News & Insights
Current Market Environment - Earnings are Great but What About Next Year?
Earnings this year have been great, posting strong year over year improvements in the first quarter. The second quarter looks promising as well. Stocks are attractively valued relative to bonds. With the market trading at a modest 15-16 times earnings, it would appear that the stage is set for a strong broad equity rally.
Appearances in this case are deceiving, in our view. P/E multiples are unlikely to expand as the current profit improvements complete their third year. Analysts are busy increasing estimates, having been a bit surprised by the durability of this profits expansion. We believe this all adds up to a likely stock market bounce without much follow through since the earnings growth expansion must finally run out of steam in the next few quarters. It would seem that for planning purposes, an investor can plan on the S&P 500 being anywhere from 8% higher to slightly lower than its current level in 2006.
Much of the stimulus applied to the economy over the past three years is being removed. The Fed is raising short-term rates, some big tax incentives built into the code in 2001 have expired, and there is a renewed focus on trimming the government deficit. This adds up to a mild headwind for stocks. There may be a short-term bounce when the Fed quits raising rates later this year but this effect should be short lived.
Without a rising tide, this leaves nothing but good old earnings and stock selection to do better than just show in the investment return stakes. This current uninspiring outlook for the broad market provides a good backdrop for high-quality shares (companies with sound dividend policies and steady earnings) to outperform the market. Also, non-cyclical names (such as those in Health Care and Consumer Staples) should take away the performance lead from the more economically sensitive stocks.
A slowing European economy and the continued malaise of the Japanese consumer masks some exciting developments in rapidly expanding countries in Asia and Eastern Europe. In our view, it is appropriate to remain fully exposed to the international markets, with a slight emphasis on smaller growth companies and emerging markets. These markets are still attractively valued vs. the U.S.
Real Estate - Potential Bubble Bath?
There should be very little serious debate that the real estate market is in a potential bubble phase in certain key economic cities and regions such as the Northeast and in California. If the bubble bursts in those regions, the economic fallout would not be limited to New York or L.A. However, bubbles can take a long time to build after it is apparent that speculative activity is driving the market. Investors in real estate, either directly or through publicly traded REITs, should have a firm grasp on the appreciation they expect and be prepared to sell or underweight the asset class when that target is achieved, not reaching for the very last dime of return. As much as possible, these investors should also avoid investing in highly appreciated properties with borrowed money. Possible declining property values combined with leverage is a recipe for a disaster.
The Altavista Investment Team-Summer 2005