1st Quarter 2007: The Pause that Refreshes

First Quarter 2007
Market Commentary

The Pause That Refreshes

As we reflect back on calendar 2006, three significant events occurred at mid-year, which had the impact of changing the tone and direction of financial markets. All were pauses within major trends. In this report, we will comment briefly on these three events and conclude with our own observations of these and other factors which we think may be relevant to the markets of 2007.

Federal Reserve

First was the recent rate pause by the Federal Reserve. After 15 successive interest rate hikes, extending from June 04’ to August 06’, the Federal Reserve Bank decided to pause. The market took this news as being exceedingly favorable, and many interpret this pause as ending the two year old pattern of rising rates. When interest rates go down, stocks usually go up. This occurs because if interest rates decline, the cost of borrowing declines, and economic activity increases.

In this case, rates didn’t decline; they just stayed the same. Nonetheless, we have had three Federal Reserve open market committee meetings since August, and at the end of the day – the Federal Reserve Governors voted to pause and to keep rates the same. Flat interest rates, combined with a consensus opinion that rates will either stay flat or go down, gives upside impetus to the stock market.

Real Estate

The second of these three factors is the slowdown in residential housing. We believe that residential real estate prices at the very least have plateaued, and more likely, have begun a slow markdown of prices. Residential real estate has risen dramatically over the past few years, and was propelled by easy and cheap money during the early Greenspan era. The 15 successive interest rate hikes referred to earlier had the effect of dampening speculation in property, and bringing a touch of reality to those who were buying larger homes with interest only and/or adjustable rate mortgages. So, one might also look at the slowdown in real estate as a pause within a major trend as well. There is also an observation of some analysts that there is a flow of funds away from real estate and into equities, which has also propelled the market.


The third pause was the drop in the price of oil after the mid-year spike. As we have previously written, the price of oil rose from $25 a barrel in 2003 to $77 a barrel last summer; at which time the price suddenly reversed and has currently been trading between $50 and $55. Up until that time, there had been a widespread concern that the world was slowly running out of oil, particularly with the increasing demand for oil by emerging Nations.

Our October commentary mentioned that, in our opinion, the catalyst for the recent correction was a Chevron announcement that they had found a major field offshore Louisiana which could contain several billion barrels of oil. While this provides some breathing room for oil companies to begin rebuilding their reserves, it will come slowly, and at great expense, because it’s 175 miles offshore, and 29 thousand feet below the surface.

We see oil as being in a demand/supply paradigm with geopolitical considerations that are very tenuous. To be sure, there are near term factors which are keeping the price down – such as a short term build up in inventories of oil and, distillates, and gasoline, and an unusually warm winter. Nonetheless, we believe the long-term factors we have written about are still in place, and therefore we see the oil market as also being in a pause.

Since rising oil prices are historically a drag on the economy; the fall in oil prices has acted to boost the economy in general, and the stock market in particular.

So the combinations of falling real estate, flat interest rates, and falling oil prices have acted as a stimulant to the market, and in our opinion, this combination is and has been the driving force behind the upward move of the stock market from mid-year thru December.

2007 Update

Implicit in today’s stock market are assumptions which result from the factors listed above. Institutional investors assume that the Fed will continue to stay on the sidelines, which in turn, would allow the economy and the stock market to continue to move ahead. Falling oil prices further act as a catalyst for the market, and stagnant or falling real estate also tends to put the spotlight onto the equity market.

Bullish Catalysts

There are other catalysts as well for the Bullish scenario, which we believe may be relevant to the market in upcoming months. These catalysts include a) the financial strength of Corporate America, b) mergers and acquisitions, c) the emergence of a global middle class, and d) the possibility of stock multiples expanding.

a) Corporate Financials

Corporate profits continue to move higher and cash flows have never been stronger. As mentioned above, the S&P 500 has just recorded its 15th consecutive quarter of double digit earnings gain.

Barrons recently reported that the S&P 500 companies are sitting on over $600 billion of cash, the highest in history. Further, corporate America is using this cash to both bolster dividends and to buy back shares of their own stocks.

Last year 1,969 companies of the 7,000 publicly traded companies that report earnings to the Standard & Poors dividend reporting service increased their dividend payouts. Only 43 firms cut their dividends last year. Another 221 firms paid an extra bonus dividend last year, which is the largest number of firms paying bonus dividends since 1978. In addition, the largest 500 companies in America also repurchased over $400 billion of their own stock.

b) Mergers and Acquisitions (M&A)

Private equity firms and investment banks are awash in liquidity. These private equity firms, in turn, are using cheap money to take over a myriad of business. Because of all the money that has been raised, M&A activity is at a near record high. M&A activity in the U.S. is expected to reach at least $1.4 trillion for 2006. That’s up nearly 22% from last year and the highest total since 2000. In fact, M&A activity has been so strong, that on the day of December 18th alone, over $100 billion of transactions occurred. Included in that particular day’s activity was a $26 billion hostile bid to take over Caremark, and a $17 billion bid for Harrahs Entertainment. Buy out activity helps stocks, because as companies get acquired, their peers tend to go up in price as well, and it creates an environment wherein there is less stock available to buy.

c) The Emergence of a Global Middle Class

As more and more countries adopt to a basic form of capitalism with global trading opportunities, there is an emergence of a global middle class.

There are a billion people in both China and India, which for the first time, have the beginnings of personal savings which allow them some basic personal comforts. The large cap, U.S. multi-national companies, are actively engaged in these countries, fulfilling many of these basic needs, and have the profits to show for it.

Along with this phenomenon is an increasing focus on the part of institutional investors to place money in overseas investments. In fact, investors last year poured $150 billion into international stock funds, versus only $30 billion into U.S. stock funds.

d) Multiple Expansion

While we have experienced a strong fourth quarter in stock prices, we nevertheless could say that the stock market also has been - not only in a pause – but in a multi-year pause. The market has been relatively flat for seven years beginning with the (Dow and S&P 500) market highs of 11,484 and 1,469 respectively in 1999, ending 2006 at 12,510 and 1,426, respectively.

During this time period, however, corporate earnings as measured by the S&P 500 have climbed from $45.17 in 1999 to $81.96 expected earnings in 2006. Dividends on the S&P have also risen, from $16.71 in 1999 to $25.05 in 2006. Further, there is a favorable spread between the earnings yield of the S&P, and the yield on a 10 year Treasury. When the earnings yield of the market (and/or) a stock exceeds the interest rate on a 10 year Treasury, stocks are generally considered a better investment than bonds. That’s the situation in today’s market by a significant margin.

All this leads us to the conclusion that the earnings increases that have historically caused stock multiples and prices to rise – may in fact be beginning to occur now. If so, it will reflect the first multiple expansion since the market bottomed in late 2002. (Remember that the last five years have been a period where corporate earnings have exploded, dividends have risen, yet prices have remained relatively flat).

So if we see economic data come in with lower numbers than a year ago, it would not be out of sync, or out of character, for the market to shrug off this data and move higher in the face of it; as there are not a whole lot of other places to put the money, and stock valuations are still very reasonable.

Bearish Catalysts

Apart from these pauses, all of which lend credence to having a higher equity mix within one’s portfolio, are several other factors which we also consider important to evaluating today’s market. In turn, these factors, if left untended, could upset the applecart and turn what some think is a “Goldilocks” environment into some serious problems.


The fall of the dollar versus other currencies over the last six years has been significant, dropping over 25% on a trade weighted basis, and 50% versus the Euro. The dollar fall is primarily tied to our increased trade deficits, yet since we also have a large federal budget deficit, the dollar will likely see additional downward pressure. Further, even though export growth was very strong last year, the mere fact that our imports are almost 70% larger than our exports means that our rate of export growth has to grow nearly twice as fast just to keep the deficit from expanding. If these imbalances continue, it puts additional pressure on the Fed to raise interest rates to protect the value of the dollar.


Our July quarterly commentary dealt with structural financial imbalances, which focused on the combined (Federal) budget and trade deficits. When final numbers are tallied for 2006, our current account deficit (which includes the trade and budget deficit) will total over $1 trillion.

Our chief concern going forward is that the Fed, instead of lowering rates, may in fact increase them. If so, it will be because higher rates will be needed to attract the foreign capital which has been financing a large part of these deficits.

If rates go up, the bond market will fall; the economy slows down, and the cost of financing outstanding obligations increases. At some point, the convergence of the falling dollar and the structural imbalances of trade and budget deficits lead to inflation, which in turn will justify higher rates.

Real Estate

Whereas Bulls view the falling housing market as a source of funds to help prop up equity prices, Bears believe that the housing market will drag the economy lower, and further believe that the combination of trade and budget deficits will force interest rates up and eventually hurt the economy.

One example of that view was evidenced by mediocre spending over the Christmas and holiday season. U.S. holiday retail sales rose only 3% over last year, and economic growth slowed in 2006 from a 5.6% annual rate in the first quarter, to 2% in the third quarter, partly due to a steep decline in the housing sector. Some see this as an overall trend of decelerating consumer spending.


We agree with most analysts that the underlying positive factors discussed above will ultimately guide the market to higher levels. We are perhaps more sanguine than some, however, and believe the dollar will trend lower as well, and see the primary risk in equities and other financial instruments as being a function of the Fed raising rates later in the year – as opposed to the consensus opinion that they will be lowered.

The reality is that both the positive and negative factors listed above, in our opinion, are likely to occur; which we believe leads toward a flight to quality, and perhaps more volatility.

The best course of action, therefore, in our opinion, is to a) position portfolios in high quality, multi-national stocks, which exhibit both earnings and dividend growth, and earn a significant portion of their earnings overseas (to take advantage of the falling dollar), and b) increase the mix of portfolios towards income producing assets, and preferably with short term durations.

As always, we thank you for your continued support, and wish you a Happy and Prosperous New Year.



Bill Schnieders

Jim Schnieders, CFA

John Schnieders, CFA, CFP®

Please copy the SCM office for a copy of the graphs referenced in this document.

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