The bulls point to the impending political gridlock with a Republican President and a Democratic Congress…neither party can mess anything up. Stock market returns in the last two years of a presidency have been historically good. The market as a whole, with a price-to-earnings [PE] ratio of approximately 18, is neither undervalued nor is it overvalued in the current interest rate environment. Corporate earnings have been robust for the past several years and, although they may slow some, earnings will likely increase in 2007. Companies are flush with cash and looking for growth through mergers. They are also returning cash to investors via stock buybacks and dividend increases. Private equity investors also have access to large amounts of cheap capital as evidenced by the record amount of buyouts this past year. The combination of stock buybacks, mergers and acquisitions has reduced the share count available for purchase. The bulls also point to the end of interest rate increases by the Fed and the possibility of interest rate cuts. Unemployment is low at a rate of 4.5%, personal incomes are still increasing, and people are spending. All of which points to a strong positive stock market return.
The bears say that interest rates are inverted, which usually forecasts a recession. The housing market is slowing with record highs in unsold new and used homes. A recent issue of The Economist states that subprime mortgages are at a 8% delinquency rate, double the rate of last year. This is almost 1 in 10. Foreclosures are twice as high as last year, prices are dropping in many markets, and builders are giving large incentives, which are not reflected in the sales price. The Economist also points to the slowing auto market, high energy and commodity prices, and instability in the Middle East. Additionally, manufacturing has weakened recently, transportation companies are reporting slowing volumes and lowered their outlooks for the first half of 2007. Lastly, certain retailers are reporting poor holiday sales.
There seems to be a balance between the two sides. There is no doubt though, the economy has slowed considerably from the first half of 2006 with a GDP growth rate of 2.2% in the latest quarter. Whether this turns into a recession or not probably depends on the housing market: if it takes a turn for the worse, then a recession may occur; if the market stabilizes, then a soft landing in the housing market may be achieved.
I am not so optimistic that the housing market bottom has been reached. Granted, sales of new homes have increased slightly the past three months, but I believe incentives and moderately lower recent mortgage rates are driving this increase. The future, however, may not be so bright as housing starts and permits and mortgage applications are down. If manufacturing, housing, and certain service areas such as transportation and retail weaken together then 2007 may not be a good year for equities. If, however, the Federal Reserve maintains interest rates and capital remains cheap, then the housing market may stabilize and work through the inventory of unsold homes, and 2007 may be a good year after all.