Guarded Posture... For Now...
We start the new year with a guarded view of financial
markets. Specifically, we expect the past year's
volatility to spill into 2008 and cause financial markets to
remain volatile as they adjust further to a weak economy.
The economy continues to struggle against a housing
recession that could last for several years; consumer
indebtedness that has reached a record 130% of disposable
income (was 90% pre-2000); and ongoing credit issues which
should continue to manifest itself in a variety of ways for
some time to come. We also think today's profit and
growth expectations are too high and are likely to be cut
with business' response to falling profits remaining the
critical "swing issue" for 2008. As this all unfolds,
we expect risk aversion to remain high and traders to be
short-sighted and intolerant of negative surprises.
Until adjustments are made and fundamentals once again begin
to show positive momentum, equity markets may find it
difficult to sustain rallies.
2008 could also be a year that refreshes investor appetites
and becomes the staging ground for a renewed equity bull
market. We note that most of the recent excesses in
investing (i.e. real estate, emerging markets, credit markets,
and commodities) have occurred away from the mainstay U.S.
equity markets. The S&P 500 is essentially at the same
level it was at the start of the millennium, and
large-capitalization stocks have returned little more than
2% above the long-term Treasury bonds over the last twenty
years (that same number was close to 6% when Alan Greenspan
made his infamous statement about "irrational exuberance"
ten years ago). Now, with the S&P 500 trading closer
to its underlying earnings potential, we can begin to
envision a bullish case emerging once we navigate through
the choppy waters that we see immediately before us.
The equity markets, measured by the S&P 500, have advanced for each of the past five
years. This stretch of uninterrupted gains was
accompanied by a long stretch of rising quarterly profit
growth. This growth ended in the third quarter of
2007. We also saw an end to growth in non-financial,
economy-wide profits in the second quarter of 2007,
according to data found in the National
Income
and Product Accounts. This also was the quarter that
equities began to lag in performance compared to long-term
Treasury bonds (see chart). Despite the data and the
markets' reaction, most analysts expect earnings growth to
rebound sharply in the second half of 2008 and produce
another year of double-digit growth. We believe that
peak profit margins, trough tax rates, rising credit costs
and slower domestic volume growth might make it more
difficult for companies to generate earnings growth much
above 5-10% for the year, net of dollar translation effects.
Pulling it all together, we see the potential for a recovery
in equity prices following some initial volatility early in
the year with a 5-10% rate of return on major market indices
from current levels. Our initial "fair value" estimate
for the S&P 500 at year-end 2008 is in the range of 1,550 to
1,625 with a midpoint target of 1,588. Further drops
in the Federal Funds Target Rate are likely, and longer-term
yields are likely to be stuck near current levels so long as
core inflation on personal consumption remains in the range
of 1-2%, excluding food and fuel, and below 3% overall.

The economy decelerated in 2007 as the unemployment rate
rose to 4.7% from 4.4% in 2006 led by a deceleration in
private sector job creation. Year-over-year, private
sector job growth has slowed to a "stall speed" growth rate
of 1%. While employees of the government certainly
count in the economy, the hiring trends in the private
sector tell us more about the forward view on the economy as
businesses expand and contract hiring plans. We
continue to see layoffs in the Financial and Construction
industries, which threaten to jeopardize overall private
sector job expansion in 2008, and therefore, we expect the
unemployment rate to rise to above 5% during the year.
With further slippage in job creation likely, we envision an
economy which starts out with negative-to-slightly positive
real growth in the first half of the year accelerating to a
low single-digit growth rate later in the year. We
note that slippage in demand in the United States has had
the effect of depressing the dollar throughout 2007.
Taken together, the lower demand for imports coupled with
currency driven exports, has served as an "automatic
stabilizer" for domestic production as calculated by the
Bureau of Economic Analysis. With the dollar already
off significantly from its highs and other banks such as
the Canadian, Australian, and British central banks have
already taken action to lower rates in response to what they
see as slowing growth, we expect to see narrowing trade
deficits to contribute less to GDP growth next year while
trends in consumption and investment remain soft.

Our asset allocation has moved from decidedly underweight
equities to a more neutral posture. We continue to
emphasize larger-capitalization growth stocks in the United
States along with some foreign exposure in growth related
sectors and countries with strong international trade and
growth profiles. The income and defensively oriented
portion of portfolios currently stress higher-quality
credits, laddered Treasuries, and a modest exposure to gold
as a hedge against a weak dollar.

Our recommended sector allocation continues to emphasize
those sectors that are consistent generators of earnings or
exhibit a strong long-run secular growth dynamic. The
sectors are concentrated more heavily in those groups whose
earnings are less leveraged to changes in global economic
growth rates.

We begin 2008 with a guarded outlook and lingering concerns
about credit, real estate, and the consumer. The
largest potential "swing factor" for the year should be
business' response to the changing environment. We
continue to monitor the relative performance between stocks
and bonds, private sector employment, and profits to identify
a potential entry point for signals as to what comes next
for the economy. However, as we navigate these
volatile markets, we expect to find opportunities. We
still perceive value in large-capitalization equities and
sectors that demonstrate consistent growth in earnings.
Our year-end target for the S&P 500 is 1,588, and our
year-end target for long-term Treasury bond yields is 4.5%
with a 3.5% Fed Funds Rate. |
Past Commentaries
December 7, 2007
NBER President Raises Recession Concerns
More
November 28, 2007
Equity Risk Heightened - Allocation Remains Defensive
More
September 25, 2007
After the Rate Cut
More
July 30, 2007
The Case For Growth
More
June 15, 2007
Data Affirms Tactical Asset Allocation Posture
More
March 19, 2007
Cutting Earnings And Equity Target
More
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