Newsletters 2008 Newsletters Outlook for 2008 (1/08)
Tuesday, 15 January 2008 00:00
In our January 2007 newsletter, we predicted that the S&P 500 would “trade approximately 10% higher in 2007 to 1560, breaking through the previous all-time closing high of 1527”. While we feel vindicated in our prediction, since the composite of all Osher equities under management gained 10.04%, the S&P 500 did not follow suit and closed at 1468 with an annual gain of just 3.53%. The Dow Jones Industrial Average and NASDAQ Composite closed the year with respective gains of 6.43% and 9.81%.
Given the large disparity between Osher equities and the S&P 500, it is clear that 2007 was a year when stock selection and sector preference made an enormous difference. Our focus on high-quality growth companies with strong international operations proved a winning bet in a year mired by the subprime mortgage crisis and ensuing credit crunch, a weakening dollar and an emerging economic slowdown in the U.S. Our underweight investment in the financial and consumer discretionary sectors proved especially prescient as the S&P banking and retailing indices moved through official bear market territory with declines approaching 30%. Similarly, our preference for large caps over small caps boosted performance as the Russell 2000 is now down 19% from its recent high and just within reach of a bear market.
2008 has started with a thud as the weaker-than-expected payroll and ISM manufacturing reports gave investors fresh evidence that the U.S. economy may be on the brink of recession. To be sure, the 18,000 new jobs created in December was the worst monthly report since August of 2003. And the 5% unemployment rate, up from November’s 4.7% rate, was the worst level since November of 2005. The relatively strong job market and low level of unemployment had been an anchor for the bullish case; especially since a strong labor market is seen as an antidote to the collapse in housing prices. While the risk of recession has clearly risen, we believe that the Federal Reserve will act more aggressively to help ward off any long-lived economic contraction. With core inflation running at 2.2% year over year and with the recently released Fed minutes acknowledging that monetary policy remains “restrictive”, the Fed has the flexibility to do what is necessary to stimulate the economy and ease the credit crisis. The Fed Funds futures now predict a 80% chance for a 50 basis point cut by the end of January.
The rising odds for recession have not been lost on the bond market, with the yield on 10-year Treasury bonds now just over 3.8%. With bond yields so low, we can’t help but make a case for equities in the current environment. The “earnings yield” valuation model compares the yield on the 10-year Treasury bond to the inverse of the stock market’s forward PE – the theory is that these two yields should approximate one another when valuations are “right”. With the current earnings yield for the next four quarters at approximately 6.5% and the 10-year Treasury below 4%, this model suggests that stocks are undervalued by over 40%. With fear of a housing-led recession, oil near $100 per barrel, the looming uncertainty of a Presidential election, war in Iraq and the threat of geopolitical unrest in hot spots such as Iran and Pakistan, we do not expect this hypothetical 40% valuation gap to close in the near future. We do, however, believe that stocks are attractively priced and should handily outperform bonds over the next several years, especially since we see slim odds for yields to move materially higher over the intermediate term.
Standard & Poor’s estimates that 2007 operating earnings for the S&P 500 will close at $87.45, just below the $87.72 reported for 2006. This slight contraction in earnings is entirely due to the massive write-offs in the financial sector. Excluding financials, earnings growth would still be positive. In fact, fourth quarter earnings are expected to be positive for all sectors except financials and materials. Standard & Poor’s currently pegs full-year 2008 operating earnings estimates at $101.09. So, at the 2007 year-end value of 1468, the S&P 500 trades at a trailing PE of 16.7 and a forward PE of 14.5. If the stock market were to trade at the same 16.7 PE multiple and hit this earnings target, it would imply a price target of 1688 on the S&P 500 for an approximate 15% annual return. If we take a more conservative $94 estimate for 2008 earnings to factor in the likelihood for further reductions to earnings estimates (half of the growth of what Standard & Poor’s currently estimates), it would imply a price target of 1569 on the S&P 500 without any PE multiple expansion.
While we cannot ignore the increasing odds for recession, we can’t remember a time when such an event was so widely prognosticated. Pessimism seems to be especially acute and the markets already seem to be discounting much if not all of the bad news feared. The American Association of Individual Investor’s Survey on Investor Sentiment currently shows 55.24% of survey respondents as bearish with only 25.71% bullish – this is among the most lopsided readings of bearishness in the survey’s history. TrimTabs reports that outflow from equities in November and December of ’07 matched the largest successive monthly net outflows since the August-September period of 2002, the bottom of the last bear market. And the current list of new 52-week lows on the New York Stock Exchange is at its highest since October of 2002. With so much negativity already priced in the stock market and so much cash on the sidelines, the surprise in the stock market is likely to be on the upside. We don’t think it would take much good news to spark a rally in the major indices. Our expectation for the next 12 to 18 months is for a range in the S&P 500 of 1375 to 1675, with 1610 our current year-end price target, equating to a potential 10% annual return.
Fourth quarter GDP is expected to come in at 2%, even in the midst of the worst housing slump since the Great Depression. U.S exports ought to continue to make up for the slack created by housing, especially since emerging economies are enjoying secular growth and the dollar is unlikley to rebound sharply given the likelihood for further rate cuts here in the U.S. Not only is there an abundance of U.S. investor cash on the sidelines (over $3 trillion in money markets from instirutional and retail investors combined) and on the balance sheets of Corporate America ($2 trillion estimated for S&P 500 companies), there is a an approximate $3 trillion hoard of sovereign wealth funds that has only begun to invest in U.S. companies. With interest rates and valuations so low and with the Federal Reserve expected to continue cutting rates, we continue to favor high quality growth stocks.
Please contact us with any comments or questions and remember to advise us of any changes that might impact the management of your investment portfolio. We look forward to a prosperous 2008.| < Prev |
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