We continue to operate from the assumption that this bull market, which is now four-and-a-half years old, is late stage, which implies an environment of heightened risk and poorer investment odds than in earlier phases of a bull market cycle. When we examine the underlying factors that shape our outlook for the stock market, we see persuasive arguments for both the bullish and the bearish cases, but for now we conclude that the weight of the evidence still indicates that the bull market is intact and deserves the benefit of the doubt.
The Bull Case
On the bullish side of the ledger, global asset markets and economic conditions continue to be supported by robust liquidity and low long-term interest rates around the world. In the U.S., a 10-year Treasury yield of 4.7% and corporate bond yields only modestly higher are very stimulative to the economy and bullish for the stock market. Apart from the sub-prime mortgage market, credit conditions could hardly be more robust.
Corporate finance and LBO activity is booming and shows no signs of deceleration. Cash acquisitions of U.S. public companies totaled $469 billion in 2006, which was the highest annual amount ever recorded. In the first quarter of 2007, cash acquisitions were $138 billion, implying a $552 billion annual pace. This buyout activity, which serves to shrink the U.S. equity base, is a powerfully bullish stock market dynamic while it lasts, but it is also a signal of a potential extreme in risk appetite and credit conditions. The last time we saw such a heavy volume of cash acquisition activity was near the bull market peak in stocks in 2000. Needless to say, buyout activity quickly dried up after the stock market peaked and buyers realized they overpaid for assets
Outside of the corporate buyout arena, investor sentiment turned cautious and hence constructive in the wake of the recent stock market correction. The equity sell-off in late February/early March served to inject some fear into investors and break up the complacency that had built up over the course of the marketfs prior, uninterrupted nine-month advance. A variety of measures of psychology among retail investors, including high levels of put option buying and short-selling activity, and cautious readings in sentiment surveys, suggest enough skepticism to support further gains in stock prices in the near term.
Technically, the stock market continues to act very well, with the NYSE advance/decline moving to new highs in March. It would be highly unusual for a bull market to end with the advance/decline line having just made a new high. Breadth is typically an excellent leading indicator of the major stock averages. Historically, the A/D line has peaked 3-6 months prior to the ultimate highs in the senior market indexes. The recent new high in NYSE breadth suggests a test by the major indexes of their bull market highs in the weeks ahead.
The Bear Case
While the above-mentioned factors argue for being patient with this bull market, there continue to be a number or reasons to maintain a cautious investment posture. Inflationary pressures have clearly not abated, which in all likelihood will preclude the Fed from easing anytime soon. The inflation measures to which the Fed pays the greatest attention (i.e. the core CPI and the core personal consumption expenditure deflator) remain well above the Fed's stated upper boundary of 2%.
Service-sector and import price inflation have recently accelerated. Productivity has slowed markedly, and wage inflation is running at 4.1% on a year-over-year basis. The U.S. dollar index is trading near multiyear lows. Commodity price inflation is very broad-based, with strength in energy, metals, and the agricultural sector.
In sum, it is quite unambiguous that inflation remains a problem and presents a major hurdle to the Fed rate cuts which investors continue to anticipate. The Fed would take a severe hit to its credibility if it let down its guard on inflation at this juncture. The consequences of such an action would likely be seen in a spike in longer-term interest rates, as inflation expectations rise and foreign buyers demand higher returns from the U.S. debt they have so willingly financed.
Recent sector trends in the U.S. market cannot be considered positive for the longer-term overall stock market outlook. The strongest sectors have been:
(1) Traditionally defensive groups such as consumer staples, utilities, telecom, and healthcare;
(2) Inflationary sectors such as basic materials, precious metals, and energy.
Leadership by this combination of sectors suggests a late-stage economic expansion with stagflationary characteristics. The weakest sectors in recent months have been finance and consumer discretionary, which goes to the heart of the areas of greatest risk and vulnerability in the economy, given the credit excesses and lack of savings that have been prominent features of this economic cycle.
The recent implosion of the sub-prime mortgage sector and renewed weakness in housing-related stocks have contradicted the notion, prevalent earlier in the year, that the worst has passed for the housing sector. Housing market excesses, which developed over the 2001 – 2005 period as housing price inflation diverged dramatically from broader measures of price inflation, are still very much in the process of being unwound. This corrective process may take several years.
In the foreseeable future, we expect continued downward pressure on house prices because of the following factors:
(1) A drop in demand for homes due to the exit of subprime borrowers and housing speculators, which is exacerbated as lenders tighten credit and regulators belatedly move to retrain mortgage lending excesses;
(2) An increase in supply as homes under construction continue to be completed and put on the market, and as homes are sold by owners who cannot afford resetting ARM mortgages, or are faced with eroding equity in their properties.
An estimated $700 billion to $1 trillion of adjustable rate mortgages [ARMs] will reset at higher interest rates this year. In short, tightened mortgage credit conditions coupled with an ongoing inventory problem in housing and soft home prices represent a continuing risk to the economy.
The macroeconomic outlook is extraordinarily difficult to gauge at this juncture. The housing market has been correcting for the past year and there have been major recent developments in the mortgage markets, but we have not yet seen significant adverse effects on the broader economy. In most housing markets, prices have stagnated rather than experiencing a significant price retracement.
Combined with low unemployment and strong income growth, this sideways stabilization of home prices has allowed consumer spending to remain resilient. Consumer spending, GDP growth, and corporate earnings have all decelerated, to be sure, but not to any degree that would appear to put the expansion at imminent risk. It seems predictable enough that we are close to a turn in the overall credit cycle and a long-awaited consumer retrenchment, but the timing of such developments is impossible to know.
The stock market has historically served as a leading indicator, so if a significant economic downturn is looming later in 2007 or in 2008, the stock market should provide advance warning. It is typical for the market to turn down six to nine months ahead of an economic downturn. Historically, by the time a recession is recognized, the damage will already been inflicted on the stock market and stocks will be more of a buy than a sell. Currently, the stock market is only providing preliminary clues, through the sector dynamics discussed above, that problems may be on the horizon.