Jerry Jordan Commentary | Third Quarter Investment Outlook
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The global equity bull market continued to expand in the Second Quarter, but sector and geographic leadership rotated in response to economic and interest rate moves. Driven by their "well heated" economies, the Chinese and Brazilian markets posted very strong returns. The US, Japan and Europe (except Germany, which rose 21%) posted high single digit returns. The chronically underperforming NASDAQ Composite led the large US indices with a 7.8% gain, followed by the S&P 500 Index with a 6.0% gain and the Russell 2000 Index with a 5.8%. Also, importantly, the S&P 500 Index finally made a new all time closing high, a feat not seen since the 2000 market peak.
This market backdrop was beneficial for the Fund, particularly as many of our investment themes, such as energy and “Google,” performed well. Of particular note was the resumption of positive performance from the solar energy stocks, an important emerging energy theme which we have favored. Our aggregate focus has been on thematic industrial earnings expansion with reasonable valuations. So far, this focus has been rewarding.
Looking ahead to the Third Quarter and the remainder of the year, we remain very positive regarding the equity markets, but feel some intermediate period of consolidation may be required before we get the next substantial advance. A period of consolidation may be warranted given the recent back up in long bond yields and the continued slowing of the US economy. We still believe that the Federal Reserve Bank is done tightening US monetary policy for this cycle, and that the prospect of stimulative interest rate cuts within the next six to nine months is increasing.
Economy & Interest Rates
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"US companies are enjoying the best of all worlds: low cost pressures and improving margins." |
The US economy has slowed sharply since the First Quarter of 2006, responding to the seventeen successive interest rate hikes by the Federal Reserve. The economy barely grew in the First Quarter of 2007, as the dual impacts of the housing recession and high gasoline prices have crimped consumer spending. But unemployment has remained near cycle lows, and the economy picked up steam this spring. This reacceleration has been coincident with continuing torrid growth in the BRIC countries (Brazil, Russia, India and China), and surprisingly strong economic growth in Europe. The global economic engine remained in high gear, as was visible in rising commodity prices, surging global money supply growth (greater than 10%) and further global Central Bank monetary tightening.
We expect global growth to slow in the months ahead due to rising interest rates abroad and slow growth in the US, following the “mini-surge” in the Second Quarter. US economic momentum and global short rates are probably two of the most important forces affecting global economic momentum. At the moment, however, evidence of a peak in China’s economic momentum remains elusive, especially noting the 300% gain in Chinese equities in the last two years. But evidence of significant drags on the US economy are very apparent, most importantly the massive buildup in unsold homes. Consumer spending will likely be a drag on the economy for the remainder of this year, probably until the Federal Reserve begins to meaningfully cut interest rates.
Notwithstanding the sluggish US consumer, the US corporate sector remains very healthy and growing. Corporate profits continue to significantly outperform expectations, and S&P 500 profit growth this year will likely be in the high single digits. Two of the primary reasons for this are improving pricing power and the fact that 48% of S&P 500 pretax profits are generated outside the US, thus benefiting from faster growing foreign economies and the weak US dollar. US companies are enjoying the best of all worlds: low cost pressures and improving margins. Clearly, outsourcing and globalization have contributed mightily to these forces.
US long bonds had a tough quarter this spring, responding in part to the “mini acceleration” in the economy that occurred between April and June. We do not view this as a problem for the economy or the stock market (except for some expected volatility), because it should operate as a braking mechanism, bringing growth back to a sustainable level of 2 to 2 1/2%. The end of the inverted yield curve should temper short term borrowing demands, and allow the economy to moderate to growth levels that allow a reduction in short term rates. Thus, we expect interest rates to decline modestly in the later in the year.
The Stock Market
We noted above that the S&P 500 Index finally closed above the peak it established in the March of 2000. What is also important to note is that S&P 500 earnings in 2007 are likely to be nearly double the level of earnings in 2000. Thus, the price earning multiple of this index has almost been cut in half during this time period while earnings momentum continues to be solid.
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"...stocks have become overbought, and there are factors that make us slightly more cautious regarding the weeks ahead.
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Nevertheless, stocks have become overbought, and there are factors that make us slightly more cautious regarding the weeks ahead. Our primary concerns relate to potential further disruptions in the housing market, rising bullish sentiment among investors, excessively bullish sentiment among hedge funds, and working our way through the recent rise in bond yields. Furthermore, the financial disruption caused by the sub-prime mortgage crisis may take many weeks to play itself out. And finally, the multiple IPO equity offerings by large private equity funds such as Blackstone and Fortress Investments, are probably not a bullish sign for supply and demand for equities.
These issues merit temperance, but not abandonment of the Bull Market outlook. Although it is impotant to note, past performance is not an indicator for future results. We are influenced by the number of significant positive factors as it relates to the market:
- Most global equity markets, including the US (excluding the NASDAQ) just made new all time highs, signifying strong trend momentum.
- While bullish sentiment has been rising, there are offsetting indications of excessive bearishness as well, notably in the record number of shares shorted on the NYSE and NASDAQ (a 25% increase in the last three months). (Source: Investors Intelligence survey of Advisory Service Sentiment, June 30, 2007.)
- Federal Reserve monetary policy is on hold, and we feel the next move should be to ease.
- Corporate profits and balance sheets continue to be very healthy and growing.
Large capitalization and higher growth stocks are starting to outperform, which is a positive sign for eventual multiple expansion.
- There is very little evidence of euphoria being priced into the US market; equity advances have simply tracked, or, in fact, lagged earnings. The price earnings ratio on the S&P 500 Index is near the midpoint of its range for the past forty years, indicating that the US stock market is not overpriced.
- Corporate buybacks and buyouts continue to gain steam, as balance sheets improve and deal financing remains attractive.
So we still think that there are significant gains ahead, especially as we see many attractive stock opportunities.
Strategy
Concurrent with our expectation for U.S. economic growth to decelerate after the Second Quarter, we continue to favor sectors with strong secular growth opportunities. The sectors we prefer include energy, healthcare, financial services, industrial, and select technology.
We retain overweight positions in oil service companies, which still offer the best combination of low valuations and high earnings and revenue growth in the market. Although these stocks have been some of the strongest performers of the past quarter, we continue to view the outlook for the industry as extremely favorable. We prefer international offshore drillers and diversified oil companies, which have less exposure to short-term natural gas price moves and the best multi-year growth profiles. Also, we have added to the Fund's in alternative energy, particularly in solar, we expect global installations to grow at a 34% annual rate through 2010.
Healthcare is another sector we have added exposure to, as we believe it should be somewhat immune to an economic deceleration and subsequently rewarded with a premium valuation. The industry has also experienced several recent acquisitions at significant premiums of 40-50%, which should provide valuation support and highlight the opportunities for value creation. We favor pharmaceutical companies with strong pipelines, life sciences supplies manufacturers, and high-tech medical device companies with new products in under-penetrated markets.
Also, we remain bullish on the large brokerages, which are trading near historical trough valuations despite record high ROE (return on equity) ratios and strong outlooks in investment banking, merger and acquisition advisory services, and asset management. While their performance has been disappointing recently, due to concerns about subprime mortgages, we believe the relatively small effect that mortgages have on the brokers’ earnings has been more than discounted in current stock prices.
Several other industries appear to have encouraging prospects as we look out into the second half of the year, including selected technology companies (especially high-growth areas such as internet advertising), and large diversified industrial companies. We have focused on the businesses which benefit from strong international growth and infrastructure investment in developing nations while avoiding businesses dependent entirely on the average consumer. Many of these corporations have made significant improvements to their cost structures in the past few years, and should continue to see their valuations expand along with their operating margins.
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The Nasdaq Composite Index is an unmanaged index representing the market cap weighted performance of approximately 5,000 domestic common stocks traded on the Nasdaq exchange. The Russell 2000 Index is an unmanaged, market value weighted index, which measures performance of the 2,000 companies that are between the 1,000th and 3,000th largest in the market. One cannot invest directly in an index. Price to earnings ratio is the value of a company’s stock price relative to company earnings.
The views in this report were those of the Fund manager as of June 30, 2007, and may not reflect his views on the date this report is first published or anytime thereafter. These views are intended to assist shareholders in understanding their investments in the Fund and do not constitute investment advice.