Newsletters 2007 Newsletters What’s Driving this Bull Market? (5/07)
Tuesday, 15 May 2007 00:00
The recent stock market correction that began in late February and saw the major market averages decline by as much as 8% now seems like a distant memory. The Dow Jones Industrial Average, S&P 500 Composite and NASDAQ Composite all enjoyed strong rallies last month and are now up 4.81%, 4.52% and 4.55% respectively through the end of April. Now over 13,300, the Dow Jones Industrial Average has rallied over 1,250 points since hitting its 2007 low of 12,050 on March 5th, a remarkable 10%+ move in only two months. At press time, the Dow has been up in 24 out of the last 27 sessions, tying a record that was set in July of 1927.
With this dramatic, sharp rise in the stock market, we would expect a very normal and healthy correction to help digest these impressive gains. Yet, we remain bullish and continue to believe that the fundamentals can at least support our base case year-end target of 1560 for the S&P 500 Composite. Since this is a mere 50 points or 3% from current levels, our “more optimistic yet less likely” target of 1615 for the S&P 500 may be in play. We believe the market may be overbought on a short-term basis and that it is premature to raise our year-end target. Still, there are many positive factors behind the recent move that suggest this strong market advance may have legs.
Earnings: As of the writing of this article, just over 80% of the S&P 500 companies have reported first quarter earnings, with 70% of them surpassing the consensus estimate. Currently, S&P 500 companies have delivered first quarter earnings growth over 9%, more than double the consensus estimate for 3.7% growth. Clearly, companies are performing far ahead of expectations and causing investors and analysts to reconsider their view of the sustainability of this economic and profit expansion.
Much of the profit expansion is being driven by sizzling demand for U.S. products and services overseas. S&P reports that 49% of 2006 revenues came from operations abroad. Thus far, 2007 earnings leadership is coming from sectors that derive a majority of earnings overseas, technology, financials and health care. We have long stated that a key driver for U.S. stocks is the industrialization of emerging economies and globalization in general. It is rather remarkable that U.S. multinationals can sustain such strong profit growth even as U.S. GDP stumbles. We believe this is a secular trend that is still in the early innings.
Fed Policy and Interest Rates: With the Fed having moved to a more neutral posture at the March meeting of the Federal Reserve Open Market Committee, the odds for a 2007 rate hike have been all but eliminated. Yet, given the recent resilience in the labor market, it is increasingly unlikely that the Fed will cut interest rates either. The weakness in the housing market and sub-prime mortgage arena are helping the Fed achieve exactly what they set out to do when they raised interest rates 17 consecutive times through August of 2006 - cool down the economy and prevent any potential up tick in inflationary pressures. By keeping interest rates stable here, despite rhetoric from many analysts that think the housing market condition warrants a Fed ease, the Fed is also ensuring that inflation expectations remain well contained. And the recent string of impressive profit growth witnessed by Corporate America gives further evidence that the Fed has successfully engineered a soft landing.
Liquidity: It is estimated that Corporate America is on pace to retire approximately $500 billion of stock in 2007 through buybacks, while private equity is on pace to take private an additional $700 billion. This $1.2 trillion combined is equivalent to 10% of the $12.7 trillion market capitalization of the S&P 500 Composite. This is a stunning reduction in supply as demand remains strong. In fact, with real estate and bonds providing little competition for stocks in today’s environment, we would not be surprised to see demand for equities accelerate, even as the stock market reaches new highs.
Merger and Acquisition: The deals just seem to keep coming as Corporate America seeks ways to invest its growing hoard of cash that has been estimated at $2 trillion. Alcoa launched a $27 billion hostile bid for its Canadian rival Alcan. Barclays and Royal Bank of Scotland are competing for ABN Amro for an approximate $100 billion price tag. Thompson is in talks to acquire Reuters for $17 billion that would create a news and information giant. Rupert Murdoch’s News Corp. announced an unsolicited $5 billion bid for Dow Jones and its prized asset, the Wall Street Journal. Even Warren Buffet announced at Berkshire Hathaway’s recently held annual meeting that Berkshire would like to make an acquisition in the $40 billion to $60 billion range. While many of these deals are stock for stock deals and will not reduce the overall market float, the robust activity serves to keep an underlying bid for equities.
Valuation: While the current frenzy of private equity and merger activity is more reminiscent of market tops than market bottoms, the valuation for the stock market remains reasonable, especially in a low interest rate environment. The S&P 500 Composite now trades at 17 times expected earnings for 2007 and 15 times expected earnings for 2008. Given the current earnings momentum for U.S. multinationals, we have increasing confidence that U.S. stocks can deliver mid to high single digit earnings growth through 2007 and at least into 2008.
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