Outlook for 2007 (1/07)

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Monday, 15 January 2007 00:00 Written by James Van de Voorde

2006 turned out be quite a good year for those bullish on the stock market, as a seemingly inexhaustible list of bearish possibilities never panned out.  The Dow Jones Industrial Average, Standard & Poor’s 500 Composite and NASDAQ Composite advanced 16.29%, 13.62% and 9.52% respectively.  Evidenced by the lagging 12.2% return for the average U.S. diversified equity mutual fund, it was a year when many equity fund managers and investors alike had difficulty keeping pace with the market, and staying the course ultimately proved a rewarding strategy.  The average 2006 return for the composite of Osher equities was 16.4%. 

Among other dire prognostications, the bears’ most prominent fears included pandemic “bird flu”, hedge fund contagion, oil at $100 per barrel, expansion of the Middle East crisis and collapsing corporate earnings.  Perhaps the most widely held bearish argument was that the economy could not withstand the rate hikes necessary to ward off spiraling inflation.  Of course, none of these predictions actually came to fruition, inflation remained under control, the Fed stopped raising rates and the stock market marched higher. 

To be sure, the mid-year correction that started in early May and lasted through mid July was a true test of conviction.  The S&P 500 Composite of large cap stocks declined nearly 8% during that span, with other, more volatile asset classes such as small-caps and emerging markets sustaining double-digit losses.  It was during that period, we suspect, that many investors threw in the towel.  With Bernanke and his chorus of Fed Governors steadily singing about the pressing need for the Fed to remain vigilant against inflation, it appeared for a moment that the bears had it right. 

Cooler heads prevailed.  Since there is a close correlation between inflation expectations and actual inflation, it is important to remember that much of the Fed’s job is to keep inflation expectations in check.  They accomplish this and restore their inflation-fighting credibility by insisting that they will do whatever is necessary to combat inflation, even when inflation seems to be on its hind legs.  The Fed’s “jawboning” successfully brought inflation expectations under control and allowed them to finally pause in their two-year rate hike campaign.  For tangible evidence that inflation expectations are in decline, one need look no further than the market for TIPS or Treasury Inflation Protection Securities.  Since TIPS offer investors a hedge against inflation, they are typically purchased by investors who think inflation is on the rise.  According to Merrill Lynch, mutual funds invested in TIPS suffered $2.5 billion of net outflows for the first 11 months of 2006, the first year of net outflows for this asset class since the Treasury introduced them in 1997.

With the Fed out of the way, at least temporarily, the stock market rallied in August and in every remaining month of the year, surprising those that expected a “seasonal setback” in September and October.  The market’s resilience in the latter part of 2006, further evidenced by the lagging performance of the average domestic equity mutual fund, suggests that the stock market rally caught many investors off guard.  A classic case of whipsaw, those that had cashed in at the market lows in May and June rushed to get back in, helping fuel the market’s strong advance. 

Our January 2006 prediction for an S&P 500 year-end close of 1380 proved approximately 3% too conservative for the actual close at 1418.30.  We were right on the overall direction, but slightly off on the magnitude of gains.  At the risk of gloating, here is an excerpt from our January 2006 newsletter:

“Given last year’s muted returns even as corporate earnings and dividends grew smartly, valuations have compressed and become much more attractive, with the S&P 500 Composite closing 2005 with an approximate trailing price-earnings ratio (PE) of 16.  Historically, when interest rates approximate 4% to 5% as they do now, the trailing PE multiple for the S&P 500 has been about 17.  The current market multiple compares even more favorably with the 19.8 average PE ratio witnessed between 1988 through 2004.  If, as we believe will be the case, the Federal Reserve finishes its rate hike campaign by the middle of the year and the economy is able to sustain an annualized growth rate near 3%, there is a possibility that we actually witness an expansion of PE multiples this year.  Even without an expansion of PE multiples, however, we project a year-end price target of 1380 for the S&P 500 for a nearly 11% increase from year-end 2005 levels.  We project a range of 1200 to 1450 for the next 12 to 18 months”.

“In addition to attractive valuations and moderate interest rates, our optimism is buoyed by the prospects for continued share buybacks, dividend increases, merger and acquisition activity and the overdue return to favor of large-cap growth stocks.  Large-cap growth stocks are now as cheap relative to bonds and the overall market as they have been in over a decade.  In addition, with the uncertainty created by the flat yield curve and softening real estate market, investors are likely to seek the safe haven of high-quality stocks that offer above-average growth and stability of earnings and dividends.  These characteristics are of course the hallmark of Osher portfolios, which we expect to outperform again in 2006.”

Ditto for 2007?  Although more cautious than last year, we think so.  While 2006 turned out almost by script, modesty prevents us from confusing our crystal ball with genius.  We do, however, believe that stocks will again handily outperform bonds and 2007 will be a particularly rewarding year for Osher clients. 

The consensus forecast for 2007 earnings growth at 9.5% is well below the impressive mid-double-digit earnings gains witnessed in 2006.  The fact that earnings are likely to slow markedly this year implies that there will be more stock specific risk for those companies that lower guidance or disappoint with their numbers.  It also means that it is very likely that the earnings expectations for many analysts are too high and may need to come down, leading to more analyst downgrades than we saw in 2006.  Companies that can deliver consistent earnings growth regardless of the economic cycle should be in high demand. 

Meanwhile, the consensus currently predicts that the U.S. economy will grow at an approximate 2% rate for the first half of the year and strengthen to a 3% clip in the second half of 2007.  Indicative of the much hoped for economic “soft landing” that we are seemingly in the midst of, these consensus forecasts for earnings and GDP growth seem very reasonable to us, especially in a low to moderate interest rate environment (the yield on the 10-year Treasury closed 2006 at 4.64%) where the Federal Reserve is firmly on hold.

There are many analysts predicting an imminent rate cut by the Federal Reserve, mostly due to recession-like weakness in autos and housing that thus far has been contained to those cyclical sectors.  The recent surge in nonfarm payrolls to 167,000 new jobs created in December was well ahead of expectations and threw cold water on the odds of a more imminent cut.  Immediately following the payroll report, the Fed Fund Futures reduced the chances of a cut from 14% to 8% in March, from 41% to 30% in May and from 86% to 66% in June.  While an interest rate cut may be in the cards down the road, our expectation for gains in the stock market this year are not predicated on the hopes for one.  In fact, the circumstances that might warrant a rate cut would imply a negative outlook for the U.S. economy.  

An interest rate cut would only be necessary, in our opinion, if the housing market were to take a turn for the worse.  We think it is still too early to call an end to the correction in housing and view this as the most significant risk to the economy and to the stock market in 2007.  While the rampant extraction of housing equity that inspired much consumer spending has already disappeared for the most part, continued weakness in housing may further dampen consumer confidence and consumer spending and ring in a newfound penchant for saving.  While good for the long-term, an excessive spurt of consumer saving would have a negative short-term impact on the economy since 70% of GDP is directly related to consumer spending.  In short, a housing-led recession in 2007 remains a possibility.  We believe, however, that the Federal Reserve would respond quickly enough with rate cuts that the potential economic contraction would be relatively short-lived.

Offsetting the weakness in housing, energy prices have plummeted recently and now stand below $55 per barrel.  The further energy falls, the more bullish we would become, as declining prices would have the multi-fold benefit of boosting consumer spending, reducing inflationary pressure and increasing profits for much of Corporate America.  Falling energy prices are precisely what the economy currently needs and, if they remain near or below current levels, may allow the Federal Reserve to hold steady on the current level of interest rates (without a cut). 

In last month’s newsletter, we pointed to the dichotomy in ISM reports, the ISM manufacturing index showing weakness and the ISM service index showing strength.  The recent nonfarm payroll report from the Labor Department illustrates a similar dichotomy.  While the service sector of the economy created 178,000 new jobs in December, manufacturing actually lost 11,000 jobs for the total net of 167,000 new jobs.  In fact, two-thirds of the 1.84 million jobs created in 2006 were from services!  It seems that we truly have a tale of two economies, with the manufacturing side (housing and auto) at or near recession and the service side picking up the slack.  Since manufacturing is now such a relatively small piece of the overall pie, the U.S. economy is far less cyclical than it once was and better able to weather these manufacturing led disruptions.  Furthermore, any weakness in demand that may result from weakness in the U.S. economy is now at least partially offset by demand overseas, especially in emerging economies.

So then, what is in store for 2007?  At 1418, the S&P 500 trades at a trailing price-earnings ratio (PE) of 16 and, based on current expectations for full-year 2007 earnings, the S&P 500 trades at a forward PE multiple of only 14.7.  Our base case is that the economy remains moderately strong, earnings growth moderates close to the current consensus, the housing market flattens (stops going down) and the Fed stays on course at current levels.  With this base case, we expect the S&P 500 to follow earnings growth and trade approximately 10% higher in 2007 to 1560, breaking through the previous all-time closing high of 1527 and all-time intraday high of 1553 set on March 24, 2000.  If energy prices drop further or if the housing market actually shows clear signs of recovery, we think a higher valuation for the S&P 500 would be warranted as the market contemplates newfound longevity of the current expansion and renewed earnings growth.  With slight PE expansion under this more optimistic yet less likely scenario, the S&P 500 might trade as high as 1615, an approximate 14% increase from year-end 2006.  However, if the Fed is “forced” to cut rates due to a worsening correction in the housing market, we wouldn’t be surprised to see a 5% to 10% correction due to the perceived weakening fundamentals, only to be followed by a sharp recovery as the Fed comes to the rescue.  With these various scenarios in mind, we project an approximate range of 1350 to 1625 for the next 12 to 18 months. 

We favor economic sectors that can grow earnings regardless of the economic cycle such as health care and consumer staples, and believe that technology and telecommunications are well positioned due to the release of Windows Vista, the “mainstreaming” of 3G wireless and pent-up demand for productivity enhancing capital spending from Corporate America.  We also favor the above sectors, as well as “predictable cyclicals” in the industrial sector, for their strong operations and growing sales in foreign markets, especially as a hedge to a declining dollar. We had been slightly underweight financials as the Fed raised rates, but have a more neutral outlook now and favor the large international banks and insurance companies within the financial sector.  We are neutral on materials, underweight in both energy and consumer discretionary and have no current investments in the utility sector.