This winter causes us a little discontent since we can see both the positive and negative influences on the markets making a definitive call on 2006 more difficult than the last three years. Stocks are not on sale to the same degree as, say, televisions at Wal-Mart, neither are they expensive. At 16 times trailing earnings, the S&P 500 seems reasonably priced, particularly when compared to bonds.
Dollars invested in the average S&P 500 stock will yield 6.25% in earnings: the 30-year Government bond doesn’t even pay 5%. Corporate profits have been growing for a time and to an extent that has surprised many. The pattern seems clear: profit growth in the market is set to slow to just above 10%, down from the 20% growth rate in 2004. To a large extent, this has been anticipated by the drop in the P/E multiple from 20 in early 2004 to the 16 cited above. The stock market multiple has a habit of increasing a bit when the Fed ceases a tightening cycle, and we suspect this will happen in the next few months, supporting the notion that profit deceleration will not derail the bull market that has been rolling since 2003. So far, so good.
On the Other Hand…
Our big concerns are not with market technicals or company fundamentals, but instead are focused on structural economic imbalances that threaten the consumer, the dollar and the general U.S. economy. Chiefly, we are concerned about the effects of the large negative trade balance (now at unprecedented record-setting levels), the dependence of the U.S. consumer on home equity borrowing to finance consumption and the resulting negligible savings rate. The consequences of a dramatic unwinding of these unsustainable trends in savings and imports could be serious.
As the bull housing market unwinds, the consumer is likely to retrench with available credit exhausted. Feeling poorer with shrunken home equity, spenders may go on a savings binge to rebuild wealth. This could knock the pins out from under consumer spending, company profits and ultimately stock prices. It tests the limits of our optimistic nature at Altavista to believe that this will all come to equilibrium in a benign fashion, and we will continue the mildly defensive stance we have maintained since early in 2005.
High-quality shares (low leverage, predictable, steady earnings and dividends) that dominate our U.S. portfolio have rarely been as attractively priced when compared to riskier stocks. A reversion to normal will reward the investor in higher quality shares when compared to investors in the dodgier growth stories that have, in tortoise and hare fashion, raced ahead recently.
Foreign shares, most particularly emerging markets stocks, have continued their winning ways. In 2005, the MSCI Emerging Market Index and the larger MSCI EAFE trounced the big stocks of the S&P 500. We expect this to continue for two reasons. First, markets outside the U.S. remain attractively valued; and, secondly, strong economic growth outside the developed nations is fueling robust profit growth, making it likely that valuations will increase. However, if the S&P stumbles significantly, say over 10%, then we expect that emerging markets shares will get trounced, not based on fundamentals but in the mild panic of a flight to safety.
Last year we believed that commodities would pull back from their highs of 2004, but that global demand would support higher prices for industrial commodities by the end of 2005. So far that has come to pass. We still believe that a portion of a client’s portfolio should hold exposure to basic economic inputs though natural resources stocks and commodity funds. History has shown this to be a good hedge against a weak dollar as well as a proxy for the industrial growth in the developing world.
Bonds & Interest Rates
Uncertainty with regard to interest rates is rooted in the structural deficit problems referred to above. If our trading partners continue to purchase U.S. bonds in a bid to support our free-spending, import-hungry ways, then long-term rates should stay within one-half of one percent of today’s low rates. This seems likely to us. It is in all parties’ interest to keep the current unhealthy process, with the profligate, tapped-out U.S. Consumer purchasing armloads of imported goods from developing countries. This process cannot go on forever and when it unwinds it could be painful, with rising rates, a falling dollar and lower asset prices. However, it does not appear to be an immediate threat.
Investment allocations to attractively valued asset classes such as foreign shares, commodities, and real estate have provided excellent returns in the current bull market particularly when compared to investors who invested chiefly in large blue-chip equities. In our view, a mildly defensive stance (more cash, short bond maturities, emphasis on high quality shares, commodities and international markets) is the way to navigate this environment, despite the recent rally in the market. If the market breaks out to the upside, then we will participate. However, if turbulence develops in the market or the economy stumbles, we will have the luxury of taking a more aggressive position at lower prices.
The Altavista Investment Team - Winter 2006