News & Insights
Summer 2006 Outlook
At Altavista, we have struck a defensive tone since early 2005. As the market continued to rally (although weakly) in 2005 and early 2006, we were beginning to believe ourselves either wrong or inappropriately early. The market action of the past six weeks has, at least temporarily, justified our defensive posture.
During the second quarter, the S&P 500 declined 1.90%. Money market funds have outperformed the S&P 500 so far this year. Riskier asset classes such as emerging markets have been hit harder. The sell off was almost certainly precipitated by the Fed's pronouncements regarding recent higher inflation readings. We believe inflation is contained at a higher level than we have experienced in the past 4 years but will plateau ata level that is comfortable for long-term investors.
We also believe that the U.S. economy is experiencing a mid-cycle slowdown from the fairly brisk 4% plus GDP growth of the past few quarters. Profit growth for the companies of the S&P 500 will likely soften as well.
Even with profits slowing, the economy cooling and inflation heating up, we are becoming more encouraged about the U.S. stock market. Why are we moderating our defensive tone we have sounded since early 2005? The answer lies in valuation.Our long time clients know that we place great store in the valuation (how cheap or dear a security or group of securities is relative to its history or other benchmark) of assets as a starting place for analysis. Currently the market is just a bit more expensive than its average for the last 60 years. Buying opportunities often arise when the market crosses its 60-year median valuation.
Our bullish stand on U.S. stocks in late 2002, and early 2003 (not coincidentally) occurred when the valuation of the market settled briefly in that range. As our Winter 2005 note indicated, we switched to a more defensive outlook when the valuation of the market rose significantly above that range.
In the interim, robust earnings and a sluggish stock market began moving the valuation of the market towards its median again. During this time we have emphasized quality shares with defensive traits and we have held more cash and short-term instruments than usual. This is still our posture today, but we are poised to take a more aggressive stance as prices have become more attractive.
International shares (especially emerging markets), which have led the performance derby over the past several years, have taken it on the chin recently. In our Winter 2006 quarterly note, we said that if the S&P had a significant loss, emerging markets stocks would likely take an even bigger tumble. That has come to pass. On June 19th, the S&P 500 was down roughly 4.3% for the quarter while emerging markets equities (as represented by the MSCI Emerging Markets index) are down over 12%. This stems from two reasons, in our view. First, in a generalized market decline, there is a "flight to safety" in which investors seek refuge in less volatile assets. Second, the emerging markets are more heavily weighted toward natural resources shares (oil, gas, mining), which have pulled back significantly. We believe that this shakeout will render the emerging markets at an attractive entry point. At the most recent price top this spring, the emerging markets were only trading at 12 times earnings, so they were not expensive. The countries in the index are in much better financial shape (trade surplus, lower debt) than they were during the last sell off almost a decade ago. To us, this means that they should be more resilient this time.
As inflation concerns have increased, the 10-year treasury yield has stayed just above 5%. This, in our view, reflects a rational response to an expected economic slowdown and reduced inflation expectations. This also supports the idea that inflation is contained. We anticipate bonds will rally (move up in price, down in yield) as the economy slows below its current trend.
The Altavista Investment Team – Summer 2006