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 July 2007 Seeking Direction
As the quarter drew to a close, the party was still in progress, but there were some indications that changes were afoot. Maybe it was just time for another beer run or perhaps the partygoers were finally ready to head home. Either way, things were settling down.
That wasn’t the case earlier in the quarter. The market staged a sharp rallying extending from mid-March through mid-June. The Dow Jones Industrials and the S&P 500 both moved to new all-time highs. Small caps tagged along, too, as both the Russell 2000 and the S&P Small Cap 600 also hit new records. Such a broad-based move is typically viewed as more sustainable than one with narrower leadership.
How We Got Here It wasn’t the actual numbers that were so important, it was the perception of what they meant. In the investing world, perception really does determine reality. Coming into the quarter, analysts had expected the 14-quarter string of double-digit earnings growth to be broken by an 8% increase in S&P 500 profits. But in the days just before they started to come out, the consensus suddenly fell to a mere 3%. (It’s interesting to speculate on how the so-called “consensus” can experience such a sharp move in such a short period of time. It’s particularly difficult to see how this could happen if analysts were truly building models and researching companies’ prospects. Is it really likely they would all change so dramatically and so quickly? Hmmm…). Investors lowered their expectations as quickly as analysts cut their estimates. By the time earnings started coming out, the bar was low, and many easily exceeded newly lowered expectations. When everyone was expecting 3%, a company growing profits by 6% was perceived as a positive surprise – despite the fact that 8% was anticipated just a few short weeks before. . When all was said and done, the companies of the S&P 500 saw earnings grow by 8% -- the original consensus. Against the backdrop of lowered expectations, that was enough to power the markets to the edge of record territory. Merger and acquisition activity was enough to kick them over the edge. Actually it was more acquisition than merger activity, driven primarily by private equity firms. Over the past year, wealthy individuals and pension plans have turned to private equity as a means of generating market-beating returns. As a result, private equity firms have found themselves sitting on a huge pile of cash. Low interest rates not only offer the opportunity to leverage takeovers, they also provide a disincentive to hold cash in lieu of investment. The time was right to put some of that private equity to work. The new wave to private equity buyouts targeted firms in industries previously off the radar. Suddenly cyclicals (Chrysler), utilities (TXU), and staples (Bausch & Lomb) were fair game. With each announcement, other shares of other companies in the same sector got a boost, and the overall market got another broad-based kick..
By mid-June, the equity market was standing at levels most had hoped to see by the end of the year. With so much going for the market, cautious investors were glancing back down, wondering what would put an end to the run, and how bad it would be.
Where We Might Be Headed And then there’s interest rates. After remaining so low for so long, the yield on the 10-year note jumped four-tenths of a percent in two weeks, briefly trading over 5.3%. Even more ironic is the fact that this occurred when the Federal Reserve was even more firmly in neutral. Many believe that low global interest rates are what fueled the recent economic expansion, so if they’re on the way out, growth may be as well.. So there’s plenty to fret about and possibly even reason to believe U.S. stocks may have already seen their highs for the year. Nevertheless, shares have held their own, still trading within striking distance of their highs. Something must be keeping them up there.
Where We’ll Probably Go
That’s a positive sign if for no other reason than the fact that it suggests there is still some cash on the sidelines. When every last possible penny was already invested, there were no willing buyers to lend support when the tech bubble burst. When stocks reacted negatively to rising interest rates in mid-June, bargain-hunting buyers quickly made their presence known, righting shares swiftly as they declined. That’s not to recommend buying on every dip – stocks are still trading at their highest level in some time. Earnings are growing at their slowest pace in awhile, too. Higher interest rates are also adding to the cost of doing business by raising borrowing costs. Even so, stocks didn’t suddenly become overpriced overnight. If they were fairly valued in mid-June – or anywhere near fairly valued – they still are today. A little market consolidation may be just what the doctor ordered after the spring runup. In fact, that’s likely to be the case until September or October. Summer is typically a slow time of the year for stocks. That’s not to say there can’t be surprise jumps or gut-wrenching declines when it’s hot outside, only that they’ll probably be short-lived. Thin markets make for increased volatility but not sustainable trends. Of course a trend could emerge, especially if there’s some sort of flare-up in the Middle East, a shock to the oil supply, or interest rates suddenly go to the moon. There’s no telling what will happen in the Middle East with so many warring factions that have hated each other for centuries. This certainly has an impact on the world’s oil supply as does the equally unpredictable summer hurricane season.
Interest rates, on the other hand, have behaved much more predictably. Although many market participants seemed utterly shocked by June’s sudden jump in yields, it’s something we predicted back at the beginning of the year. Who wouldn’t have seen it coming? Rates have consistently remained below 5 ½% for over six years – that’s well below their 7%+ historical average. Meanwhile, key lending rates have been on the rise in Europe and even Japan. With domestic food and energy prices (sorry core inflation fans) moving up, who wouldn’t have thought U.S. rates would rise? Oddly enough, higher domestic rates may actually be a blessing if for no other reason than it keeps the market in control. The dollar strengthened as the 10-year Treasury pushed over 5%. That can help exports while keeping U.S. investments competitive abroad. In addition – if you believe interest rates can help cool a potentially overheating economy – they can help keep the Fed and possibly even congress at bay. We’d much prefer leaving financial management to the market than to any governmental body. Coming from such a low level, interest rates can rise for awhile before even approaching their historical average. As long as the move is orderly and within limits, there’s little to fear. Perception plays a role, too. As long as investors are concerned about bond yields, they’ll be more cautious in their equity trading as well. This might afford stocks a little more time to consolidate and let earnings catch back up. By the time October rolls around, stable and/or rising second and third quarter earnings may be enough to propel fuel a year-end rally. By then, rates may have stabilized at mildly higher levels, and we can all have a happy New Year. Now if we could just do something about the Middle East and those pesky hurricanes… Search this site! Just enter you key word or words:
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HE HIGHER YOU CLIMB, the more frightening it is when you look down. That’s how investors felt in the second quarter of 2007. As major domestic equity indexes (with the notable exception of the Nasdaq) moved to new highs, they couldn’t help but wonder when the party would end and if it would end badly.
