A Wake Up Call?

Yesterday's dramatic decline in stock markets globally is an important reminder of the risk of complacency. Since late Summer 2006, the market has risen steadily with only very minor reversals. We were once again reminded don't go up forever without at least a "technical" adjustment from time to time. And these adjustments can be swift and painful. However, investors with well diversified portfolios that kept their heads yesterday are still in great shape - no need to panic.

The big decline was perhaps sparked by the Chinese sell-off. However we think there may be more to it. The economy has slowed - GDP was revised downward to just up 2.2 and the Chicago PMI was below 50 again (above 50 is good, below not so good), the mortgage markets are jumpy, new housing starts are still falling fairly rapidly, the Democrats in control of Congress are looking to increase their share of your wallet and oil has bounced of its recent lows. All this uncertainty and and a stock market that has risen sharply off its lows seems ripe for a correction. It may have started yesterday. We don't think it will be too bad or too long and it should be a good environment for bargain hunters. So make a list of the stock you wish you had bought last summer and look for opportunities to build a position.

Focus on Expectations

A day after our post on using the market as a forecaster, the Wall Street Journal has an interesting article on a change in the way the Fed looks at employment and inflation. The Fed is becoming less concerned that in the short run high levels of employment or unemployment have a meaningful impact on inflation. Now, this doesn't mean changes in the level of employment will be totally ignored by the Fed, but it does seem less likely that the Fed will alter rates on employment changes. This is good news for interest rates in the current high employment environment.

The Fed has heightened its focus on inflationary expectations and changes therein. Review our prior post on the spread between 10yr TIPS and 10yr Treasuries. It is market based measure of inflation expectations. And today it shows expectations at a low ebb. Our bet, the Fed stands pat.

Markets as forecasters

We often talk about inflation in our posts. Why? The level and direction of inflation has a very important impact on interest rates. And interest rates are a key input for valuing the stock market. Last week's dip in the market is evidence of that linkage - the CPI was worse than expected and investors sold stocks.

Thus it makes sense that if there was a way to forecast inflation with some degree of accuracy, we could make better investment decisions. Where can we find such a forecast? The usual suspects, economists, government experts, the Fed, have a spotty forecasting record which could result in some nasty surprises. So we look to the market for help. Here is a chart of the spread between 10yr US Treasury TIPS (inflation protected bonds) and traditional 10yr US Treasury bonds.

The spread provides important insights into inflation expectations. When it is rising, the market fears accelerating inflation. When it falls, the market is expecting stable to falling inflation. Notice that this spread has remained in a narrow band for about three years. And at the moment it looks like the market is not expecting a worsening inflation situation. That's good news for stocks!

Why Earnings Growth Matters

In many of our posts, we report on the corporate earnings environment. It doesn't take a rocket scientist to understand the linkage between economic/business conditions and a corporation's ability to grow profits. Positive GDP growth, modest inflation, stable (falling) interest rates and benign government interference (e.g. taxes, regulation, etc.) should allow corporations to grow sales and profits. Negative GDP growth, rising taxes and regulation, unstable inflation/interest rates make growing profits very difficult indeed.

Why does this matter to investors in stocks?

The direction of earnings is perhaps one of the most critical factors to overall stock market health. A study by FTN Midwest Securities shows a very high degree of correlation (r=.83) between the direction of earnings and the market (in this case measured by the S&P 500). Simply put, when earnings go up the market tends to go up.

Surprisingly the same study shows that the pace of earnings growth is not correlated to the level of the market. So today's level of angst about slowing earnings growth may be over done.

Bottom line: Earnings growth matters. As long as the environment allows corporations to grow their earnings, even at a modest pace, the market should retain a positive bias. So while looking for slower earnings growth this year, we're still looking for a market advance.

CPI Runs Hot

After all the positive news over the past several weeks, today's report on the CPI was just a bit disappointing. Both the "headline" number of +0.2% and the "core" gain of +0.3% were above expectations and the prior three months levels. Of note, healthcare costs took a big jump - +0.8% - in January.

While not we're not happy with these numbers, we're not really concerned as one month does not make a trend break. We still believe inflationary pressures remain relatively mild and at a level the Fed can tolerate. Indeed it seems to us that we've entered a period of interest rate stability across the yield curve which should provide a favorable backdrop for the stockmarket.

Under Promise, Over Deliver

While bullish last Fall we were nonetheless surprised by the scope and magnitude of the market’s advance in the fourth quarterof 2006. This occurred despite a significant decline in residential housing, the ongoing turmoil in the Middle East, and a significant shift in the make-up of the Congress.

We believe the market rally was fueled by unexpectedly strong earnings gains, attractive valuations (thanks to stable interest rates), falling energy prices, a significant amount of M&A activity, and thankfully, a lack of natural or manmade disasters during the quarter. Recent reports released by the Departments of Commerce and Labor have increased our confidence that the US economy can sustain reasonable levels of growth in 2007 without a meaningful risk of accelerating inflation. As a result, we believe that 2007 offers promise for investors in equity markets globally and particularly here at home.

We also adhere to the view that larger cap stocks are likely to out-perform small/mid cap stocks in 2007 after years lagging behind.

At this point in the market cycle, we believe small cap valuations have become stretched beyond their normal ranges. Investor expectations for smaller companies seem elevated as well, leaving little room for disappointments. And disappointmentscan lead to sharp corrections in small cap stock prices.

On the other hand, we feel many large cap stocks are selling at much more appealing valuation levels. Investor expectations remain subdued and many analysts are expecting slowing growth. This sets up the favorable scenario of larger companies exceeding expectations as they report year end results and offer forecasts for 2007. For investors, it's almost always better for companies to under promise and over deliver.

The choppiness of the market in the opening weeks of the new year is a sign of investor nervousness and uncertainty as they try to position their portfolios for 2007. While we believe the current environment looks favorable, we remain concerned about the potential impact of geopolitical events, uncertainty resulting from the change in Congressional leadership, and the potential for an adverse policy shift by the Fed.

Nevertheless, as it stands today, it looks as if 2007 will be another positive year for stocks.

Good News on Inflation and Growth

Recent reports out of the Departments of Commerce and Labor are encouraging for the market. Last week's GDP report and today's report on labor costs and productivity should be construed as good news for the prospects for economic growth and controlled inflation in 2007 in our view. The 3.5% rise in GDP provides a positive backdrop for business while improved productivity may ease concerns about falling profit margins and inflationary pressures - at least for the near term.

Despite some hawkish Fed comments, we don't expect significant changes in interest rates. And, the strong economic growth evident in recent reports will help support solid earnings growth in the corporate sector. Solid earnings growth and stable interest rates are usually a recipe for rising equity prices.

So, for now we're looking for stock market gains for 2007.