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 November 2006 Running on Empty
Truth be told, neither of these landmarks meant much from a technical standpoint yet they did provide a psychological lift to investors who had spent most of the year fretting over the Fed, energy prices, and geopolitical crises. Anything that was market oriented -- especially positively market oriented -- was a welcome change. Momentum has a way of feeding on itself, and that's what happened in September and October. When the Dow started making its move, it pulled investors in from the sidelines. Those who had been content to sit on cash after the spring selloff jumped in in an effort to avoid missing the big run. Short sellers -- those who sell borrowed shares in hopes of replacing them at a lower price and pocketing the difference -- added fuel to the fire. Feeling increasingly squeezed as stocks continued to move up, many closed their positions by buying the stocks they shorted, adding to demand and driving them even higher. Professional money managers were drawn in as well. Even if they felt shares were already overpriced, inflows from investors made it incumbent upon them to invest it or risk falling further behind their respective benchmarks. With only two months left in the year to close the performance gap, money managers felt pressured to enter the market to make up the difference.
So if the past two months broke with tradition on the upside, what about the final two months of the year, two that have typically been kind to stocks? Will they be different, too? There are two main schools of thoughts here. The first holds that this is a breakout like the one in 1982 that marked the beginning of the last major bull market. Low interest rates, little inflation, and a sustainable economy can provide the necessary support for a long run. The more bearish view sees little left to power further gains. Crude oil prices have declined $20/bbl from their summer highs and OPEC is ready to move to support prices should they fall below $55/bbl. Interest rates are already low and the Fed has gone to great pains to signal little intention to move them lower. In addition, the housing market has definitely slowed, removing one of the major supports of the economic expansion. With all these negatives, there isn't much left to drive stocks higher.
Outside the Market Ever since they started increasing interest rates about a year and a half ago, the Fed has been one of the most prominent external forces. When the Federal Funds Rate stood at 1% in mid-2004 just about everyone knew they couldn't stay there long. Although they had managed to hold at that level for about a year, it was pretty obvious they'd have to start rising. When they did, speculation immediately turned to how far they would go. After seventeen ¼-point increases, the Fed finally took a break this past August. The communication following the meeting went to great pains to say this was just a "pause" and not necessarily the end of the tightening campaign. The Fed declared itself now "data dependent" -- as if that isn't always the case. Investors struggled to interpret both market and economic conditions in order to understand what that meant. Energy prices and the housing market have been two other factors to watch. Both are inflationary, but rising home prices have been taken positively while higher energy prices have been viewed negatively. As home values increased, homeowners felt richer. Not only did their balance sheets increase, greater home equity provided a potential source of funds for consumer spending.
Rising energy prices had the opposite effect, serving as a growing tax on consumers. The average consumer saw greater and greater portions of his or her income going to energy. Energy companies and their shareholders enjoyed some of the largest profits ever reported, but they were the only ones to truly benefit. Both of these trends reversed in September and October. The average selling price for existing homes began to decrease, with October's showing the sharpest decline since 1970. Crude oil prices fell over $20 from their July highs to their late-October lows. On the plus side, both of these reversals lessened the threat of inflation and suggest the Fed will stay on the sidelines. Some real estate analysts even speculated that the Fed would soon lower rates if the housing market continued to deteriorate. As you probably already know, lower interest rates can spur demand in the housing market as consumers qualify for larger loans with lower interest rates. They also help stimulate stock performance as companies are freed to borrow to replace worn out plant and equipment as well as fund new projects. Lower borrowing costs allow more revenues to fall directly to the bottom line, increasing earnings and share prices. Unfortunately, rate cuts really aren't likely over the short-term. Over the recent past, the first rate cut has come approximately six months after the last increase. That would put it somewhere in the first three months of 2007. But the Fed won't be in any rush to start cutting, especially in response to the slowing housing market. Truth be told, the Fed's "easy money" policy that had brought short-term rates to 1% by mid-2003 is thought to have led to the excesses in the housing market, possibly even leading to what many believe was the "housing bubble". Not wanting a repeat, the Fed will be slow to drop rates. With energy prices on the decline, they may not need to. As gasoline has become more affordable, consumers are finding themselves with leftover cash to spend elsewhere. Declining energy prices reduce inflationary pressures. The economy may actually be self-correcting as long as the Fed doesn't act too hastily in one direction or the other.
Whereas few consumers often think of home prices unless they're actually involved in a real estate transaction, most think about energy prices every time they gas up their cars or pay their utility bill. With both lower, consumer sentiment should hold steady or possibly even increase, helping spur economic growth through steady or rising consumer spending. The economy may need some additional stimulus as third quarter GDP growth was weaker than anticipated. Economists had expected the pace to slow from prior quarters, but still post a respectable 2.2% increase. Instead, growth slowed to 1.6%, the lowest pace since the first quarter of 2003 at the tail end of the three-year equity bear market. With year-over-year growth of core personal consumption expenditure (PCE) series rising at a 2.3% clip versus 2.7% in the second quarter, the bond market priced in a 73% chance of a rate cut in the first half of 2007. However, those looking to these external factors -- especially the Fed -- in making their investment decisions, tend to overlook a critical fact: The Fed doesn't care about spot energy prices or lower home sales. Their mandate is to provide price stability. Sure their actions impact these other concerns, but they still won't rush into the market to prop up home sales unless doing so would promote price stability throughout the economy. In other words, if as an investor, you're hoping to rely on the "Bernanke Put" to help insure your investments' success, don't. You'll be better off looking for other, more fundamental reasons to base your decision; perhaps those internal to the market itself.
Inside the Market The inverted yield curve is another reason for caution. Typically yields on longer maturities are lower than those on shorter-term bonds, but that hasn't really been the case sincle late last year. This "inversion" is currently well pronounced and suggests changes are afoot. In the past this pattern has been viewed as a harbinger of recession. It's occurred when short term rates were too high, slowing the economy. At the same time, investors weren't too fearful of inflation so didn't require a premium for longer-term investments. As the economy slowed, short term rates eventually came down with the additional liquidity increasing inflationary concerns and along with them, long rates, ultimately returning the yield curve to its traditional upward sloping design. But that's not what's going on this time. Yes, the economy is showing signs of slowing but inflation is already a concern. It's been speculated that long rates have remained lower than normal due to foreign demand for domestic bonds, but now with rates rising globally, that explanation is losing a little of its luster.
Regardless of the ultimate reason, yields -- especially those of longer maturities -- are already fairly low and there's little if any catalyst to push them lower. It's quite conceivable that with the Fed out of the market and inflation still an issue, they'll gradually trend up into 2007. If rates continue to rise globally, U.S. rates will have to follow suit, just to remain competitive. The second half of 2007 may look better from a fixed income perspective if only because a slowing economy may leave room for rates to begin coming back down. Even if that comes to pass, that's nothing to get excited about now, especially since a late 2007 bond rally may only take prices back to where they are today. Stocks need some sort of internal catalyst, too. Falling energy prices and strong earnings provided support in the third quarter, but both are now nearing the end of the line. OPEC has made it fairly clear that they will take definitive measures to cut production should crude oil fall below $55 a barrel. Currently trading at $58, there's little left to go. Earnings growth is also beginning to decelerate -- that's what usually happens in this part of the economic cycle. According to First Call, analysts expect third quarter earnings to be up 12% from last year's comparable quarter. They also think 2006 earnings will be up 10% from last year. That's all good, but they also expect next year's earnings will grow at only 6% and the long-term future growth rate will fall to 8%. With a P/E of 16.8x, the S&P 500 while not overvalued, is still above its historical average o 15x.
Bulls argue that in a relatively low rate environment, P/Es can continue to expand even without strong earnings growth. While that's true, we continue to believe that sustainable share price advances are ultimately driven by earnings growth that will be much harder to achieve in 2007. In fact, it's quite likely the Santa Claus rally came early this year. Stocks tend to rise in December as the holiday spirit and the prospects for the New Year lift investors' expectations. After this autumn's strong gains, this effect should be muted this year -- if it occurs at all. That's not to say a selloff is imminent, only that stocks may have already seen their highs for the year. It's conceivable that stocks will drift lower in November once earnings announcements come to an end. There could then be a mild December rally, but it's not likely to carry shares well beyond today's levels. Going into 2006, we anticipated high single-digit equity gains and bonds to be flat to slightly down. This is still achievable even with a mild correction. Without any major setbacks in the next two months, 2006 is shaping up to be a surprisingly good year. Unfortunately, 2007 will be a little more challenging. Search this site! Just enter you key word or words:
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OR ONCE, IT REALLY WAS DIFFERENT this time. Stocks staged a nice rally in September and October, the two months that have traditionally been the worst for equities. By late-October the Dow Jones was trading in rarefied air. After surpassing its January 2000 high, the average quickly moved past 12,000.
