Four home runs in a row . . .

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?

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.

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.

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.

2006 - A Quick Review

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.

Some better news!

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!

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?

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.

No Productivity Gains in the Third Quarter

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.

Will the election matter to the market?

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.