Across My Desk: Outlooks from the pros
With half of 07 behind us, how does the future look for investors?What follows below are a bunch of points of view for a number of investment pros. There's a lot of reading here, but I guarantee you'll find it informative. Happy reading:
Manny Weintraub, head of Integre Advisors.
Why is the market still going up? "It is the path of least resistance," says Weintraub, formerly managing director of Neuberger Berman and now head of Integre Advisors, "because stocks are very cheap compared to bonds - not a little cheap, very cheap. All of these private equity deals are happening because they can be financed and they can be financed because stocks are cheap relative to bonds.
"$300 billion worth of U.S. stocks, or 1.4% of all U.S. equities, was taken out of the market either through takeovers or share buybacks in the first four months of the year. In the past, if stocks were cheap relative to bonds, then managers of pension funds and endowments might have moved some money out of their bond portfolios into their stock portfolios and that would have provided some sort of tailwind to stocks. But that is nothing compared to what we are going through right now.
"The whole market is at a relatively cheap valuation compared to what it used to be. Today's market is very different from that of 2000, when the 10-year bond was yielding 6.5% and the market was trading at 24x earnings. Today the market is trading at 16x earnings, and at the same time, treasury yields are 4.8% for a 10-year treasury, a near 2% decrease in the cost of financing. That provides the opportunity. And there is a certain amount of risk aversion, as well. With the economy slowing down, companies don't want to build new factories, so they are building up cash and buying back their own shares, or buying competitors... and that is what has been happening with money at this point in the cycle.
"This will not continue everyday, forever. We have just broken the longest uptrend in the S&P 500 since 1944. But, I do not think this is the beginning of the end. It has taken us seven years to get back to the S&P at 1500, but this is not a stagnating situation like the Dow in the 60s and the 70s. In seven years the S&P is much more likely to be 3000 than 1500.
"We'll continue to move up until valuations on the market go higher, or bond yields go higher."
Kent Croft, President and CIO, Croft-Leominster
- Overall, we believe the markets are reasonably valued.
- As bottom-up value investors, we are finding buying opportunities in all capitalizations.
- Global growth will continue to lift US corporate sales and earnings.
- With 55% of companies in the SP500 doing business overseas, we expect the SP500 to return between 4-6% in the second half of the year.
- Prominent value themes in our portfolios are in broadband and energy areas.
- We don't see any big spikes in concern areas as Economy continues to be fundamentally sound - relatively low interest rate environment, low unemployment, and moderate inflationary pressures.
Kim Daifotis, CIO, Fixed Income, Charles Schwab Investment Management
- Overview: FOMC likely to remain on hold for the remainder of 2007. The focus on economic data continues to be the delicate balance between growth and inflation. Global inflation has ticked up and has led to higher rates.
- Duration/Yield Curve: Slightly short to neutral duration relative to benchmark given latest back up in rates. Expect early year increases in interest rates as market removes FOMC easing expectations.
- Governments - Treasury/Agency Securities: Heavily underweight these sectors in favor of securitized sectors.
- Spread Sectors: Most spread sectors near historic tights vs. treasury securities. Our slight spread duration overweight favors sectors and securities with low spread volatility. The fund is underweight higher quality industrials with very little spread tightening potential in favor of the securitized sectors and financials.
- Credit: Slight overweight to the credit market expressed via lower quality, short maturity corporate bonds. Expect continued pressure on the industrial sector from shareholder interests, including share buybacks, dividend increases, and LBO/MBOs. Overweight financials, especially subordinated bank, finance, and insurance securities with less LBO risk. Selectively overweight certain industrial issues.
- Securitized Sectors: Overweight securitized sectors vs. agency and high quality industrial sectors. Stable MBS and CMBS offer equal to greater spread with generally low spread volatility without the risks detailed above in credit.
David Goerz, CIO, HighMark Capital Management
- Equity growth slowdown fears overblown. Indices, economy not governed by calendar (duration) or simple index level
- All about earnings--strong earnings on above consensus economic growth and productivity yielding high margins, including international. Some concern about inflation with higher energy costs, wages, and commodity prices passing through, but ever broader U.S. economy is earning remarkable profits and throwing off excess cash flow to pay down debt, buy back shares (share count dropping), buy other companies, and pay more dividends. Quality of earnings also very much improved, closing the gap between reported and operating earnings. Strong potential for another upside surprise again.
- Inflation concerns are overblown---secular disinflationary forces continue. Fed is not yet targeting inflation, but assumed preference for <2% is misguided. Energy price impact rolling over through mid-year push down inflation. Falling CPI will dampen cost of living increases and pull down wage growth trends although unemployment low. Increasing capital investment helps keep wages in check as sentiment improves.
- Disinflationary Forces
- Globalization of everything, particularly labor
- Aggressive unbridled hyper-competitive companies
- Internet Price Transparency, and
- Accelerating Innovation and Creativity
- Exceptional profitability benefiting from sustained and remarkable profit margins is a global phenomenon. Profit margins remain robust if input cost pressures pass through, but competition requires ever more innovation to keep pace. Innovation is replacing simple tasks requiring employees to retrain for high value added jobs. Booming developing economies bolstered by urbanization and industrialization a irrepressible & insatiable consumer demand for luxuries, better living standards. Strong global growth on track into 2008.
- Remarkable cash flow should support accelerating Capital Investment and M&A activity, in addition to rising dividends and buybacks. Buybacks in second quarter topped a record $115 billion.
- Bond Market: Supply Demand Imbalance: "Conundrum Physics"--Why has the yield curve flattened as interest rates increased? Structural supply/demand imbalance -- too much demand for longer maturity, higher yielding debt chasing limited issuance. Suggesting inversion is a specter of slower economic growth is misguided. Demand usually governed by economic conditions (inflation expectations), but non-economic demand is simply exceeding supply for longer maturity debt. Who is chasing global yields: insurance companies, DC contributions, immunizing DB plans, hedge funds & corporate (excess cash to invest), foreign governments, offshore investors in lower yielding countries. Shrinking new issuance in Treasury, Corporate, and Mortgage sectors---still issuing, just not enough. Triggers observed: Recently increased corporate issuance with rising LBO activity and CDO/sub-prime exposure.
- The lowest generational real yield should be enough to trigger rising nominal Treasury yields eventually.
Neil Hennessy, President and Portfolio Manager, Hennessy Funds
- The interest rate picture has become slightly more complex and even the bond market has become very volatile lately, but remember that rates are still at historic lows, and we still have historically low unemployment. The economy will continue to be powered forward by moderate growth, with low inflation and a healthy job market.
- We still like the consumer discretionary space, and specifically retail names. The American consumer will continue to show resilience in their spending, which will not only manifest itself in retail, but with larger purchases as well...including automobiles, homes, etc.
- Private equity has been, and will continue to be a major force in the marketplace for the foreseeable future, if the current credit environment remains the way it has been for the past few years. They have been raising lots of money, and that money will have to be put to use in some way, shape or form. Look for more billion dollar deals to come from private equity in the upcoming months.
- Oils still continues to be the black cloud over the market with investors believing that the price of oil will continue to slow the economy. We believe otherwise. High oil prices did not seem to affect the ability of the market to produce returns last summer, and oil was at $78 per barrel. We look for oil to settle in somewhere around $50 per barrel.
Ryan Jacob, Portfolio Manager, Jacob Internet Fund
- Themes for 2007: Strive to more balance risk and reward for what is likely to be a more volatile 2nd half of 2007; favor companies which have more conservative balance sheets (i.e. more cash, low/no debt); focus on areas that are exhibiting strong secular growth trends (i.e. Internet advertising, open source computing); consider more international exposure as a way to further diversify and participate in higher growth economies (i.e. China)
Edward Maraccini, Portfolio Manager, Johnson Asset Management
We continue to be cautious in the current economic and market environment moving forward. The market has already returned our full year expectations posting positive results in the mid to high single digits. We continue to expect below potential economic growth in the second half of the 2007. Expectations for earnings growth are moderate for the mid year period but may be overly optimistic for the fourth quarter. With the equity market valuation at roughly 17x LTM earnings, above the long-term average of approximately 15x, and economic growth and corporate earnings decelerating we believe there is near-term risk. Inflation has been tame and we continue to expect the same due to competition and the globalization of labor. We also believe that corporations have the ability to keep prices low as costs rise given the high level of profit margins. Fed action is likely near year end or early next year as growth weakens and inflation moderates.
We believe there is continued risk in the housing market and its effect on consumer spending. With housing prices declining, inventory rising and adjustable rate mortgages resetting; we believe the probability the situation worsens is high. Higher mortgage payments, declining net worth and greatly reduced mortgage equity withdraw options should have a negative impact on consumer spending.
We continue to expect large caps to outperform small caps due to their ability to take advantage of strength in the global economy, more attractive valuation and higher dividend yields.
Kirk Mentzer, Senior Vice President and Director of Investment Research, Huntington Asset Advisors
Domestic Equity: We remain neutral on equity markets with an expected total return of 8% for the year (expected range is -4% to +15%). Valuations are reasonable and momentum could carry the market higher near-term given our view for stable interest rates. However, our emphasis areas are becoming more defensive. We expect the earnings growth outlook to deteriorate significantly from current levels and sense more imbalances developing in the economy. Therefore, this year could see more volatility than usual. We advocate that investors continue seeking opportunities to buy higher quality and larger market capitalization companies in the commodity areas and stable sectors such as healthcare.
International: While the U.S. economy will clearly be slowed by the drag from the housing market, the outlook in Europe and Asia is improving. The idea that the rest of the world can grow while the U.S. slows is gaining acceptance globally outside the U.S. Earnings estimates for companies in Europe and Asia are supportive, valuations on stocks are reasonable and the U.S. dollar's gradual erosion continues. These factors are indicators that overseas investment is likely to continue to provide attractive returns. Given the underlying risk factors from rising inflation and debt levels, the focus remains on larger, well capitalized companies with stable earnings prospects.
Robert Millen, Co-Portfolio Manager, The Jensen Portfolio
For 2006, as was the case for 6 of the last 7 years, small cap stocks outperformed their large cap counterparts. Value stocks outperformed growth stocks. Over the past 4 years, lower quality stocks (as measured by earnings and dividend consistency by Standard & Poor's) have outperformed higher quality stocks by an unprecedented 500 basis points a year. Market volatility has remained at historically low levels indicating a willingness to take risk, which has paralleled global economic growth, abundance of liquidity and in our view a general mis-pricing of credit.
Through May 31, 2007, mid-cap stocks have led the market with large caps slightly outperforming small caps. Economic activity is slowing in the U.S. with the average earnings growth of the S&P 500 companies at about 8% for the first quarter of 2007; well below its previous 5 year average of 14%. However, continued economic strength is evident in many other areas around the globe. Interest rates are rising globally and inflation remains a concern in most growth economies. This type of environment should be unfavorable to smaller domestic companies and those in cyclical industries. On the other hand, the environment should favor larger, higher quality growth companies; particularly those that derive a significant portion of their revenues from outside the U.S. These global companies with more consistent earnings growing at low double digit rates should stand out by comparison and be of greater interest to investors. During market retreats, there will be opportunities to acquire quality growth companies at favorable prices.
George Rue, CIO, New Covenant Funds
- US economy expected to grow by 2-3% in 2007, lower than 2006 but certainly not recessionary.
- Stocks have widened the lead over bonds, with large caps leading small caps. Growth is ahead of value and the rally that began in March has pushed every sector into the black. -Top performing international regions are primarily emerging markets.
- The upward move in interest rates signals that the Fed is not likely to reduce short term rates any time soon.
- The market's view of the economy continuing to do well is fueling inflationary pressures and is the primary reason for the rise in yields.
- Longer term yields are expected to climb but not to troublesome levels
- Continues to be some degree of frailty in the housing market with mixed results on home sales data but some degree of improvement with construction activity stabilizing over the last 3 months.
- Despite the presence of record prices at the pump, consumers were more upbeat during May. As the labor force has strengthened over the last four years, so too has confidence. Employment strength has prevailed over the negative impact of rising energy prices.
Jeff Schappe, CIO, BB& T Asset Management
- The U.S. economy appears healthy and any chance of a near-term Fed ease has been erased. The job market is solid and income growth is steady, which has enabled the consumer to hold up better than expected. Business spending and investment has accelerated recently, as have both manufacturers and services.
- The front end of the yield curve is likely to outperform as the yield curve eventually steepens. This could be from short rates falling if the economy softens or long rates rising if the economy continues to accelerate.
- In the fixed income markets, investors have become too complacent about risk the past few years as evidenced by all credit spreads, especially high-yield.
- The equity market has further upside potential. With price-to-earnings multiples below long-term averages, stocks are attractively valued. Earnings growth remains healthy and should pick-up over the next several quarters, driving share prices higher.
- We are re-affirming our commitment to a quality bias, buying the stocks of financially strong companies with reasonable earnings growth prospects.
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