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Amber Lights Flashing - Time for Caution

Volume 76, No.3

For the past 25 years America has experienced unprecedented growth, interrupted with only two temporarily mild recessions. During this period of time, the Dow Jones industrial average has advanced from below 1000 to its current levels, impressive by most any measure. We continue to be very optimistic on the long-term outlook for the US economy. However, even in this resilient market, a period of economic leveling off sometime within the year 2008 is a distinct possibility.

In order to reach valid conclusions regarding the trend in the economy and the possibility of changes in the behavior of the stock market over the next one or two year period, let us consider the various pro and con arguments.

The case for the maintenance of current stock market expansion:

1. Population growth, relatively full employment, and the continued technological progress provide the basis for an unaltered underlying growth trend.
2. In the last few sessions, Congress has passed a massive amounts of stimulative legislation involving the government in new areas of activity, which include the expansion into Medicare drug benefits. If effectively administered, this new social legislation could increase their ability to produce and broaden their basis of purchasing power.
3. The war in Iraq will provide short-term stimulation as long as the military operations are contained and can be carried out without disrupting normal activities of the economy.
4. As the Federal Reserve reduces the current Federal Funds and Discount interest rates, the economy continues to absorb much of its slack. In spite of increased inflationary pressures, US prices are increasing more slowly than the rest of the developed world. This, and a lower dollar, favors the international trade position of the US.

The case for a gradually higher stock market:

1. There is a broad historic relationship between the state of the economy and the price of common stocks. Long-term economic growth trends, which are expected to continue, should be reflected in higher stock prices, as has been the case in the past.
2. In its recent peak, the stock market as measured by the Dow Jones industrial average, was selling a 20.2 times estimated 2007 earnings. This is below the mean price earnings ratio of the last six years.

The case for an economic leveling off:

1. The current period of expansion is nearly 5 years old and getting a bit long in the tooth. Statistically, the current boom is old. We concur with most economists that the business cycle is not dead.
2. There are several indications that consumer enthusiasm may be tapering off. The past few years, consumer spending, aided by installment and mortgage debt, has grown more rapidly than the economy as a whole. The inverse of the wealth effect as home prices continue to fall and the impact of $100 per barrel oil has and will continue to impact spending habits.
3. Because of the overriding need to correct our deficit of international payments and to maintain the dollar’s position throughout the world, the current administration's ability to act in the monetary arena on the domestic front is limited. As a result, we believe the Federal Reserve policy has been modestly restrictive this year. The banking system is now somewhat extended in its obligations as it absorbs an estimated $1 trillion worth of sub prime mortgage debt, (of which as much as one half may be at risk). This is not the first time over-extended debt has impacted our economy. However, due to more creative Wall Street collateralized obligations, the impact is being felt beyond the traditional holders of this debt; insurance companies.
4. There is a danger that, if the money supply continues to be expanded at a greater pace than production and services, economic imbalance may ensue. In spite of an increasing money supply, most banks are loaned out and thus the quality of loans have, at times, been low and this may develop into a credit shortage, (acute enough to inhibit the recent rates of expansion of commercial, industrial and consumer debt).

The case for lower corporate profits - even if production gains maintain the present pace:

1. Inflationary pressures are on the increase, impacting manufacturing and retail inventories that must be replenished at higher costs.
2. It is uncertain that the gains in productivity can be sustained. Under such conditions, profit margins will be under pressure and corporate profits could move down, even under continued conditions.

The case for a lower stock market:

1. We do not believe that the historic pattern of periodic reaction has been altered. Human nature has not changed. At any moment, and for no ascertainable reason, the public's mood can shift to one of pessimism.
2. The market as measured by the Dow Jones industrial average, is 83% above its 2002 low and 25% above the level of January 2006. Such increases cannot be maintained indefinitely.
3. Short of psychological and political considerations, the level of the market is influenced mostly by the direction of earnings. If earnings move down, or if the prospect is for lower earnings, the market will move down.
4. Over the long term, common stocks with substantial natural resource holdings generally provide a good inflation hedge. Over the shorter term, accelerated inflation usually has a negative effect on stocks because inflation pushes up costs faster than prices can be raised and thus depresses earnings. In the event that the US experiences a more pronounced inflation, there carries with it the remote possibility of flat or declining stock prices similar to that of the early 1970s.

Conclusions:

• The economy. After weighing all the above arguments, we reach the opinion that odds favor; (a) a mild economic slowdown within a year or so, (b) a contraction in profits.
• The market. There is a good chance that the market will suffer a 10% to 15% temporary setback interrupting the fundamental long-term upward trend.
• Investment policy. We counsel buying a little “insurance” against the possibilities which we have outlined:
  1. All margin account should be eliminated.
  2. High-risk portfolios should shift to more defensive sector allocations
  3. Low-quality, volatile items should be eliminated.
  4. High-quality growth instruments selling substantially above their historic price earnings ratios should be reviewed and replaced with more reasonably priced defensive growth stocks.
  5. Portfolio equity allocation should be nearer to the lower end of an appropriate range.

Although we continue to be bullish on the longterm US economy, we think it may now be prudent to be more cautious with respect to the equity markets.

Not since the euphoria of the late 1990s, have we counseled clients to be more cautious. The short-term issues of the current credit crunch, weak dollar, and higher energy prices in concert with the longer-term issues of potential inflation and acceleration of the money supply; lead us to the conclusion that more selectivity on current and future equity holdings is in order.

However, due to our long-term optimistic outlook for the US and world economies, this concern does not rise to the level of selling current holdings, only that we should be more aware of the current risks and understanding that near-term equity performance may be below the long-term trend.

Patience is a virtue.