Jerry Jordan Commentary | First Quarter Investment Outlook
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The U.S. equity markets defied the historically positive year-end seasonal bias and posted negative returns in the Fourth Quarter, significantly reducing the positive equity returns for the year. But, equity returns in the quarter were highly variable between different geographies, market indices, and sectors. The big winners for the year were emerging markets, large capitalization rapid growth stocks, and commodity-based companies. The big losers were financial and consumer discretionary industries, as credit dried up and credit quality spreads exploded. But even within the groups there was enormous dispersion in the Fourth Quarter, for example the Chinese Shanghai A shares declined 5% in the quarter, while India soared 17%, notwithstanding the turmoil in neighboring Pakistan. In the end, most U.S. indices posted mid-single returns, ending the year well off the highs. The big investment story of 2007 was the continued economic surge in the developing economies.
While US stocks faced a challenging and volatile environment in 2007, our focus on strong earnings growth stock themes proved profitable throughout the year. Because developed economies slowed sharply toward the end of the year, as the credit crunch gained momentum, central banks were forced to pump liquidity into the financial system and the Federal Reserve cut interest rates multiple times. Meantime, gold, oil, and other commodities continued to surge due to rapid growth in developing economies, as well as potentially reflecting a move away from paper currency. Thus, outside of the financial-related sectors, corporate profits remained robust, and created many opportunities for attractive returns among our favorite growth themes.
Looking forward, we remain bullish in our outlook for U.S. equities for 2008, but we do expect a challenging environment for many stocks during the first half, as the credit crunch sorts itself out. Our bullishness is premised on attractive growth opportunities, the declining interest rate environment, reasonable equity valuations, and marked professional skepticism regarding stock market prospects.
Economy & Interest Rates
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"The big investment story of 2007 was the continued economic surge in the developing economies." |
While the U.S. economy has been slowing for awhile, there was a short burst of stronger economic activity in the Third Quarter, when the U.S. economy grew at a 4.9% annual rate. But due to inventory builds and net export growth, this burst was an anomaly against the prevailing trend. The domestic economy is clearly afflicted by the spreading credit crunch and the steep decline in the U.S. housing market. In fact, the acceleration in the Third Quarter will likely make the subsequent return to weak conditions feel even more abrupt. For example, First Call earnings estimates for the S&P 500 Index have dropped from +10.4% in October to -9.4% in December, an incredible 20% decline in profit expectations! The evidence is clear that the Group of Seven (G-7) economies (i.e., 7 world leading industrial countries), which constitute 70% of global Gross Domestic Product (GDP), are now slowing to very low nominal and real growth rates, and may soon slide into negative growth in the months ahead. The momentum of the developing economies has been the largest positive economic influence, as export growth has remained very strong. The continued strength of the developing countries, when viewed against the weakness of the G-7 countries, is unprecedented and will likely cause an overall global economic slowdown in the months ahead.
We agree with the conventional wisdom that the economy may “brush with recession,” and potentially recover later in 2008. In addition to the credit market trauma and the crisis in housing, the highly respected Economic Cycle Research Institute recently indicated an economic contraction has started, based on its weekly leading indicator index. This dovetails with recent weak readings of manufacturing and retail activity. At this time, however, we do not believe that the contraction will be either long or severe because: 1) unemployment in the U.S. is still very low, 2) export growth will likely remain strong, 3) the depressed Dollar has made the pricing of U.S. products and services highly competitive, and 4) the duration of the current slowdown in interest rate sensitive areas, such as housing, would indicate a potential bottoming out in the latter half of the year.
The Federal Reserve has cut interest rates and we are optimistic that they may continue to do so during the first half of the year due to the weak economic conditions described above. In fact, it appears to be “behind the curve,” and could be forced to accelerate rate cuts. During the last two Federal Open Market Committee (FOMC) meetings, the Federal Reserve indicated renewed concern in fighting inflation, and less concern regarding the weakening economy and rising credit spreads. While recent inflation readings have been high, as the global economy slows, inflation pressure may inevitably recede. As the economic news could get uglier in the months ahead, we expect the Federal Reserve to get more aggressive in its accommodative policy stance.
The Stock Market
We expect that the bull market in U.S. equities will continue in 2008, but that the economic slowdown will cause some volatility and anguish in the first half of the year. Currently, one could characterize the U.S. stock market as subject to the following influences: neutral sentiment, negative price trend, mildly positive supply/demand, a positive monetary backdrop, and an uncertain earnings outlook. Thus, we would not be surprised if the stock market makes negligible returns in the next six months as earnings prospects and economic momentum deteriorate.
Current market sentiment is neutral in that while long-term strategists are generally positive on market prospects (i.e., this would be a negative sentiment reading for stocks, because sentiment readings are contrarian at extremes), most market professionals and traders are either neutral or negative, as evidenced by the high levels of short interest, high put/call ratios* (more buying of puts than calls indicates a bearish sentiment in the market), and low hedge fund invested positions. But the readings on either side are not extreme enough to warrant a major reversal in trend at the present.
The current trend in the equity market is negative because most U.S. indices are trading below important moving averages, i.e., the 50-day and the 200-day moving averages. In fact, ominously the 50-day moving average on the S&P 500 Index had broken down through the 200-day moving average, historically a negative technical event. Also of concern is the large number of 90% down volume days and 90% up volume days in the Fourth Quarter, representing huge clusters of aggressive buying and selling. This represents active churning, but not investing that would reflect healthy inflows of buyers into the market. Finally, deteriorating market breadth (advancing stocks versus declining stocks) reflects an intermediate decline in the technical health of equities. The deteriorating breadth is consistent with the mixed picture of the supply/demand for equities, with very little inflows into mutual funds, but continuing healthy corporate buying and potential buying from the high levels of shorts.
The final influential factor for stocks in the next year is the monetary and liquidity backdrop, which we expect may become increasingly positive for equities as the year progresses. The Federal Reserve commenced its interest rate cutting cycle last summer, and could cut interest rates substantially in the months ahead. Additionally, much ballyhooed Sovereign Wealth Funds, started by countries in the Middle East and Asia, will look to put billons to work, especially in the U.S. with the U.S. dollar 35% below its highs. As the economy may stabilize with lower interest rates, liquidity could flow into stocks again, especially growth stocks.
2007 was a great year for growth stocks, which, as a sector, started to outperform in late 2006. We expect this recently emergent growth outperformance to potentially last several more years, as economic momentum becomes more subdued and our growth stocks gain premium valuations. Thus, the stock picking environment that occurred in 2007 should persist throughout 2008.
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"...we expect 2008 to be an opportunistic year and will require active investment strategies." |
Strategy
Due to our expectation for a sharp but short GDP deceleration, we remain focused on companies that are poised to demonstrate strong growth and whose valuations have already priced in a cyclical slowdown.
We retain overweight positions in energy industries, including oil service, exploration & production, and alternatives such as solar power. While we understand that these have historically been cyclical industries and have often suffered in a decelerating economic environment, we believe that the energy theme is a secular growth story and the stocks remain cheap relative to the market and their historical valuations. Should a pullback in the price of oil negatively affect these stocks, we believe it would provide an opportunity for them to strongly outperform the market for the rest of the year.
Health care continues to be our other favorite sector, as it should be rewarded with a premium valuation as earnings in other sectors decline. The upcoming presidential election may cause some volatility in health care segments this year, but we would view sell-offs as buying opportunities. Health care may continue to benefit from strong demographics and necessary increases in medical spending for the foreseeable future. Our holdings include large capitalization pharmaceutical and biotechnology companies with strong drug pipelines, high tech medical device manufacturers, life science tools providers, and managed care organizations.
The portfolio has small positions in metals and materials as well, including gold/silver producers who may benefit from increasing economic uncertainty. We also recognize that market volatility could create attractive entry points in companies that benefit from the ongoing infrastructure build in developing nations. In addition to our holdings in copper miners, we are monitoring opportunities in other materials providers.
In conclusion, we expect 2008 to be an opportunistic year and will require active investment strategies. Many industries will struggle, but strong secular growth themes should continue to prosper.
*Put and Call Options on Securities. A call option is a contract under which the purchaser of the call option, in return for a premium paid, has the right to buy the security (or index) underlying the option at a specified exercise price at any time during the term of the option. The writer of the call option, who receives the premium, has the obligation upon exercise of the option to deliver the underlying security against payment of the exercise price. A put option gives its purchaser, in return for a premium, the right to sell the underlying security at a specified price during the term of the option. The writer of the put, who receives the premium, has the obligation to buy, upon exercise of the option, the underlying security (or a cash amount equal to the value of the index) at the exercise price. The amount of a premium received or paid for an option is based upon certain factors, including the market price of the underlying security, the relationship of the exercise price to the market price, the historical price volatility of the underlying security, the option period and interest rates.
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The Group of Seven (G-7) consists of seven of the world's leading industrial countries: France, Germany, Japan, the United Kingdom, the United States, Canada and Italy.
The S&P 500 Index is a broad based unmanaged index representing the performance of 500 widely held common stocks. One cannot invest directly in an index. Price to earnings ratio is the value of a company’s stock price relative to company earnings.