Mid-year Review and Outlook

We said the following things on December 30, 2005.

  • Federal Funds Target Rate will go to at least 4.75%
    This was a chicken forecast, but we did get it right. With the funds rate at 5.25%, we expect another hike to 5.50%. If the Fed gets spooked about inflation, 6.00% is a possibility.
  • We expect stocks to return 2.50% for the first half… and 6.60% for 2006
    With regard to our standard benchmark for stocks, the S & P 500, we couldn’t have called this one better: in the first half, the index returned 2.71%. We stand by our 6.60% full-year forecast.
  • [In stocks]… emphasis on energy and materials sectors
    We got this one half right. The energy sector has been the best performing sector so far this year. Of ten sectors, materials was the fifth best. For the rest of the year, we still favor energy and materials.
  • [In stocks] healthcare sector… should perform well
    We completely missed with this one. This traditionally-defensive group has performed badly, coming in eighth out of ten sectors. Even in the turmoil of the past several weeks, the sector has not done well. Still, history is on our side based on the Presidential and Fed tightening cycles, and we stick with the call for the second half of the year.
  • Peak in long-term interest rates in 2006… could be a decent year for bonds
    Unless the recent high of a 5.25% yield on the ten-year treasury is the peak, we could be wrong on these two calls, but we are sticking firmly with them for the remainder of the year.

Outlook

The volatility we have seen in the past several weeks has been unsettling, but it gives investors a chance to review long-term investment strategy against the backdrop of fallen prices.

Fundamentally, the U.S. stock market is in good shape. While not cheap, price-to-earnings ratios are reasonable, although profit margins could contract, sending P/Es higher. Inflation is not a real problem at the core (i.e. excluding food and energy) level. Furthermore, globalization and productivity gains will keep inflation in check. The Fed should be done raising rates shortly, absent a spike in core inflation or unexpected economic growth. As a result of the latter, the economy will slow, further dampening inflation, which will set us up for lower interest rates as bonds rally along with stocks.

Technically, the signals are mixed. On the positive side are the surveys of investor sentiment, which show widespread pessimism amongst stock investors. This is positive from the viewpoint of the contrarian. Most domestic stock indexes remain above key levels, although the NASDAQ does not. The latter is one source of unease for us, as the NASDAQ typically leads the way upward in a rally. Furthermore, more stocks need to participate in rallies. In other words, it should not be a relative few stocks that do well, but most should. The technical aspects make us wary of being overly enthusiastic about stocks in the short term.

Should you have any questions, please do not hesitate to contact us with them. We welcome your feedback of any sort.

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