For those of us who have been predicting an equity market correction in 2006, this year has been a humbling experience. The Dow Jones Industrials average is up 12.9% for the year and is at nominal record highs. Meanwhile, the NASDAQ is up better than 8% and the S&P 500 is 10.5% higher than where it started the year. These numbers should send most bears into hibernation and few will have the temerity to go against the trend.
What the stock market is missing however, is how slow the economy will become in 2007 and how slow the Fed will be to address that malaise with monetary stimulus. There is a disconnect that exists between the paltry growth of G.D.P. and the strength in pro-forma earnings profit growth. The robust returns of the major stock averages remain unconfirmed by economically-sensitive commodities and by the bond market, as well. All the while, the yield curve has remained in its unnatural state of inversion, yet equities defy this reliable harbinger of recession.
It is my thesis that the Fed will cut rates in 2007, but only in response to concrete evidence that the U.S. economy is in recession, which should occur in the first or second quarter. If stocks finally acknowledge such economic weakness and correct substantially, that may mark the time when equities should be bought, albeit with more caution than we are seeing today. Keep in mind, all voting members of the Fed are not in agreement regarding where rates should go next, which indicates the market may be premature in believing the Fed stands ready to lower rates at the first signs of economic trouble.
What will throw the economy beyond just slowing growth and into recession are the delayed effects of 17 interest rate hikes, slowing monetary growth rates and the crumbling housing market, which is far from putting in a bottom (despite proclamations from the former Fed chairman Alan Greenspan). As I have indicated in previous commentaries, home price to income ratios are at a record of 5.3:1, the inventory of existing homes are at a 10-year high of 7.3 months and new home construction rates continue to be above intrinsic population increases, all of which forebode a protracted and painful correction in real estate prices. These conditions have been slow to retard consumer spending but should continue to manifest themselves in pernicious fashion throughout 2007.
Recent Government statistics indicate that the U.S. economy is already teetering on the brink of recession, with the 3rd quarter G.D.P. growth rate of 1.6% and Tuesday's October retail trade data indicating sales decline of .3% for standing merely as recent examples of this slowing trend. How much longer the equity market can ignore this data and anticipate the continuation of double digit earnings growth is unknown, but manias can, of course, last longer than expected. Eventually, however, weak economic data will cause investors to worry about earnings rather than cheering a quiescent Fed. It should prove to be prudent strategy not to chase this over-extended domestic market rally and instead focus on foreign opportunities that offer both dividends and a hedge against a falling U.S. dollar.
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