For
the past several years, we have started off the year with a list
of potential surprises for the coming calendar year. To
qualify as a “surprise,” the prediction should be
outside the consensus view and be more likely not to happen than
to actually
occur.
At this point you may well be asking “why do you care about
things that are not likely to happen?” Nonetheless, an exercise
like this is important. Making 
investment decisions in an uncertain
world requires one to consider the impact of various economic and
market possibilities; even if their likelihood is less than 50%.
Not only is it good to be prepared, but sometimes those lower probability
events are attractively priced. And, almost every year, there are
some lower-probability, out-of-consensus events that do, in fact,
occur.
In recent years, our surprise lists have actually performed quite
well. In 2006, however, the surprise list was a mixed bag. Let’s
recap:
- The Economy Slides Into A Recession
Housing did start to falter and economic growth was slipping by year’s
end, but 2006 clearly did not produce a recession.
- The U.S. Stock Market Disappoints
In mid-July, the stock market was barely holding a gain and performance was
basically in line with cash and bonds, making this surprise look good. Then,
thanks to a rally with nary a correction, the market finished the year with
an above-average gain. The market definitely did not disappoint.
- The Dollar Does Worse Than Expected
The dollar was worse than expected. After gaining ground in 2005, it fell 8%
against a broad basket of foreign currencies in 2006.
- The Energy Sector Will Remain Strong
Even though the energy sector makes up less than 10% of the over-all stock
market in terms of market capitalization, it is expected to generate just
over 50% of the S&P 500’s operating profits in 2006. This is even
an improvement over the great earning years for energy in 2004 and 2005.
The energy sector also outperformed the S&P in terms of total returns.
- Inflation Will Be Less Than Expected
The Consumer Price Index (CPI) was unchanged in November on a seasonally-adjusted
basis after two consecutive 0.5% energy-price-driven declines. The CPI is
up 2.0% versus a year ago, but down at a 3.9% annualized rate in the past
three months. Break-even inflation spreads between inflation-linked bonds
and Treasury bonds also slipped.
- High Quality Should Outperform Low Quality
Low quality outperformed high quality last year in both fixed income and equities.
- Geopolitical Risks Will Reassert Themselves
At mid-year, with heightened conflict in Israel, along with a massive terror
strike in India, coupled with essentially flat stock market returns in the
U.S. and dismal investor sentiment, this looked spot-on. The last half of
the year’s price action changed that view though.
- The Biggest Risk To The U.S. Market Is Political, Not
Economic
Given the President’s low approval ratings, it looked like the Republicans
might lose control of Congress in the mid-term elections. If so, a less-investor-friendly
democratic leadership might jeopardize the stock market in the closing months
of the year. The Democrats did indeed wrest control from the Republicans in
November, but the market hardly batted an eye.
Surprises for 2007
We start with the belief that some 2006 surprises that did not
materialize last year, are still in play for 2007.
1. The Economy Will Do Worse Than Many Expect
While most economists seem to be looking for sub-par economic growth
(and some better than that), few are actually calling for a significant
dip in economic activity. To us, the primary driver of whether
or not the economy underperforms the consensus view is state
of the housing sector.
The consensus view on housing seems to be that the worst is behind
us and the market will improve moving forward. Indeed, there are
a number of recent data points that bulls take to indicate that
the residential real estate market is stabilizing after significant
weakness in 2006.
There are, however, other pieces of data that are not so favorable.
There are nearly 6 million vacant houses currently available for
sale or rent. That represents nearly 5% of all houses compared
to an average of 3.5% during the 1990’s. That means 1.3m
houses need to be sold to get back to average. Plus over 1.6m new
homes are expected to be built this year. Lastly, with the prime
spring selling season coming in a few months, it is expected that
more homeowners will be putting their homes on the market, so the
inventory of homes available for sale could spike even higher.
Given abundant supply, and remembering our Economics 101 classes
from many years ago, it’s hard to expect that selling prices
won’t have to go lower to clear some of the excess supply.
Another part of the consensus view is that even if real estate
prices drop, the trouble will not spill over into the rest of the
economy, and historically, that may have been true as housing was
not that big a part of the economy. But today, it’s probably
more vital to the economy’s over-all health than ever before
both in terms of its impact on employment and spending.
In recent years, the housing boom has been responsible for the
lion’s share of job growth in this country. According to
a study by Northern Trust, from 2001 to April 2005, nearly half
(43%) of all new private-sector jobs were housing related.
Real estate has also had a major impact on consumer spending over
this time frame. First there is the “wealth effect.” When
consumers feel wealthier, they tend to spend more. This effect
has most often been associated with gains in the stock market,
where it is estimated that a $100 increase in stock market wealth
translates into an additional $4 in consumer spending. But estimates
for a similar increase in the value of someone’s home reveal
a spending boost that is more than twice as high ($9). And Since
2001, an amazing 70% of the increase in household net worth has
come from rising home prices.
Second, in addition to the psychological boost from the wealth
effect, consumers also directly tapped the rising equity in their
homes to increase spending. Rising home prices and lower interest
rates triggered a refinancing boom whereby homeowners withdrew
significant portions of the increase in the value of their homes,
which turbo-charged consumer spending. Typically such mortgage
equity withdrawals (MEW) have averaged about 1% of disposable income,
but during the housing boom MEW peaked at 10% in 2004!
With home prices no longer rising or perhaps falling, this prop
for the economy is likely to continue to dissipate. In fact, MEW
has already declined to 5% of income. Without the impact of MEW,
it is estimated that GDP growth over the past three years would
have averaged less than 1%.
In sum, if the prices of houses continue to fall, most likely
consumer spending and the over-all economy will be negatively impacted.
2. The Stock Market Disappoints
Another holdover from last year is our concern that the returns
on U.S. stocks could surprise on the downside. While we are not
necessarily saying that stocks lose money this year (not a good
bet since stocks do make money most years), we do think a reasonable
surprise to the market could be a lower return to the stock market
than many expect.
Individual and professional investor sentiment is extremely bullish.
As regular readers of this commentary know, the market generally
moves (at least eventually) in the opposite direction of sentiment
extremes. The logic is that if everybody is bullish, who is left
to buy and push the market higher; and vice versa.
Currently, according to a Business Week survey of 80 analysts,
89% are bullish for 2007. Only 8% are bearish, with only 3 of the
80 analysts expecting a decline of more than 10%. A 10% loss this
year would definitely surprise the consensus.
Another survey testifying to the optimistic imbalance is the survey
of financial advisors by the Russell Investment Group. They found
that 86% of the advisors are bullish and only 1% expect a loss
of 10% or more. Some of the sentiment measures are near, if not
already at, historic highs.
This optimism from professionals is sort of remarkable given the
market’s incredible run in the second half of the year (never
mind other fundamental factors). Ned Davis Research reports that
this is now the longest bull market without a 10% correction in
history. In fact, the 8% drop last spring was the shallowest pullback
of any four-year market cycle since 1934. Not only that, but the
market’s ascent since then has been one of the smoothest
on record. The market has not even experienced a 2% pullback since
last July. This has happened only one other time since 1964.
3. The Dollar Is Stronger
Contrary to our (correct) view last year, we think the U.S. dollar
could do better this year. While we remain long-term bears on
the dollar, we could foresee the dollar having a bear market
rally just as it did a few years ago. One of our surprises for
2006 that did not materialize – that high quality investments
would outperform low quality – is actually the consensus
view for 2007 and here we agree with the consensus. In such conditions,
when the market is rewarding quality, or even in a more extreme
case when there is a more pronounced “flight to quality”,
the U.S. dollar tends to perform better than other currencies.
Given the U.S.’s role in the global economy, particularly
its size and economic advantages, the U.S. currency is generally
seen as a safe haven. A stronger dollar would surely surprise
many.
The implications from a stronger dollar are twofold. One, a rising
dollar typically goes hand-in-hand with weaker commodity prices.
While we are still believers in the notion that under-investment
in commodity production over the last decade or two means that
we are in a long-term bull market for commodities, the “fad” of
commodity investing might be in for a rough year in 2007.
Two, a stronger dollar is not a plus for international stock and
bond markets versus U.S. domestic stock and bond markets. Even
if the international markets post gains, the gains could be reduced
or eliminated due to currency losses. Despite the U.S. market coming
in dead last among the major international indices (MSCI EAFE,
MSCI EAFE Value, MSCI EAFE Growth, MSCI Small Cap, MSCI Emerging
Markets) each and every year since 2002, it would not be unreasonable
to see international stock market performance ebb versus U.S. performance.
Not only is that trend mature, but relative valuations and growth
rates are not quite as attractive as they have been for international
securities against the U.S. market.
4. The Yield Curve Gets Steeper
The yield curve has been inverted this year (short rates higher
than long rates), if the economy is weaker than expected, another
potential surprise to the market could be a steeper yield curve
courtesy of a Federal Reserve that starts to lower short-term
interest rates. Though our general expectation is that the longer
maturity bonds won’t necessarily rise significantly, we
don’t think they will drop in parallel to the short end
of the curve. Thus the curve starts to steepen again as long-rates
become higher than short rates.
Most of our surprises for 2007 seem to hinge on the housing market.
While the consensus view is that housing is on the mend, we think
the probability is much higher than many think that it will actually
get worse this year. If that is the case, many consensus views
will surely miss there marks this year.
Sincerely,
Eric M. KobrenRusty Vanneman, CFA
PresidentDirector of Research
Portfolio
ManagerCo-Portfolio Manager
