflationary implication), there is a chance (albeit slight) that the Fed’s next move could be to raise rates, not drop them.  That would not only have an immediate negative impact on the stock market, but also longer term as M&A activity would slow.

This report has more questions than answers, but I wanted you to know about some of the more meaningful things on my radar.