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.

Slow Growth in 2007

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!

Will Santa Bring Coal To Traders This Season?

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.