Key Risks Challenging This Market

The Dow continued to press higher this week producing a frothy media focused on an arbitrary number, Dow 12,000. For most investors the Dow isn’t a very good representation of their portfolio, so it is more a psychological factor than a representation of economic strength. Our current market strength can be boiled down to two predominant factors: Low long-term interest rates and corporate earnings strength. To understand where the market is headed from here it is essential to understand the risks surrounding these factors.

Low long-term interest rates are the result of a Fed that was forced to suppress rates excessively to stimulate economic growth. What has kept them low is a subject of much debate. The leading arguments have to do with foreign demand for bonds driving prices higher and limiting yield expansion. The yield curve is currently inverted which has historically meant an economic slowdown is imminent. The severity of the slowdown is closely linked to the steepness of the inversion. Many economists agree the mild inversion we are experiencing places the probability of a recession at 25-30%.

The fly in the ointment is inflation. The Fed’s pause is predicated on their rate cycle campaign having the effect of slowing the economy enough to avert demand enough to lower inflation. The Conference Board’s Leading Indicators has been down five out of the last eight months and housing is still sliding, but neither of these seems to be enough to slow inflation and the Fed is getting visibly worried. Yellen, Fisher and Plosser, three of the twelve voting members of the Fed now are openly expressing concern that inflation is gaining a foothold on the economy calling into question the resolve of the Fed’s current neutral policy.

It is widely expected that the Fed will hold fast next week because they don’t want to monkey with the markets two weeks before an election, but with key inflation indicators like the Commerce Department’s Price Deflator touching 11 year highs, the Fed will be forced towards a more hawkish stance if the data does not change soon. Hopefully for the markets the sharp drop in energy prices and the aggressive pricing by auto companies will soon start to show up in the data and ease Fed fears.

The big risk to the markets in 2007 will be earnings. Q3 2006 looks to like it will be a 15% year over year growth number for earnings for the S&P500. That is well above the mean trend of 8%. We are on pace for similar growth in Q4, which would mean the longest stretch of double digit earnings growth in history.

At some point in 2007 companies will probably have to reduce guidance. Depending on the economic climate at the time this could lead to a couple quarters of lackluster performance. My thesis has been for weeks that the downside is limited by what I perceive to be relatively low valuations, but should the Fed continue to fret over inflation and offer investors a higher yielding alternative, the stock market’s valuation could shift leaving room for further downside.

Our current rally is puzzling. It has been led by high beta and cyclical stocks, not the normal candidates for appreciation in our phase of the economic cycle. Another interesting development has been the weakness in transports. The divergence between industrials hitting new highs and the transports continuing to lag might be looked at as a divergence between earnings and the economy. Without some sort of confirmation, impetus for growth or justified leadership we may be seeing a signal that our rally has a cap. Statistics tell us that Q4 of an In-Term Election Cycle tend to be very positive for equities, but the future of 2007 continues to look murky as the Fed is finding it increasingly complex to thread the needle of a soft landing. At some point the market will begin to discount this uncertainty.