Outlook for The Market, The Fed and Housing

Includes: DIA, QQQ, SPY
by: Mike Goodson, CFA

I generally do not forecast the direction of the market, what the Federal Reserve is going to do or where house prices will be a year from now, but these are questions I hear most often from non-professional investors as well as the talking heads on TV:

The Market. I think the market is in pretty good shape. Consensus estimates for corporate profits still look fine for 2007 and show another growth year for 2008. I generally do not care too much about the actual numbers for profits (since I do not focus on "the market," but rather on cheap stocks), but I do like to be assured that profits will be higher next year. In terms of valuation, the market is trading at 17.8x 2006 EPS and about 16-17x the estimate for 2007. This is a bit higher than the "average" valuation, but given where interest rates are, the market does not look expensive to me. Statistically speaking, the market looks fine. As always, investor psychology and unforeseen events (like we saw mid-August) can impact the market, but going with the most likely scenarios, I think the market is probably higher by year-end and should see positive returns in 2008.

The Fed. As I see it, the Fed's primary responsibilities are to control long-term inflation and to manage monetary policy (that is how much cash flows into the system) to dampen the economy when it grows faster than desirable and to spur the economy when recessions loom. I like the analogy of the US economy as a wood burning stove. The Fed puts more wood in when the fire is burning low and backs off when the flames are hot. I think the market is expecting the Fed to ease several times from now until March and the first move could come as early as September 18. Although the economy may be fine right now, I think all the negative news in the media has the potential to talk consumers into spending less and create some kind of self-fulfilling prophecy. If the Fed eases now while the economy is not in trouble, I think we could see a very good stock market like in the late 1990s. I fleshed out this idea in a previous entry. So I think easing is likely if not to rescue the economy, to stem the risk of consumers being spooked by all the negative trends they constantly hear about in the media.

Home Prices. US households created $18.5 trillion in wealth over the last 5 years and only $4 trillion (22%) of that came from real estate, according to Tobias Levkovich, Smith Barney's Chief Equity Strategist. To hear it in the media, one might conclude that ALL US wealth is tied to real estate and it?s going to zero. I also learned recently that only 6% of US homes have adjustable mortgages and that maybe 4% of the total may in be trouble from resets that the owners may not be able to afford. That means that 96% of homes in America are not at risk from resets, sub-primes mortgages and the like. That said, there is a sizable oversupply of new homes in the market and I suspect that it will take a few years to work through. Prices according to one expert may fall 10-15% over all from peak to trough, but could be more severe in some parts of the country. But these markets also likely saw the most appreciation over the last few years. It seems unlikely to me that 4% of the US residential home market in trouble is unlikely to cause a significant economic slowdown unless this effect becomes magnified through reports in the media. I own a basket of homebuilding stocks that I bought way too soon (yes, it was a mistake -- thanks for bringing up that painful subject...), but I still think they are very cheap and should perform well over the next several years as the inventory gets worked off. Not my best trade this year, but I am hopeful for the future.

Here are a couple of other things I have learned recently:

Subprime. About 70% of the all the subprime-related securities were held by the hedge funds and other leveraged investors. That is why we saw forced selling when investors realized that many of these assets were nearly worthless. Fellow VesTopia Investment Director Andy Greig did a fine job of explaining what happened in August in this article. According to Smith Barney, the entire subprime asset class represents only 0.5% of the US capital markets. The volatility we experienced in August was clearly a case of the tail wagging the dog, but does not necessarily mean the system is broken or that subprime contagion will spread widely and destructively.

Oil Profits.

With crude prices in the $70-75 per barrel range, oil producers generate annual profits equal to total US corporate profits, according to Smith Barney. Of this, Saudi Arabia receives 40%; the UAE gets 20% as does Russia. This enormous amount of liquidity, that mind you is generated every year, needs to go somewhere. Large capital flows most often land in the most liquid markets, which implies the US market. No matter whether this capital lands in the US bond, stock or real market, it suggests a nice tail wind for investors here.

As I suggested at the beginning of this entry, I am not making forecasts on any of these things, but I suspect that some of my readers are wondering what I am thinking. Here you go. I continue to believe there are attractively priced stocks worthy of owning. And I continue to spend nearly all my time search for and analyzing cheap stocks in order to find these gems among the dross (like OMG).

Source: Smith Barney, Yahoo Finance