It is Time to Rebalance

At the end of last week, the indices were all moving towards new highs. Despite slowing earnings growth the market just keeps heading up. While the long term trend is healthy, I think we are in for some turbulence. Usually when the market moves aggressively ahead, pushing toward new highs, after a while it takes very little news to derail the train. It seems inevitable as we head into the summer that the market will consolidate its gains by pulling back a little. The market will then take the summer off to digest the latest gains.

While the majority of the economic news remains positive there are negatives looming out there. For instance, there is slower U.S. employment growth, tightening credit, higher gas prices, slowing corporate earnings growth, and falling housing prices). Despite the negatives, the current situation does not warrant selling and walking away. Corporate earnings are still strong and P/E ratios are still reasonable (see chart). The current market conditions do warrant implementing a strategy of rebalancing and trimming. Increasing cash holdings over the next few weeks will enable an investor to take advantage of any pull backs. The catalyst(s) that could spark a correction is (are) unknown, but it could finally be the U.S. consumer cutting back or disappointing economic data.

It is likely that turbulence will be minor should it happen at all. The new global economy will continue to perform well pulling the U.S. market along with it. The story here is really the global economy and not just us anymore.
For right now, the market is still hot because of accelerating merger-and-acquisition activity. As of the end of last week the mid cap market has been blazing hot since the start of the year. In the last few weeks large cap domestic stocks have picked up the pace. It is very unclear whether large caps will finally outperform small and mid caps this year. It is inevitable that large caps will at some point outperform its small cap brethren in the future due to valuation metrics (see past blog postings for more information). International stocks are still chugging along with the MSCI EAFE up approximately 8% for the year. Bonds are showing some life with the Lehman Bros Aggregate index up almost 2% year-to-date.

The Economic News

I regularly attempt to explain the current state of the economy, the Federal Reserve’s policy stance, and other news items that could impact the markets. It is difficult to present the general state of the economy in just a few paragraphs, so I was thrilled when I discovered this scorecard designed by JPMorgan. I’ll try to regularly include it in my future newsletters. If the chart seems unclear just click on it to get a larger clearer view.

Many economists believe that we are close to full employment (5% or less unemployment is considered full employment by economists and the Fed). These gurus fear that full employment could lead to rising wages which could then cause inflation. The Federal Reserve is focused on the core rate of inflation (inflation less the volatile food and energy segments). Inflation is currently at the high end of the Fed’s defined range of acceptable. So the Fed’s board members want the core inflation rate to fall but don’t want to raise interest rates again to achieve it. The Fed wants the market to adjust itself.

When Bernanke became Federal Reserve Chairman he stated that he wanted to communicate the Fed’s intentions more clearly to investors. The unintentional result has been the inversion of the yield curve (short term interest rates are higher than long term rates). In order to get long term interest rates up, the Fed has begun to abandon its policy of clear communication and transparency. It is instead refusing to send a clear message. The Fed recently changed its stance to neutral (instead of signaling its intention by stating a bias towards raising or lowering rates) but it is all posturing. The most recent Fed minutes from its last meeting are meandering and unclear. Consider, for instance, this excerpt from the minutes:

…the prevailing level of inflation remained uncomfortably high, and the latest information cast some doubt on whether core inflation was on the expected downward path. Most participants continued to expect that core inflation would slow gradually, but the recent readings on inflation and productivity growth, along with higher energy prices, had increased the odds that inflation would fail to moderate as expected; that risk remained the Committee’s predominant concern.

The Fed's mixed reactions regarding inflation are unsettling to many analysts and economists. It is all part of an elaborate game of chicken as the Fed desperately tries to balance the need to moderate inflation with keeping the economy growing. If the Fed has to raise short term rates to check inflation it might also destabilize the financial markets. If the Fed states a bias towards lowering short term rates, it could cause the markets to grow too quickly the old boom followed by bust pattern). The Fed hopes to avoid these scenarios by convincing the market to raise long term rates which should help moderate full employment and wages and hence cool the core inflation rate. It will be interesting to see who blinks first, the markets or the Fed.

The Financial Pragmatist

Libby Mihalka

Where are the markets going?

The current market turmoil shouldn't spoke investors but caution is still warrented. I enjoyed reading Bob Doll's weekly commentary which captures the spirit of current market activity. So here is his Monday commentary in full. Read and enjoy!

The Financial Pragmatist
Libby Mihalka

Weekly Investment Commentary
By Bob Doll is Vice Chairman and Global Chief Investment Officer of Equities at BlackRock
April 9, 2007

The U.S. stock market seems to be following a pattern of one week being up and the next being down; and last week was one of the "up" ones, despite some mixed economic reports (the Institute for Supply Management's manufacturing index declined, while Friday's payrolls report was better than expected). Market sentiment was helped by the resolution over the issue of British sailors and marines being held by Iran as well as by continued high levels of merger-and-acquisition activity. For the week, the Dow Jones Industrial Average gained 1.7% to 12,560, the S&P 500® Index climbed 1.6% to 1,443 and the Nasdaq® Composite rose 2.1% to 2,471.

In our opinion, last week was fairly typical of the type of economic environment we expect going forward—that is, one in which economic growth slows, but not so quickly as to spark a recession. Additionally, we believe that lingering signs of economic strength will disappoint those who are hoping that the Federal Reserve will soon enact rate cuts. We do believe, however, that as economic growth continues to weaken, inflation pressures will recede, which should set the stage for the Fed to begin cutting rates in the second half of this year.

Over the next couple of weeks, investors will shift gears to focus on first-quarter corporate earnings. At present, consensus expectations are for first-quarter earnings growth to be around 3% to 4%, with overall 2007 growth levels to come in slightly below the 7% mark. For our part, we continue to believe that 2007 growth levels will be a bit below that—likely around the 5% area.

One factor that has been helping to push equity markets higher despite evidence of slowing economic and earnings growth has been ongoing corporate deal activity, which has been driven by a combination of high levels of cash available to companies and attractive equity valuation levels. We have been seeing high levels of stock buybacks, mergers and both public and private buyouts. In the first quarter, like the fourth quarter of last year, there was more than $1 trillion of reported deal activity, marking the first back-to-back quarters at that level since 2000. In our opinion, this environment is likely to persist until either the availability of capital dries up or until equity valuations rise considerably.

Looking ahead, we believe that the global economic backdrop remains healthy and conducive to continued good equity market performance. The potential danger of a hard economic landing in the United States remains, although we believe such an event has a low probability of occurring. Over the next few months, we expect markets to remain bumpy as investors digest ongoing news of slowing economic growth and weakening corporate profits growth, but do not believe these events will mark the end of the current bull market.