Wednesday, January 17, 2007

Market and Sector Turning Points?

Most equity markets around the globe, the included, have experienced a steady rise since this summer. The S&P 500 Index gained 1.26% in December, its seventh straight monthly increase. In fact, over the last several years, the rising economic tide seems to have lifted most markets. Although many markets may seem to be overvalued, maybe not the U.S. large capitalization equity market, markets do not generally correct simply because they appear overvalued. At this point in the economic cycle, high quality dividend paying stocks can serve as a potential safe haven.

Below are a few highlights from the Hussman Fund's November Research and Insight newsletter titled, Profit Margins, Earnings Growth, and Stock Returns:
  • The value of an investment is based on sustainable earnings and not just current ones, investors ought to be paying a lot more attention to profit margins.
  • Corporate profits as a percent of GDP hit 13 percent in the second quarter, a 50-year high.
  • Following the earnings plunge of 2001-2002, the recent economic rebound has put net income at about 8.5 percent of revenues, a 50-year high.
  • For the S&P 500 companies, capital expenditures as a percent of revenue has fallen from 7.5 percent to 5.6 percent today.
  • Financial companies-including investment banks, regional banks, real estate companies, and insurance companies-now contribute 28 percent of the S&P 500's total income.
  • Profit margins are a bit like P/E multiples in that when they move from low levels to high levels, they can provide a tailwind to returns. On the other hand, when margins move from high to low levels, earnings growth becomes more challenging...
  • When earnings are weak, investors become frustrated and unwilling to pay much even for a dollar of depressed earnings. The opposite is true after a long expansion in earnings.
Reading the entire newsletter will provide some perspective on the potential factors that might lead one to view the market as fully valued. The Hussman Funds' all equity mutual fund is classified as a long/short fund.

In this week's Barron's Streetwise section, Michael Santoli notes:
  • ...the greatest risks lay in markets that are priced as if they hold no risk.
  • Plenty of markets around the world appear to be close to this condition. Yet the market for big U.S. stocks is not among them.
  • ...shares of household-name companies have lagged other asset-classes badly.
  • Last year, nearly $140 billion-or 90%- of all inflows to stock funds went offshore. And small investors are doing what they always do, chasing last year's performers.
  • All else being equal, this is bullish for U.S. shares, as the little guy is usually a contrary indicator at important market turns...
Lastly, highlights from the January 22, 2007 BusinessWeek's Business Outlook:
    • the unemployment rate remains tight at 4.5% last month, only a tick above October's 51/2-year low.
    • The bigger risk to the economy down the road is not weak growth but accelerating inflation.
    • Expectations of lower rates have always been predicated on weaker consumer spending... real consumer spending appears to have grown last quarter by an annual rate of about 4%...
    • Through December 26, Internet sales at U.S. sites for nontravel items during the holiday season were up 26% from a year ago, to $23.2 billion, according to an estimate by comScore Networks. The company says retail e-commerce outside of gas, autos and food now accounts for about 7% of all retail outlays.
    • Gift-card sales are booming, a trend that boosts January receipts, often at the expense of retailers' December numbers.
    • Prior to the holidays, the National Retail Federation Gift Card Survey projected a 34% jump in card buying from the previous year, to $24.8 billion.
    • Average hourly pay of production workers in December grew 4.2% from a year ago, up from 3.2% in the same period last year.
    • Income of production workers last quarter was up 6.4% from a year ago. Adjusted for inflation, the pace was the strongest since the boom of the late 1990's.
    • While the acceleration in wage growth is great for consumers, it is not so comforting to the Fed.
    Based simply on the above three points of view, it seems the markets/economy could be at an inflection point. Certainly many investors and strategists are saying the markets are due for some typr of correction. From a contrarian point of view, it is not likely the markets correct simply because they appear overvalued. Has the Fed possibly engineered a soft landing?

    I really can't name a famous and wealthy market timer-so what is an investor to do? I believe focusing on those parts of the equity markets that have not increased at a rate similar to some emerging markets, provides some opportunity. Also noted in Barron's

    Morgan Stanley strategist, Henry McVey "...the U.S. stock market is "the best house in a bad neighborhood," -- meaning the most attractive market in a cash-saturated, generally overpriced world. Still, as one real-estate truism suggests, if you buy the nicest house in a poor neighborhood, it's unlikely to be spared if things take a turn for the worse; it may just lose less value than others as the owners await a new buyer. That's worth considering in a universe where global markets trade in near unison, and where leveraged, professional "fast money" is setting the marginal price.

    Profit Margins, Earnings Growth, and Stock Returns
    Hussman Funds
    By William Hester, CFA
    November 2006

    In Risky World, U.S. Is Better Bet ($)
    Barron's Streetwise
    By Michael Santoli
    January 15, 2007

    Strong Job Markets Dash Hopes For Rate Cuts ($)
    By James C. Cooper
    January22, 2007

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