Jerry Jordan Commentary | Fourth Quarter Investment Outlook
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At the close of the quarter, despite the incredible price swings, most indices ended modestly higher, with the significant exception of the rapidly developing nations: Chinese stocks rose 45% in the quarter, India was up 18% and Brazil rose 11%. Hong Kong’s Hang Seng Index, benefiting from a relaxation of rules for Mainland Chinese investments there, soared 24% in the quarter, up 40% from its August lows. Thus, while borrowing conditions eroded materially in the quarter, plenty of money remained available globally to buy stocks.
Our current equity outlook is bullish. We believe monetary conditions are now accommodative, equity earnings and valuations are still very attractive by historical standards, and many important growth themes continue to offer attractive investment opportunities.
Economy & Interest Rates
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"We believe monetary conditions are now accommodative, equity earnings and valuations are still very attractive by historical standards, and many important growth themes continue to offer attractive investment opportunities." |
The economy, like the stock market, has experienced significant volatility recently. The US economy slowed sharply in the First Quarter, responding to rising interest rates and the deteriorating housing market. But in the spring the economy re-accelerated sharply to almost 4% growth, benefiting from strong foreign economies (export demand) and inventory rebuilding. The explosive sub-prime crisis ended the re-acceleration, and it now appears that the economy will experience only negligible growth in the second half of the year. In fact, the recent slowdown is so pronounced that many economists are beginning to ponder whether a recession has commenced.
We do not think that a recession has started for the overall economy, but it may be that US consumer spending could hit recessionary levels due to 1) very different credit conditions, which persist for many borrowers; 2) a terrible housing market; and 3) very saturated markets for consumer goods like automobiles and electronics. And while the consumer outlook appears moribund, and constitutes the larger portion of the US economy, the corporate sector remains very healthy with strong balance sheets and business prospects, largely due to overseas strength. In fact, the growing influence of overseas business may be permanently reducing the cyclical influence of the US consumer, especially with the declining dollar.
While strong overall foreign business may be offsetting the weak US consumer, there is abundant evidence that economic conditions in industrialized nations are beginning to slow in response to the credit crunch. Two weeks ago the U.K. experienced its first run on a bank in a century with the Northern Rock crisis, while business conditions in Europe and Japan have rolled over materially. However, business conditions in the emerging economies remain strong. Because the emerging economies consist mostly of manufacturing industries, it is likely that their strength lags the slowdown in global demand occurring elsewhere and may dissipate over the next year.
We expect economic conditions to slow and remain challenging through the end of the year. This, in turn, will likely cause foreign central banks to follow the Federal Reserve’s lead, and lower lending rates. Further, the Federal Reserve should continue to cut rates over the next six months, which should allow the economy to re-accelerate sometime next year. Treasury bill rates continue to remain lower than the federal funds rate, thus portending further rate cuts.
The Stock Market
“Don’t Fight the Fed” is an important adage to consider whenever the Federal Reserve commences a new monetary direction. Such a new direction occurred in the Third Quarter, and thus equity investors must consider the impact of lower interest rates on equity valuations (i.e. higher valuations), against the backdrop of declining earnings momentum. Our net conclusion from the “sea change” in monetary policy is that this is almost always positive for equities. In sum, we want to own stocks, but not stocks with eroding business fundamentals. We believe this is a great environment for growth stocks! Thus, we expect our favorite secular growth themes to be well poised with rising valuations.
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"We believe this is a great environment for growth stocks!" |
Strategy
We remain focused on companies that should exhibit strong growth during this slowdown in the U.S. economy, including those that benefit from international demand. The sectors that we continue to favor include energy, healthcare, and financial services.
Our largest holdings remain in energy-related companies, particularly those exposed to increased spending on exploration and production. Due to our outlook for continued high oil prices and stronger than expected earnings, we have recently added positions in diversified oil companies. We are also optimistic about the prospects of other commodity-oriented businesses, which are seeing strong demand from developing nations. Commodities, notably gold and copper, should also benefit from the huge increase in worldwide money supply.
We retain overweight positions in the healthcare sector, particularly in companies with revenue and earnings growth that we expect will outpace the overall market. Our holdings include life science tools manufacturers, pharmaceuticals with strong product pipelines, high-growth medical device companies, and managed care organizations.
While the performance of financial services stocks (particularly the large brokerages) was disappointing in the Third Quarter, the group is emerging from one of the worst credit markets in the past 20 years with solid book values, strong return on equity ratios, and near trough valuations. Global economic growth will provide many new opportunities in investment banking, advisory services, and asset management for the brokerages, many which derive more than half of their revenues outside of the U.S.
In conclusion, we believe that this is an excellent environment for stock picking and for investing in growth stocks generally.
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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 September 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.