1st Quarter Commentary
Think Long Term
February 1, 2008
January was a difficult month for investors. Stock market volatility is likely to remain high through the second quarter of this year as investors continue to adjust to a recession in the U.S., slower growth overseas and ongoing issues with credit. Nonetheless, we advise looking for longer term investment opportunities produced by near term uncertainties.
On the positive side, the recently more aggressive interest rate strategy by the Federal Reserve has buoyed the markets. The futures for Federal Funds are implying a further decline to 2% from 3% currently. Given the likelihood that the economy has entered a recession, we believe, as well, that short term rates are headed lower. Most importantly for the markets is that the Federal Reserve continues to aggressively add liquidity to the economy. Historically, adding liquidity at a time when the economy is weakening has ultimately been bullish for the stock market. We believe it will be again.
Equity valuations are not excessive as they were in 2000. Assuming a five percent decline in profits for 2008, stock valuations are generally reasonable, especially in the context of low interest rates. Until their recent rally, the financials and consumer discretionary stocks seemed to be discounting a recession as well as most known credit concerns. As discussed previously, these two sectors traditionally lead a market recovery. It is reassuring that this leadership was apparent once again during the recent market rally. We believe it unlikely that a renewed bull market can occur without leadership from these sectors.
Valuation risk does exist, but we don’t place high odds of it occurring. Rising inflation could pose a risk to valuations, but with the U.S. entering a recession and the rest of the world beginning to slow down, we believe moderating inflation is more likely than rising inflation. Very weak profits, especially relative to expectations, could pose a downside risk to valuations. There will be individual examples of this, but we don’t envision a severe problem for corporate profits generally. Overall, valuations are already reflective of reduced growth expectations.
Another positive is the potential for new and increased buying of U.S. stocks. Cash as a percentage of personal disposable income is at a 30 year high in the U.S. Cash holdings are high in money market funds and even in many stock mutual funds. In a low interest rate environment, stocks of U.S. companies with good growth prospects should be appealing to the individual investor. Moreover, readers may recall that individuals moved from stocks to housing as their asset class of choice in the 2000 – 2003 period. We expect U.S. individuals will return to U.S. stocks. Moreover, we have seen new buyers of U.S. equities-sovereign wealth funds. Our guess is that we have only seen the tip of the proverbial iceberg in their purchase of U.S. stocks.
We expect increased merger and acquisition activity. The proposed Microsoft/Yahoo deal may help set the example of more deals to follow. On a secular basis, the U.S. economy is biased to consolidate units of production and service. A recession and subsequent recovery together with a potential change in favorable capital gains tax treatment could bring further corporate consolidation.
Finally, historically the stock market has been weak during the first half of the presidential election year, only to strengthen during the second half of the year.
The negatives for the markets are generally well known. What is not clear is their degree and duration. A recession is in process, but is not likely to be extended and may not be deep thanks to monetary and fiscal policy action. Corporations are generally in relatively strong financial condition compared to the past and the largest degree of risk in the consumer sector may be, as we are seeing in housing, with the marginal consumer.
Credit issues remain and from time to time could roil the markets and/or raise new worries about growth. Lending practices have turned quite conservative and may remain so for some time. Nonetheless, mortgage refinancing has begun to rise thanks to lower rates. Banks, especially larger ones, have added capital and the Federal Reserve is promoting a more favorable environment to grow profits and capital. Credit ratings downgrades are ongoing, especially in the mortgage area. Hopefully, new capital will opportunistically enter the stressed monoline insurance sector.
The bottom line is that monetary policy is aggressively embarked on a policy of reflation in an attempt to minimize dislocation from slower growth. We believe central banks outside the U.S. will follow with a similar policy. Proposed fiscal stimulus, if enacted, will provide added support to the economy during the summer. All in all, we believe investors should be starting to focus on long term investment opportunities, using any near term set-backs as entry points.
A. Marshall Acuff
Managing Director
Chair, Cary Street Partners Investment Committee
Cary Street Partners Investment Advisory LLC
