Perspectives on Investing

A Little Respite

2007-07-30T16:13:00.001-04:00

Today's gain of almost 100 points in the Dow Jones Industrial Average provides a least a short respite for investors after two terrible days in the stock market last week. The decline occurred despite the strong economic news released on Friday coupling strong GDP growth with fairly stable inflation and falling interest rates. The 10-year Treasury yield fell below 5% which we believe is an important bell weather for the market.

The bottom line? We'd hang in there with equity positions as this market looks inexpensive to us on an earnings basis - particularly when compared to the 10-year Treasury as we think this should set the stage for further gains to the upside.

Back to Blogging on the Markets

2007-07-25T14:08:00.000-04:00

It has been some time since my last post - the result of a busy work schedule and a bit of indifference thanks to the rising stock market.

I think most of us spend too much time on the minutiae - the daily economic reports, earnings results, interest rate spreads, etc. - and too little time on the big picture. Putting events into their proper context is an important component to successful investing.

It is interesting to note, therefore, that despite $3 gas, rising mortgage delinquencies, terror attacks, slowing economic growth, the market has made a significant advance with the Dow Jones Industrial Average crossing 14,000 for the first time in history!

Now, of course, we have started to experience some choppiness in the past several days including a couple of triple digit declines. And all of sudden, market participants have come to the conclusion that the sub-prime market woes will spread to the rest of the economy. Bill Gross, the famous bond manager from PIMCO, was on CNBC yesterday talking about a five to ten percent correction thanks to a widening spread between high quality and "junk" bonds. We'll he's right - spreads have widened but no more than back in 2005. Lending is not going to come to a halt, and the economy will continue to move ahead.

So put let's put the past few days in context. The market has done fine so far this year - indeed more than fine and a little correction is probably a good thing. The economy is growing, earnings are rising and interest rates have stabilized (at least for good credits!). So relax, don't listen to all the noise, and perhaps look for some bargains.

Four home runs in a row . . .

2007-04-23T11:07:00.000-04:00

Last night, the Boston Red Sox, hit four consecutive home runs. At the time the Sox were trailing the hated New York Yankees by three runs. The four home run outburst powered the Sox past the Yanks and to ultimate victory.

Using last night's performance as an analogy for the stock market may be a bit of a reach but I'll try! And, since it's been a while since my last post, I'll be able to cover a lot of ground with it. Here goes:

Home run #1: The Economy. Without a doubt, the economy's growth rate has slowed from last year's levels. However, the final revision of the 2006 was upward to 2.6% from 2.0% so we ended the year with a bit of momentum. We'll find out how much in just a few days as the Q1:2007 GDP preliminary report is out on the 27th. We're betting that it will be a "decent" report (say 2% give or take) albeit slowing somewhat given the rocky housing numbers and some unexpectedly poor weather - particularly in March. Remember that employment has remained strong and the unemployment rate is still low. So people are working and spending money and growing the economy.

Home run #2: Inflation/Interest Rates. Despite spikes in some commodity costs (have you bought any gas recently!) core inflation rates remain relatively subdued. While they may be a "smidge" above the Fed's comfort level, they are not spiraling out of control. We think that given somewhat slower GDP growth, continuing concerns over the subprime mortage market (and its impact on housing overall), the Fed can and will stand pat for some time to come. Stable interest rates are good for the economy and the stock market.

Home run #3: Corporate Earnings: Earnings reports are starting to flood in and, so far, companies are meeting forecasts at a rate surpassing most investors expectations. In fact, it appeared to us that last month, investors were bracing for some major disappointments. And while there have been some high profile misses, such as Yahoo! and AMD, strong reports from the likes of Google, Caterpillar, and even Intel have driven the market to new highs.

Home run #4: Buyouts galore: It seems that we start every day with at least one, multi-billion dollar buyout. While many of the buyers are private equity firms and hedge funds, we're also seeing some significant corporate buyout activity as well - witness today's by of Medimmune by AstraZeneca. The result of all this activity is a meaningful reduction in the amount of publicly traded stock. The simple law of supply and demand continues to provide uplift to our stock markets.

Bottom line? A month ago it looked like game over for the stock market. However, thanks to the four "home runs" listed above, we're once again making new highs in the Dow Jones Industrials. Time will tell if the bull market will keep its lead over the bears - but I wouldn't leave the park just yet.

A Wake Up Call?

2007-02-28T08:45:00.000-05:00

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

2007-02-26T08:22:00.000-05:00

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

2007-02-25T10:58:00.000-05:00

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

2007-02-21T10:35:00.000-05:00

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

2007-02-21T10:03:00.000-05:00

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

2007-02-12T10:20:00.000-05:00

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

2007-02-07T19:40:00.000-05:00

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.

2006 - A Quick Review

2007-01-04T09:22:00.000-05:00

The new market year got underway yesterday with some interesting stock market action. More on 2007 in a later post. For now, let's step back for a brief review of 2006's market action.

Here are the latest twelve month returns (thru 12/29/06) for various asset classes:

S&P 500: 15.80%
3-Month T-Bill: 4.85%
LT Treas. Bonds: 1.40%
Gold (US$): 23.92%
CPI (1 Month lag): 1.97%

A couple of comments:

Most market participants were not expecting a double digit gain in the stock market at the start of 2006. But thanks to several key factors including better than expected corporate earnings, the end of Fed rate hikes, stable long term interest rates, the impact of private equity players, and perhaps the better than expected news on weather, oil, etc. Oh, by the way, the residential real estate bubble was finally pricked in 2006. Housing related equities suffered unsurprisingly, however, the economy and the rest of the stock market took the real estate troubles in stride.

Long term treasury bonds were up slightly for the year leaving long term interest rates essentially unchanged for the year. And interestingly, the CPI is running right around 2%, hardly a level for serious concern.

All-in-all, 2006 was a great year for the stock market. But that's history. We're looking forward to 2007.

Slow Growth in 2007

2006-12-21T09:27:00.000-05:00

Over the past ten days we've seen some interesting economic reports. Last week's report on the CPI was surprisingly good - almost unbelievable. This good news was offset earlier this week by the PPI report which was much worse than expected. Today, the final report on third quarter GDP was released. It was down from the last revision to 2.0% vs 2.2% but up from the initially reported 1.7%. And also today, the Conference Board released its Leading Economic Indicators index for November, showing a gain of 0.1% - the third increase in a row - pointing to further growth in the economy.

What should we make of all these mixed reports? Simple. The economy has slowed but is still growing. Inflation is not accelerating out of control. We think that the Fed can stand pat on short term interest rates, perhaps cutting in 2007.

We're expecting more of the same economic action in 2007. That is slow GDP growth, controlled inflation, stable interest rates and rising corporate profits and cash flows. We believe that this will be a favorable environment for stocks and bonds (although our preference is for stocks) and we would tend to focus on companies with solid top line growth, stable/rising margins, and positive free cash flow generation. We expect more M&A activity across a number of sectors of the economy. And, at the risk of sounding like lemmings, our bet is that larger cap stocks will be the better play in 2007.

The risks to our scenario are the same ones we faced this year and include energy supply disruptions, terrorism, a worsening Middle East situation, N. Korea, storms etc. The new unknown is the impact of a Democrat controlled Congress. Watch taxes, particularly the talk on dividends and cap gains - as the impact would be certainly negative for stocks.

All-in-all, we think being cautiously optimistic on the economy and market in 2007 is the correct stance for now. So, don't worry, be happy and have a very. . .

Merry Christmas!

Some better news!

2006-12-05T10:14:00.000-05:00

Maybe there will be more than just coal in investors' stockings after some fairly positive news on the economic front today.

Labor Department data released today provided some more evidence that inflation is not spiraling out of control. Unit-labor costs were revised much lower in both the second (from +5.4% to -2.4%) and third quarter (+3.8% to +2.3%). As a result, instead of rising at a 5.3% rate over the last twelve months, unit-labor costs were revised down to a reasonable 2.9% annual gain.

Productivity figures were also revised upward to 0.2% from flat in the third quarter as initially reported. While this result was disappointing to some, we would note that the sharp slump in residential construction may be putting undue pressure on the productivity figure given that home builders either can't or won't reduce employment as fast as the decline in construction activity. We suspect that once homebuilding "normalizes" the solid productivity gains in other sectors of the economy will become more of a positive factor.

This is an important and positive report on inflation which significantly reduces the risk of further Fed rate hikes for the foreseeable future in our view. And stable rates should at least be neutral for the stock market.

On another front, the ISM services index rose to 58.9% from 57.1% in October surprising most economists - who had been expecting the index to slip to 55.8%. This is counter to the fall below 50 for last month's manufacturing figure and should assuage some fears that the economy will fall into recession next year.

Bottom line, these results should offer some comfort and joy to investors.

A Lump of Coal!

2006-12-01T11:10:00.000-05:00

Looks like investors received another lump of coal in their stockings with today's release of the Institute of Supply Management's monthly ISM index. This measure of manufacturing activity hit a 2006 high in the spring and has been drifting lower ever since. Today's report that November's number was 49.5 has particular significance for the market when you remember that a reading below 50 is indicative of contracting manufacturing activity.

Not surprisingly, the stock market has begun to slide on concerns that economic growth may slip further than expected and as a result, earnings may fall short of expectations next year.

Before you panic and sell everything, this is the first ISM index number below 50 in a couple of years. Since then the economy has grown strongly. And, this index reflects the manufacturing sector of the economy which is an increasingly less important factor in overall growth. So lets wait for perhaps another month or two of reports below 50 before we panic!

Oh, there's a silver lining to this report. Treasury bonds have strengthened today, pushing interest rates down a bit more. It's going to be tough for the Fed to raise in the face of evidence of a slowing economy and an inverted yield curve.

We believe next week's employment report may be of more help to investors' understanding of the current and future economic picture than to today's ISM.

Will Santa Bring Coal To Traders This Season?

2006-11-30T11:47:00.000-05:00

It's been a while since our last post, so I'm not going to go into great detail about all the economic numbers reported since early November. Suffice it to say that the inflation reports released before Thanksgiving were better than most expected and certainly good news for inflation watchers. I've created a link to the releases for both the PPI and the CPI if you want detail.

Yesterday (11/29/06) we got the first revision of 3rd quarter GDP. (There's one more revision on the way. Imagine trying to tell your boss you needed three tries to get your work right and keeping your job!) GDP was revised up to +2.2% versus the initial report of +1.6%. While it's clearly an improvement, 2.2% still represents a deceleration from the prior quarter. There was some good news on inflation in the report as core personal-consumption expenditure index rose 2.2% (yr./yr.) - down significantly from last quarter's 2.7% rise. This inflation number may still be high for some but at least it's heading in the right direction. And there was some impressive results on the corporate profit front with the government's number showing a 30% gain versus last year. Here's the link if you need all the gory details: Q3 GDP

Of course, all these numbers are measures of historical performance. And as investors, we're more interested in what happens next. We've seen a few numbers (Chicago PMI, new unemployment claims, and some of the housing stats, for example) that make us think that economic growth will remain subdued going forward. It's probably not a great environment to sustain the high profit growth we've seen recently but it's a good bet interest rates stay in their current range. So right now we're looking for some appreciation in stocks next year - just nothing out of the ordinary.

And what about a Santa Claus rally this December? With some of the market averages already up double digits, we somewhat concerned that Santa will have coal in his bag.

Employment Results Startle Analysts

2006-11-06T12:58:00.000-05:00

This past Friday's employment report from the Labor Department has been the subject of much discussion among pundits. Not because non-farm payrolls rose a less-than-expected 92,000 in October, but because the prior two months were revised upward by a total of 139,000 jobs. September's figure alone was revised up by 97,000. (Remember how surprisingly small September's gain was initially?)

The household survey reported an impressive job growth number for October of 437,000. This was a huge increase over September's household survey number of 271,000 new jobs. And, the headline unemployment rate fell to just 4.4%.

So what should we make of these numbers?

First off, it's tough to be overly pessimistic about the economy near term given these results. We suspect that holiday spending will be fine despite the problems with housing.
Second, strong employment gains often hurt productivity over the short run and may account for some of the recent disappointment on that front.
Third, there is a growing shortage of labor so wage inflation will be harder to keep in check, raising doubts about any Fed rate cut in the near future.

No Productivity Gains in the Third Quarter

2006-11-02T08:50:00.000-05:00

The Labor Department released productivity figures for the third quarter and they aren't very encouraging. In fact productivity for the quarter was unchanged and the prior quarter was adjusted downward significantly (read the release here). As we mentioned in a recent post, rising productivity offsets rising employment costs and helps to keep a lid on inflation. So right now, companies are not able to offset rising labor costs with productivity improvements and will either try to raise prices (bad news for inflation) or take a hit to their profit margins (bad news for earnings growth). Either way, this is not a positive for stocks.

For the optimists in the crowd, we observe that the productivity numbers can be a bit flaky as the measurement of output in some sectors is quite difficult. How does one measure the output of the financial sector for example? So wait to early December for the report on nonfinancial productivity before jumping out the window.

More Evidence of a Slowing Economy

2006-11-01T10:18:00.000-05:00

Today the Institute for Supply Management (ISM) released the results of their October survey of purchasing managers - the Purchasing Managers Index (PMI). At 51.2, the index points to further growth in the economy. (Remember that any result above 50 indicates economic expansion, while below 50 indicates contraction.) However, this result was below the prior month as well as expectations, and can be construed as further evidence of a slowing economy.

A look behind the headline number provides for some interesting reading (you can access the press release here). In particular, the ISM survey on prices indicates that purchasing managers are seeing lower prices. I'm not sure how much of this relates to energy, but this has to be a hopeful sign for inflation. And, the numbers on new orders and inventories seem to indicate the potential for some further slowing in economic activity.

The ISM survey is an important indicator of the direction of economic activity. It does not help much with gauging the magnitude of the change in GDP. So based on today's release, it looks like the economy will continue to grow but we still lack clarity on the rate of growth over the next several months.

Employment Cost Index Up - Bad News for Inflation?

2006-10-31T11:23:00.000-05:00

The Labor Department reported today that the Employment Cost Index rose 1% (or more than 4% annualized) in the third quarter and 3.3% for the latest twelve months.

Many, including myself, view the ECI as the "super core" inflation measure since employment is the predominant cost of doing business in our service-based economy. When the ECI runs above the CPI, as it is doing now, it has to raise concerns of further acceleration of the consumer price index as businesses raise prices to offset rising costs. The implications for Fed policy, interest rates and the stock market if the ECI continues to track above the CPI are not positive, in our view.

Before you panic, however, there is another key figure due out later this week - productivity. This measure of output per man-hour is a critical offset to the ECI. Simply put, if productivity grows at least as rapidly as the ECI, the chances of accelerating inflation are lessened and the pressure for the Fed to act is reduced.

Stay tuned!

Will the election matter to the market?

2006-10-27T12:27:00.000-04:00

With the midterm elections less than two weeks away, investors are debating the impact of potential changes to the make-up of both the House of Representatives and the Senate. The direction of the economy, taxes, government spending, the war in Iraq, all have the potential to see major changes in 2007 and beyond. But for the stock market, does it really matter what happens on November 7th?

It seems not. According to the folks at FTN Midwest Securities, the stock market has risen an average of 19% in the year following midterm elections. And since 1959, every post midterm year has been positive, even with changes in control of the Congress.

So have fun debating politics - and (it seems) don't worry about your portfolio.

One caveat: Past performance is never a guarantee of future results.

GDP Growth Slows to 1.6%

2006-10-27T11:46:00.000-04:00

The GDP report this morning surprised investors to the downside at only +1.6% versus expectations of more than 2% growth in the third quarter. The plunge in residential investment carved about 1% off the GDP result. On a positive note, the rate of inflation as measured by the personal consumption expenditure index slowed sequentially and consumer spending rose nicely.

What do these results mean to us?

Inflation looks to be under control, allowing the Fed to stand pat on interest rates for the time being.
Growth in the economy, ex-housing, looks fine - consumer spending rose 3.1% for example. But we wonder how long the overall economy can continue to grow when such an important component, housing, is in freefall.
Slowing GDP growth will ultimately impact corporate earnings growth. We've enjoyed a string of double digit profit growth quarters - this can't continue forever (unfortunately) so stocks could be vulnerable after the strong gains since last summer.

The good news is that our economy is diverse enough to absorb the shock of a collapse in housing and still grow. As a result, we think the risk of a recession is fairly low. However, the likelihood of subpar growth for the next several quarters has increased and investors will need to get used to slower earnings growth as we head into the new year.

Oh, and don't forget, these numbers are subject to revision and may be better (or worse) than today's report!

Commodities Trend Break!

2006-10-18T11:09:00.000-04:00

Take a look at this chart of the CRB index of commodity prices. After a period of steady increases, the CRB has recently experienced a noticeable (if not significant) break in that upward trend. Of course, oil is an important component of the CRB so much of the index's price erosion is due to the recent decline in energy prices.

Our take? Ultimately, commodity prices are driven by the forces of supply and demand. So perhaps the trend break reflects some slowing in economic activity. The good news, to the extent the CRB reflects inflationary pressures in the economy, its recent fall is further evidence that inflation has at the very least stabilized for the time being.

Inflation's Not So Scary After All

2006-10-18T11:06:00.000-04:00

Yesterday, markets were startled by an unexpectedly high core PPI report (see our last post). So, we held our breath waiting for more bad news from the CPI report today.

It didn't happen. In fact, the CPI actually fell more than expected thanks to gas prices. And the core CPI (excluding gas and food) rose 0.2% as expected.

So, what do we make of these numbers? While the core rate is still above the Fed's "comfort level" it doesn't look to us like there is a big risk of acceleration of the core rate of inflation. And as a result, we suspect the Fed will stand pat for awhile longer - good news for equity investors.

Inflation Scare!!!

2006-10-17T16:09:00.000-04:00

Halloween is just a few weeks away, so it seems appropriate that investors got a real inflation scare today.

First the good news. The Produce Price Index fell a whopping 1.3% last month. Needless to say, the collapse of gasoline prices caused much of the overall drop in producer prices.

Now for the scary part! Core PPI (excluding food and energy) rose 0.6% in September or about 3X what the economists were expecting. All of the increase was to be found in finished goods (autos for example). Both crude goods (ie. raw materials) and intermediate goods prices declined in September.

Bottom line? I'm not willing to read much into these numbers, as I am wondering if the finished goods increase reflects hikes in raw and intermediate goods in prior months.

But watch out - tomorrow is the CPI!

Bonds Better Than Stocks in 3rd Quarter

2006-10-13T14:13:00.000-04:00

The third quarter was great for stocks with the S&P500 rising more than 5% between June 30, 2006, and September 30, 2006. But bonds did better! Look at the chart to the right. It compares the performance (price only) of the SPY, an S&P500 Index ETF and the TLT, a long bond ETF (click on the link for more info on ETF's). Long bonds rose in value over the period as interest rates fell, thanks to the end of Fed tightening, signs of a slowing economy, and lower energy prices. (Remember that there is an inverse relationship between interest rates and bond prices.)

Perhaps, the upward move in bonds (interest rates down) has had as much to do with a strong stock market as earnings reports, investor sentiment and the like. At the very least, falling interest rates (rising bonds) made stocks more competitive, particularly after their sharp correction from early May.

Please note the recent change in trend I have circled. The stock market continues to head higher while bonds have reversed trend and are falling in value. Interest rates have backed up a bit. While we don't believe this "trend-break" portends any serious problems for the stock market, it may raise the likelihood of a pause or short correction of the stock market's advance.

Since we're a bit bullish, we'd take advantage of any near term weakness in the market.

Inflation Report Positive, Stocks Negative. . .

2006-09-19T13:31:00.000-04:00

Today's producer price index (PPI) was meaningfully below expectations, more evidence that inflation has perhaps peaked or that at the very least, we've moved into a sustained period of inflation stability. Not surprisingly, bond investors were cheered by the news and we've seen a broad rally in the fixed income markets today. But the stock market isn't following. Indeed, at midday stocks are down. What gives?

In our view, one of the key determinants of stock prices is earnings. Simply put, stock prices follow earnings growth over time. So during periods of rising earnings such as we've seen the past few years, stocks do ok. However, periods of stable or falling earnings growth are generally bad for stocks. So what does this have to do with the PPI?

We just reviewed a report from Merrill Lynch which shows a very tight correlation between Core Crude PPI and the earnings of the S&P 500. A rising PPI equates to rising earnings growth, falling PPI results in falling earnings growth.

Perhaps today's good news on inflation is not such good news for the stock market.

More Positive News . . .

2006-09-15T11:00:00.000-04:00

Today's inflation report, the CPI rising 0.2%, is further evidence of at the very least a temporary stabilization of inflation. We also note the continuing slide in gold and today's new 2006 low being made by crude oil as further vindication of the Fed's decision to leave short term interest rates unchanged. We suspect that the next Fed meeting will result in no action. This is good news for the financial markets and both stocks and bonds are up this morning as a result.

We think that the earnings reports that will start to filter in the next several weeks will be the key for a meaningful stock market advance. Pay particular attention to any statements regarding the outlook for the fourth quarter as positive comments should hold the key to driving prices higher.

In case you missed it, gold is heading south. . .

2006-09-11T13:44:00.000-04:00

Take a close look at this chart on the right. It is a twelve month price chart of the streetTracks Gold etf (symbol: GLD) from BigCharts. A share of GLD is equal 1/10th of an ounce of gold and thus a great proxy for the metal itself. Of course, the price of gold is affected by a number of variables and is viewed by many as an inflation hedge. So it is very interesting to note that gold peaked in late spring and has been trending lower ever since. It now looks like GLD is breaking below its 200 day moving average (approx. $58.5) and starting a new leg down. What does it mean? Time will tell but we suspect GLD's breakdown reflects moderating inflation expectations and good news on interest rates. Watch out though, falling gold prices also reflect concerns of a slowing economy and the risk of a recession.

OUCH!! Unit Labor Costs Up 5%

2006-09-06T09:41:00.000-04:00

This morning the Department of Labor reported that second quarter unit labor costs rose 5% over the past year. This is clearly not good news on the inflation front. Higher labor costs are ultimately passed through to consumers in the form of higher prices for goods and services (inflation!) or absorbed in the company's profit margins (lower earnings!). Either way, this is not good news for stocks or bonds and we've seen markets sell off in pre-open trading today.

But don't give up hope. There was some positive news in the release. Most importantly, productivity improved in the second quarter increasing 1.6%. Higher productivity helps to offset rising labor costs and keeps inflation pressures in check.

Summer's Over!

2006-09-04T11:23:00.000-04:00

Today, Labor Day, marks the unofficial end of summer. With vacations coming to an end and the kids heading back to class, we can begin to look forward to the final quarter of the year. Of late, we have received relatively positive news on the economy with inflation stabilizing, energy prices falling, the Fed pausing, earnings growing and markets moving higher. We believe this favorable trend will remain in place for the balance of the year.

However, September has been a tough month for stocks in the past. The third calendar quarter (July, August, September) is notoriously difficult for companies and analysts to forecast. People go on vacation, severe weather can have a major impact (as it did last year) and there is a tendency to push for a strong fourth quarter at the expense of a quiet third. Thus the chances of nasty earnings surprises and market volatility are high. So as the earnings reports come in, we'll be looking for evidence of sustained growth in the fourth quarter and next year to confirm our positive view of the markets.

Happy Labor Day!

Have Interest Rates Peaked?

2006-08-31T11:27:00.000-04:00

Check out this weekly chart of the yield on the 10-year U.S. Treasury bond.
Sure looks like interest rates peaked around the middle of June. The data we've discussed in prior posts is backward looking and at best is confirmation of our views. Markets, on the other hand, tend to be forward looking. We believe this change in Treasury yields is an important indicator of a more favorable interest rate environment going forward - an important positive factor for the stock market.

Data Starting to Support Fed's Pause

2006-08-31T09:46:00.000-04:00

In just the last few days we have seen more data suggesting that the Fed's pause in hiking short term interest rates was both justified and likely to be sustained for more than a couple of months. In particular, today's announcement from the government's Bureau of Economic Analysis of solid growth in consumer spending and incomes and slightly better news on inflation. Take a look at this chart we found at Joe Ellis' Ahead of the Curve web site comparing the PCE deflator (lagged three months) versus the fed funds rate. Importantly, it appears that the Fed has finally got the fed funds rate above inflation. We'd conclude that any stability in the inflation numbers should translate in to a less "hawkish" Fed.

All in all,this is good news for the stock market in our view. It appears that the economy is growing (perhaps at a slower rate) and inflation/interest rates stabilizing. Stable interest rates will take some of the pressure off valuations and perhaps drive increased demand for stocks.

By the way, there are a lot of intersting charts and analysis at the Ahead of the Curve web site maintained by Joseph H. Ellis, a partner of Goldman Sachs who was ranked for eighteen consecutive years by Institutional Investor magazine as Wall Street’s #1 retail-industry analyst. The website is based on his recently published book Ahead of the Curve. It's certainly worth a look.

Gas Prices Down, Stock Prices Up?

2006-08-28T11:35:00.000-04:00

Wholesale gasoline prices have fallen sharply in the past couple of weeks. Indeed, according to the American Petroleum Institute, wholesale gasoline fell 7.6% during the week ended August 21, 2006 and now stands 14.5% below the record high price set on September, 5, 2005. We are already seeing the impact at the gas pumps. In our state, Massachusetts, regular has broken below $3.00 per gallon. We suspect we'll see further declines after Labor Day as summer driving demands lessen. This is clearly good news for drivers. It may also be good news for investors.

Why? Money not spent on gas will be spent elsewhere, giving a boost to retailers. Consumer confidence should improve as stability returns to the gasoline pump. And, most importantly in our view, stable or falling gas prices should help reduce inflationary pressures and perhaps let the Fed leave interest rates alone for a while. Reduced inflation, stable interest rates, and improved consumer sentiment should add up to a better environment for stocks.

Obviously, a serious disruption in oil supplies or refinery capacity would play havoc with our positive scenario. So, we'll be watching the pump and the Weather Channel for the next month or so. Let's hope for a mild hurricane season!

Supply vs. Demand

2006-08-25T20:51:00.000-04:00

The law of supply and demand is one of the basic underpinnings of economics. It applies to practically all aspects of economic activity - including the stock market.

We recently reviewed this chart from Ned Davis Research which shows that the supply of stock has been shrinking at an accelerating rate for the past several quarters. Share buyback's and merger & acquisition activity are more than offsetting new equity issuance from IPO's and the like.

When you have stable demand for a good (milk, gasoline, or in this case, stocks) and supply is reduced, the price is adjusted upward until a new equilibrium between supply and demand is reached. So one could conclude that the reduced supply of stocks should have a positive impact on share prices (again assuming stable demand). And a reduced supply of stock with coupled with rising demand could put significant upward pressure on stock prices.

Of course, demand for stocks is not stable. It is affected by a myriad of variables in addition to the supply of shares, including economic activity and corporate profits to the search for Bin Laden. Indeed, demand for stocks has been ebbing of late given all the concerns we have discussed in previous posts, leaving stock prices stable at best. So, a shrinking supply of stock by itself is certainly not a guarantee of future gains.

What intrigues us is the notion that when demand for stocks does return, the reduced supply should provide additional help moving share prices higher.

Investment Lessons from Tiger Woods

2006-08-23T10:36:00.000-04:00

Tiger Woods has won the last three tournaments he has entered, starting with the British Open and culminating with his dominating performance at the PGA last weekend. Common to all three wins was Tiger's limited use of the driver.

Tiger can hit a driver as far as anyone on tour. It is exciting to watch and when everything is in synch, Tiger gains a huge advantage over the field by hitting the ball well down the fairway. But, the driver is for most golfers, including Tiger, the least accurate club in the bag. When not well struck, it can cause a lot of trouble. An investor would likely describe the driver as high return (distance) with high risk (low likelihood of keeping the ball on the fairway).

Starting with the British Open, Tiger Woods made the decision that given the golf courses he was facing (the environment), he wasn't prepared to accept the potential for an errant shot using his driver (risk). So he left the driver in the bag, using more accurate clubs to safely advance the ball off the tee. Tiger was thus able to win all three tournaments by executing a lower risk, consistent strategy of keeping the ball on the fairway and avoiding a disastrous mistake with his driver.

We believe the market environment today, is much like the golf courses Tiger has faced recently - having the potential to earn an acceptable return but punishing investor mistakes. And, that Tiger's approach of controlling risk and executing a consistent strategy can work well when investing in today's uncertain times.

So we're leaving some of our higher risk investment strategies "in the bag" for now and instead staying focused on quality companies at reasonable valuations, keeping portfolios well diversified to mitigate some of the risks we've discussed in prior posts and trying to avoid mistakes.

Is The Stock Market Correction Over?

2006-08-21T11:09:00.000-04:00

One has to be impressed by the market action last week. Major averages such as the Dow Jones Industrial Average and the S&P 500, rose between 2.65% and 5.16% leaving all but the Nasdaq Composite in positive territory for the year-to-date.

Investors were encouraged by last week's economic news which seemed to indicate a slowdown in economic growth and hopes for lessening inflationary pressures. Energy prices moderated as well, as it appeared (at least for now) that the conflict in Lebanon would not spiral out of control. And, perhaps most importantly, corporate earnings growth remains solid.

Last week's market action begs the question: Is the correction, begun last May, finally over?

We believe there are reasons to be constructive and we expect further gains over the balance of the year. Our positive stance is based on the following observations

Solid fundamentals: Q2 reports generally met or exceeded expectations;
Attractive valuations: With stocks off their spring highs and earnings continuing to grow, valuations have fallen to reasonable levels;
Stable interest rates: Rising rates are almost never good for stocks. The Fed pause and last week's news points to at least some rate stability in the near term, the potential for cuts in 2007 and providing a better environment for the stock market.

While more sanguine about the market's future, we are also mindful of risks that could derail a market advance. Will the Fed's 17 rate hikes ultimately tilt our economy into recession resulting in falling profits and stock prices? Will the conflict in the Middle East spread, disrupting oil supplies and raising global tensions? Will inflationary pressures force a resumption of Fed rate hikes? Answers to these questions, unknown today, will come in time.

Between now and then we're reminded that the greatest opportunities are often present themselves when uncertainty is high.

More signs of slowing. . .

2006-08-17T13:25:00.000-04:00

Today, the Conference Board's index of leading indicators was reported down 0.1% versus the consensus expectation of a 0.1% gain. This is one more sign that economic growth is slowing and it should be viewed positively by those looking for the Fed to continue to stand pat on interest rates. Our concern? Slowing growth will make it harder for companies to grow their earnings perhaps offsetting any positive impact from lower rates.

For a long time now, we've enjoyed reading Michael J. Mauboussin's "Mauboussin on Strategy" reports from Legg Mason Capital Management. For those with the inclination, we would heartily recommend you visit Legg Mason's web site to read his latest report. And, Michael has recently published a book, MORE THAN YOU KNOW, Finding Financial Wisdom in Unconventional Places, an updated compilation of many of his prior reports that is also worth a read.

Inflation Data OK . . . For Now

2006-08-16T12:08:00.000-04:00

The Consumer Price Index data just released this morning offers some additional good news on the inflation/interest rate front. Core CPI (excluding food and energy) rose 0.2% a bit less than was forecast while the overall CPI rose 0.4%, in line with expectations. Other data out today on housing and industrial production painted a picture of slowing growth. Indeed, July housing starts fell a bit more than expected while building permits declined sharply. Industrial production rose 0.4% in July, a bit less than expected, indicating continued growth in the coming months but at perhaps at a slower rate.

Our take? These reports certainly bolster the favorable inflation news from yesterday and raise the likelihood that inflation and interest rates have plateaued. While this is good news for investors, we're not out of the woods yet. Along with the producer and consumer price indexes, we'll be watching the employment cost index and productivity numbers to give us a better feel on core inflation trend. And we'll be watching the slowing economy's impact on corporate earnings in the coming months. Falling inflation and rates are certainly positive for stock valuations. But if earnings start to fall, it will be tough for stocks to make headway. Stay tuned. . .

A pause that refreshes?

2006-08-15T10:33:00.000-04:00

This is the inaugural post on our new blog, "Perspectives on Investing". Here we will comment on the markets, investment topics, news events, respond to your questions and more.

Last week, after seventeen straight quarter-point hikes, the Fed finally passed on raising short term interest rates at their regular meeting. Yet, the market was underwhelmed by the news. Why? The language in the Fed's press release left the door open to further hikes, perhaps as soon as the next meeting. It will depend on evidence that inflationary forces are indeed receding as Fed Chairman, Ben Bernanke expects.

From our perspective, that evidence is decidedly mixed so far. Recent employment data for example, shows job growth slowing but disturbingly, employment costs rising significantly faster than productivity. Employment costs are a key driver of core inflation, so the current situation is clearly of concern to us.

Today, we got favorable news on producer prices, with the core rate actually falling 0.1% last month. This good news has sent bond and stock markets upward as investors bet that the inflation news will continue to get better, that Ben Bernanke is right after all, and that the next direction for rates is down. Of course, there will be more news tomorrow and it's anyone's guess whether it will be good or bad, indicative of accelerating or decelerating inflation or an indicator of the Fed's next move.

Bottom line, we suspect that the market will continue to be volatile for the time being. Whether it's the violence in the Middle East, high oil prices, evidence of a slowing economy, concerns over corporate profits or uncertainty about the next Fed move, investors will find a reason to stay on the sidelines.

In our view, the correction that began last May will finally come to an end when some of these concerns are alleviated. We think a sustained stock market advance can occur once there is enough evidence that inflation is under control, that rates have at least stabilized and perhaps poised head lower. The risk to this scenario? Has Fed has already raised rates too much, the economy slows too much and corporate earnings slide? We'll just have to wait and see if this is the pause that refreshes.