Blue Chips on a roll… June 30th marked the end of the best quarter for blue chip stocks since the final three months of 2003, with the Dow Jones Industrial Average gaining 8.5%, and the S&P 500 advancing 5.8%. Despite this impressive quarter the outlook for the second half is anything but clear.
The pendulum has swung… The next change in Fed policy is likely to be a rate increase instead of a reduction, reversing the sentiment prevalent at the beginning of the year. The ongoing strength in the domestic economy, in the face of inflationary pressures, supports the view of a potential rate hike by the Fed. While the Fed could very well remain on the sidelines for the rest of the year, the long-term trend in interest rates now has an upward bias, in our view. With this outlook toward higher interest rates, lingering inflationary pressures, a struggling housing sector, and tremors on Wall Street concerning hedge funds with exposure to home mortgages, the economy is likely to exhibit sluggish growth for the remainder of the year. However, the bearish view that the housing slowdown will push the economy into recession in the second half is likely to be proven wrong. A rebound in manufacturing and capital spending, as well as ever resilient consumer spending, appear to be enough to offset the weakness in housing. From an economic perspective, the bottom line is that stock prices will have to be driven by earnings growth as the threat of higher interest rates will keep a lid on price earnings ratios.
The M&A Train continues to roll… Meanwhile, despite the rise in interest rates, 2007 will still be another record year for mergers & acquisitions. In the first half of the year, the value of mergers on a global basis was close to $3 trillion, up 51% from the first six months of 2006. Goldman Sachs, a perennial powerhouse in M&A, consulted on deals worth over $800 billion in the first half of the year alone. At the same time, corporations continue to be flush with cash, which supports continued record M&A activity, dividend increases, and share repurchases. All of these factors bode well for continued gains in stock prices.
So what do sluggish economic growth, record M&A activity, and strong cash flow mean for stock prices going forward? At the risk of being redundant, (over and over again as Yogi would say) an answer to this critical question hinges upon earnings growth.
The worrisome burden of high expectations… The bottoms-up estimates from Wall Street analysts predict 19% earnings growth on average for the S&P 500 in 2007 and 22% growth in 2008.
Digging a little deeper, earnings growth is forecasted to accelerate in 2008 over 2007 for more than half of the S&P 500. Even for those companies expected to show decelerating growth, the average gain in earnings is forecasted at a still robust 14%.
If this level of earnings growth is achieved, then it would be quite reasonable to expect the bull market to continue. But is seems a stretch to think the current economic landscape can support 20% earnings growth over the next two years, even with continued record M&A activity and balance sheet strength.
Interestingly, the top-down estimates from economists and strategists is significantly lower with S&P 500 earnings growth forecasted at only 6% in 2007 and 7% in 2008. Historically, bottoms-up estimates are almost always higher than top-down predictions. The primary reason is that virtually all companies tend to predict better than average results. Since analyst estimates are based on company guidance there is a degree of optimism built in to bottoms-up estimates. In reality, except for companies headquartered in Lake Wobegon, not all of them deliver above average results. Still, the gap between analyst’s estimates of 20% growth and economist’s predictions for 6% growth definitely leaves room for negative surprises at individual companies. The risk to the market is that there will be an increasing number of earnings disappointments in the second half of 2007. Thorough fundamental analysis will be critical to avoiding these portfolio damaging situations.
From the opposite perspective, companies that can deliver positive earnings surprises through product innovation will likely be well rewarded by consumers and the investment community. A good case in point is Apple. June 29th marked the beginning of the most significant social event of the season, as half the western world, it seemed, lined up to buy the iPhone from Apple. The long lines of consumers anxious to purchase the $549 iPhone demonstrate the power of innovation in a global economy where truly break through products are rare. Analysts predict the iPhone could drive earnings higher at Apple by 40% over the next two years, which has been the main catalyst for the stocks impressive 44% gain in 2007.
So given the economic outlook and the potential for earnings disappointments, we enter the second half of the year with a cautious view. The fact that the market hasn’t had a meaningful correction in four years, as defined by a drop of at least 10%, adds to our uneasiness. Stay tuned.
