Investment Outlook, 2007
January 1, 2007
Y2K and 7
Certainly you remember Y2K. It was the political and economic myth that forecasted all kinds of bad things as the calendar flipped from 1999 to 2000. Since computers were not programmed to handle digits higher than 1999, they would crash, dooming the nascent digital economy; planes would fall from the sky; and, actually, we can’t remember all the other disasters which were supposed to transpire, but didn’t.
But wait! Shortly after 2000 began, the great “Bull Market” of the 1990s came to an end and U.S. stocks went into the worst “Bear Market” since the early 1970s, some say since the 1930s! The bear market preceded, as bear markets always do, the recession of 2001, which was the first in over a decade. Like the recessions before it, it was brief and shallow (so brief and shallow that it didn’t even show up as a decline in year-over-year GDP for 2001). Then, 9/11! So maybe the “doom and gloomers” were right about Y2K but for the wrong reasons.
The fallout from this bad stuff continued for another year or so after 9/11, but since late 2002 the economy and financial markets, both domestically and internationally, have been okey, dokey! In fact, the past five years have been about the best period for global economic growth on record. As can be seen from the charts below, global economic growth has been growing consistently and getting less volatile for quite some time.
Stock markets around the globe have also been doing well over the past four years, as can been seen from the chart below.
As capitalism took root around the world, hundreds of millions, if not billions, of people have gone from abject poverty to what they consider middle class, even if by U.S. standards they are still dirt poor. Except for a few pockets of stubborn stupidity, most countries have adopted free, or a least freer, market economic policies and free, or at least somewhat free, trade. Globalization, which many still condemn as unfair, has contributed mightily to a great thirty-year run of global economic expansion and increasingly subdued inflation. And importantly, from where we sit, the outlook doesn’t look that bad.
The United States is in a long-wave, technologically oriented expansion that has led to longer and stronger economic expansions and shorter and milder downturns which, by historic standards, barely qualify as recessions. However, this does not mean that occasional setbacks won’t happen. But, and it’s a big but, as long as politicians don’t turn to counterproductive fiscal policies things could chug along nicely for quite some time. Things to keep your antennae up for include higher taxes, more regulation, protectionism, and less of a commitment to free trade. Also, be on the outlook for an escalation of class warfare and the politics of envy. The bottom line, in Montgomery Brothers’ opinion, is growing the economic pie, not on how to best divvy it up.
Currently, the United States has about the lowest level of government spending as a percentage of the total economy as any developing country. Unsurprisingly, we also have the strongest growth. And, with its commitment to free trade, the United States remains the global economic growth engine. Asian economies, especially those of China and India, depend on the U.S. to help fuel their export-oriented growth while their domestic economies mature. It’s highly unlikely that global central banks, especially those of Asia, would stop lending the United States money to buy their goods. The current set-up is a global win-win. So next time someone tells you that the U.S. trade balance will lead to our demise, ask them why? And, ask if they remember Y2K?
Economic Outlook
We’re not really sure whether we’re sicker of hearing about the “goldilocks economy” or of hearing about a “soft landing,” but either is certainly preferable to a recession. Ironically, due to the size and diversity of the U.S. economy, most Americans would only know that the United States was in a recession by learning it from the media. Even more ironically, many Americans believe that we are always in recession due to the media’s overly negative coverage of all things economic.
Fueled by stimulative fiscal policy (some might consider it more sound than stimulative) and lubricated by enormous monetary stimulus, the U.S. economy has rebounded well from the brief and shallow recession of 2001. The U.S. economy seldom needs the fiscal and monetary oversteering that is provided by politicians and the Fed since it does a great job self correcting. In fact, Montgomery Brothers is always impressed by how well the economy weathers all the well-intentional abuse heaped on it by the politicians. At any rate, as you can see from the chart below, economic growth has been purdy darn good recently.
While the United States has certainly entered a patch of slow economic growth, we feel that the doom and gloom is, as usual, more than a little overdone by a hyperventilating media. Let’s see if we can’t slay some of the more popular economic shibboleths.
Near the top of every doomster’s list of worries is the overextended, debt-burdened consumer. These poor schmucks spend too much, save too little, and are in hock up to their eyeballs. Tomorrow, or certainly the day after, they will close their wallets and go into spending hibernation. Without a doubt, there are some dopes who borrowed too much and/or unwisely, and we’ll read about their plight, but many, probably most, Americans are in good financial shape with debt levels that are in line with their expanding net worths and growing incomes. Rising stock prices are offsetting flat to declining home prices, which, like most stocks from 1995 to 1999, have gone through a protracted period of rapidly rising prices. Shown below is a chart which overlays median home prices from 2001 to 2005 with the S&P 500 for 1995 to 2002.
Draw your own
conclusions.
Housing will always slump after a boom. It does so because home building is cyclical and generally gets way overdone by nutty speculators fueled by easy money. New home building will decline until inventories are worked down, and existing homes for sale will either be withdrawn from the market or see their asking prices slashed by motivated sellers. That’s how it works.
We also are regularly (constantly?) subjected to the impending disaster which will result from the evil twin deficits. The trade deficit, mentioned above, is the larger of the two. As the U.S. economy downshifts to slower growth, our imports, which are mostly of consumer goods, will similarly slow. Additionally, even if foreign economies also slow, U.S. exports, which tend to be higher value added and are more industrial in nature, should continue to expand. Why, if the United States is about to collapse, as Lou Dobbs keeps warning us, do so many countries, and more importantly, private investors (who represent over three-quarters of the purchases of U.S. stocks and bonds) keep buying our debt and equities? Could it be that investing in the most politically stable, freest market economy with the most liquid and transparent financial markets in the world appeals to an awful lot of people?
And what about the federal budget deficit? Why, if the federal budget deficit is shrinking, in what Larry Kudlow refers to as “the greatest story never told,” is it still viewed as such a problem? In spite of federal spending well in excess of GDP, the budget deficit is declining because tax revenues are growing even faster than spending. The federal deficit is now down to around 2½% of GDP which is less than most other developed economies. Plus, our economic growth is faster! Since Congress was unable to pass many appropriations bills, much of the government’s spending for fiscal 2007 is frozen at 2006 levels. This essentially guarantees a smaller budget deficit for the current fiscal year. Beyond that, Democrats claim to be adherents of “pay-go” policies, while President Bush is likely to veto any “revenue enhancements” (a.k.a. tax increases) which we believe might actually slow the growth of taxes. If the budget deficit (and federal debt for that matter) are such a worry, why are long-term interest rates near 40-year lows?
The U.S. economy appears to be on relatively solid footing with job growth decent, incomes now expanding and consumer net worth high. Corporations have record amounts of cash on their balance sheets, with record profit margins and record returns on equity. The state of the federal budget is acceptable and trade is likely to be less of a drag on growth than the statistics currently indicate. Inflation seems to be decelerating, interest rates are low, and the stock market is up. While it isn’t all blue skies and green lights, it certainly isn’t the dire predicament it’s often painted to be.
Interest Rate Outlook
By raising the discount rate a couple of times early in his tenure and holding it at current levels while economic growth has slowed and inflation has decelerated, Ben Bernanke has gone a long way toward establishing his inflation fighting bona fides. While many point to the inverted yield curve (see below) as a harbinger of recession, Montgomery Brothers believes it at least partially validates the Fed’s inflation fighting credibility.
While the Fed has not drained very much of the liquidity from the system which it created earlier in the decade, the more recent price of gold and the dollar have lessened our concerns from earlier in 2006 when both were screaming “INFLATION!” While most debate whether or not the Fed will be able to pull off a soft landing, we wonder why the Fed is trying to steer the economy in the first place. Why doesn’t it focus on its main job of maintaining the purchasing power of the dollar? We should be more worried about the potential debasement of our currency (a.k.a. inflation) than about the possibility of recession.
The economic bears point to the yield curve as proof positive about the impending recession. While one certainly can’t rule a recession out, there are other indicators (even in the bond market) that a recession is unlikely. Yield spreads are narrow, the prices for credit default swaps are low, and the spreads between plain vanilla Treasury and TIP yields are minimal.
Bernanke has said many times that monetary policy is now data dependent. Recent revisions show that government data is not always dependable. In a recent speech, Fed Vice Chairman, Donald Kohn, stated, “We are uncertain about where the economy has been, where it is now, and where it is going.” This does make us a bit nervous since the Fed often errs in its judgment calls and actually failed to predict either of the last two recessions. Most continue to say that the Fed is the key to the outlook. GULP!
Montgomery Brothers has been more standoffish on bonds than maybe it should have been, but it really hasn’t had a huge effect on our bond returns since cash equivalent yields have risen to above those available from intermediate and longer-term Treasuries. While junk and foreign bonds have produced greater total returns than Treasuries and corporates, we do not believe those returns justified the risks. We are considering buying five-year maturity U.S. Treasuries as the possible “sweet spot” bond money investment, if and when the Fed decides to ease. Montgomery Brothers believes that five years is the approximate pivot point for a steepening in the yield curve should the Fed shift policy (yet again.)
Stock Market Outlook
While “inverted yield curve” is the battle cry of the economic bears, the stock market is the battle standard for the economic bulls. While the second year of a presidential term is historically the weakest of the average four-year cycle for stocks, this certainly was not the case in 2006. The total return for the S&P 500 in 2006 was 15.8% and, as can be seen from the chart below, everything from the largest cap (Dow Industrials) to the smallest (Russell 2000) participated.
[RUTZ = Russel 2000; INDU = Dow Jones Industrial Average; SPX = S&P 500 Index; COMPQ = NASDAQ Composite; MID = S&P Midcap Index.]
Montgomery Brothers readily admits that it was too cautious on stocks during 2006, but we are always happier to wonder why stocks are going up than to know exactly why they’re going down. You don’t have to look far to find reasons why stocks did well last year. In spite of rising short-term rates, longer-term rates were little changed. Even though the economy slowed, corporate profits continued to grow much faster than the economy. And, with a slowing economy and slumping housing market, liquidity flowed into financial assets, in general, and stocks, in particular.
Quite simply, the reason that stock prices have been rising is MONEY! If “this time it’s different” was the mantra going into Y2K, “this time it’s the liquidity” was the mantra for Y2K+6! As is usually the case, Wall Street backs a logical explanation into every void. Bullishness is now fairly rampant except among individual investors. Even perma-bear Merrill Lynch equity strategist, Richard Bernstein, has turned bullish. Talk about being late to the party!
As was the case in 2005, earnings went up faster than stock prices in 2006 so price/earnings multiples declined. Will Y2K+7 make it three in a row? Once again we will forecast that large cap growth stocks will outperform small and mid caps. Actually, since the May to June market correction ended, large caps and small caps have outperformed the S&P 500, and all have outperformed mid caps. (Mid caps have, however, outperformed in virtually every period measured over the past twenty years, so we’re due for a breather.)
While we remain cautiously optimistic (the ultimate investment cop-out), we again point to the brazen lack of regard for risk by too many market participants. When the stock market posted middling gains in 2005, many turned to hedge funds and other alternative investments in order to garner (hopefully) higher returns. While many hedgies and alternative investors claim to be risk averse and negatively correlated to the market, an awful lot are just plain riverboat gamblers. As the market picked up steam, the performance of many of these investments started to lag the market. Who needs to pay 2 and 20 to be beaten by an index? The only logical solution for these guys was to throw money at their stocks and to lever-up their returns in order to play catch-up ball with the indices. After all, their bonuses were at stake! But now that we’re into Y2K+7, will they, as the Shirelles once sang, “still love me tomorrow?”
We’ve been consistently impressed not only by the blatant disregard for risk but also by the incredible internal strength of this move. There have been no significant pullbacks that allowed anyone to sneak into the market on the cheap. Those left behind will tell you that this market is getting tricky and that the easy money has been made. I’ve been doing this for 32 years and can’t remember when easy money was made on Wall Street. You gotta assume risk, sometimes a lot of risk, to make that easy money, especially four years into a bull market.
We continue looking for opportunities to buy good companies on the cheap or above-average earnings growth companies at reasonable valuations. More people playing the game make it harder to find such opportunities. The high-quality and cheap large-cap growth stocks that look good to us have names like AIG, Amgen, Apache, Home Depot, Intel, Tyco, and Wells Fargo. Growth at a reasonable price (GARP) names that look like above-average investments to us include Arch Capital, Bed Bath and Beyond, BHP, Carnival, E*Trade, Nabors, Sasol, Teva, and Verisign. Lastly, turn-around situations such as Corning, DuPont, and Medtronic are of interest.
Happy Y2K plus 7!
January 1, 2007
John E. Montgomery
7475 Wisconsin Ave, Suite 810
Bethesda, MD 20814
301-652-6950 Phone
301-652-6954 Fax
888-293-6668 Toll Free