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The Goldilocks theme is dominant on Wall Street, as markets have embraced the view that growth remains firm while inflation pressures are easing, and consumer spending appears to be weathering the housing downturn just fine. Wall Street is convinced that the combined tailwinds from low unemployment, rising incomes, record net worth, rallying stock prices, and lower long-term interest rates and energy prices are more than sufficient to offset the headwinds to consumption from a downturn in the housing market.

This confidence is reflected in the performance of consumer discretionary stocks, which have been outperforming the broad stock market since early September, and was reinforced last week when the Commerce Department reported that retail sales in November (ex. autos and gasoline) increased at the fastest pace since January. Support for the Goldilocks premise is also found in the recent firming in leading economic indicators from the Economic Cycle Research Institute [ECRI]. The growth rate in ECRI’s leading economic index recently hit a 29-week high, prompting ECRI to comment: “Though the U.S. growth outlook remains lackluster, recession risks have clearly receded.”

Although the weight of the evidence currently supports a constructive growth outlook for 2007, and the soft landing scenario should at present be our baseline assumption, we remain concerned about the consumer’s status, and continue to believe that consumer spending could weaken significantly in 2007. We think it is premature to conclude that because the housing contraction hasn’t yet adversely affected consumer spending it won’t in the future. It could be that consumer spending is reacting very slowly to the still unfolding correction in housing.

In particular, we have yet to see the full effects of the removal of the stimulus from home equity extraction. Extensive mortgage equity withdrawals played a key role in stimulating growth in consumption, and that dynamic, which is now over, seems to have been forgotten or minimized by Wall Street. More broadly, the housing boom has been a major driver of economic activity and employment in the last several years, so the current downturn continues to warrant caution in terms of its potential effects on the economy and the financial markets. There certainly appears to be room for disappointment in the markets, as Wall Street
has concluded that the housing slump will not inflict any serious damage on employment or consumer spending.

At the start of the year, we expected the economy to slow as the year progressed, primarily due to the anticipated housing correction and the effects of higher interest rates. Along with this slower economic growth scenario, we thought corporate earnings growth would also fall. We have been correct regarding slower GDP growth, but reported earnings growth has been better than our expectations.

It is certainly impressive, and somewhat of a conundrum, that earnings have continued to increase at low double-digit rates, despite slowing GDP growth, energy and commodity price shocks, and tight labor markets, which have put upward pressure on unit labor costs. Looking ahead to next year, Wall Street expects continued strong earnings growth in the high single digits, which implies a further widening of profit margins that are already at record levels. (Profit margins are 35% higher than levels that prevailed in the 1990s, implying that if margins were adjusted to 1990s’ levels, the P/E ratio of the S&P 500 would currently be 25x, rather than 18x).

Slowing Corporate Earnings?

Thus far, guidance from corporations has yet to contradict Wall Street’s bullish 2007 forecast. In fact, according to Zacks Research, which tracks earnings estimate revisions on a rolling four-week basis, revisions to 2007 earnings remain in an upward trend, with estimate increases for the S&P 500 exceeding estimate cuts. As a result, another year of robust earnings growth is being factored into stock prices, which implies that the stock market may be vulnerable if 2007 earnings guidance begins to turn negative and earnings performance proves disappointing.

If the economic and earnings outlook for 2007 deteriorates, we will begin to see earnings estimate cuts exceed estimate increases, which has invariably been the pattern prior to previous downturns and recessions. Profit growth over the past several
years has been exceptional, but has been driven by an unusually sharp decline in the personal savings rate and massive debt accumulation at the household and government levels. If these trends reverse, corporate profits will undoubtedly be impaired.

Evidence of Excessive Bullish Sentiment
Much of the early support for the recent stock market rally came from an excess of pessimism and the market climbing a “wall of worry.” But as bullishness has risen alongside stock prices, sentiment conditions have progressively turned negative and have
now become a headwind against further stock market gains. Examples of currently extreme levels of bullish sentiment include:

(1) The VIX Volatility Index has fallen to a multi-year low below 10
(2) Several investor sentiment surveys, including Investors Intelligence and Market Vane, are at their most
bullish readings of the year
(3) Investor positioning in the retail-oriented Rydex family of mutual funds is more heavily skewed towards bullish positions
than any other time this year
(4) Put/call ratios are at their lowest levels of the year, reflecting low demand for the downside protection that put options
provide

More broadly, confidence in the resilience of the economy is very high. There is a general assumption that abundant liquidity and fairly low interest rates are infallible insurance against a significant economic downturn, and that in any case, the Fed can counter any serious weakness that may develop with interest rate cuts.

Bullish sentiment is more of a characteristic than a determinant of a top. Excessive bullishness will not in and of itself derail the
longer-term bull market trend, but it can certainly signal instances where the near-term risk/reward dynamic is skewed towards the downside. Although the current market may be held up by seasonal influences through year-end, we think we have reached one of those junctures and would advise postponing new stock market purchases until current overbought and overbullish conditions are corrected.

Source: How Long Can Consumer Confidence, Earnings Weather the Housing Bust?