Riding the Roller Coaster
Worries about subprime mortgage defaults, tighter borrowing standards, continued negative news on the housing demand front, and some weak corporate earnings announcements have all combined to offer a serious test of the market's resolve in the past two weeks.
We were struck by an abundance of market observers calling the recent rout a "healthy" correction. We can only assume these same observers were characterizing the market's ascension to record heights as "unhealthy." A reintroduction of risk was especially evident for those who bought on July 25 only to witness a 5% decline in valuation.
We suspect the unfortunate aftermath of a tightening of previously loose credit standards will continue for some time, affecting housing and leveraged buyout activity, and may cap the upside for major markets. Housing, in particular, was a major driver of household wealth from 2001 to 2006, and it acted as a strong stimulus to the economy, as rising home values made households feel wealthier and home equity loans fueled outsized increases in consumer spending. The removal of that stimulus, we believe, will be a major factor behind weaker growth in consumer spending in 2008 vs. 2006 to 2007.
Standard & Poor's Investment Policy Committee has a 2007 year-end target for the S&P 500 of 1,510, which has been in place since Nov. 15, 2006, even as the "500" ascended beyond 1,550. Our target implies a 6.5% calendar year rise (8% total return) for the index. A main rationale for our subdued market performance expectation was the rather weak (vs. the last five years) corporate earnings growth environment forecast by S&P's equity analysts.
In 2005, S&P 500 earnings rose 13%, and in 2006 they increased another 15%. As we've noted in other commentary in The Outlook, we expect earnings growth of 8% for 2007. A fair proportion of that growth should be driven by stock buybacks and favorable foreign currency translation at the expense of a weak dollar, meaning real earnings growth is minimal.
There are some that regard a market trading at 16 times 2007 earnings expectations as inexpensive, but they often conveniently forget that corporate earnings growth has been nearly halved in the past year, which we believe limits p-e expansion potential. Essentially, investors buying today are getting much less bang for their buck than they did in 2006, and therefore should be less willing to "pay up" in terms of the multiple.
We are most concerned about corporate earnings for the S&P financial sector, the single heaviest market-cap weighting in the S&P 500, which is particularly dominated by regional banks and investment brokers. The potential for reduced loan growth, higher provisions for credit losses, and reduced M&A activity are the primary factors limiting financials' earnings growth potential. Indeed, the S&P financial sector has been the worst-performing of the 10 sectors in the S&P 500 thus far in 2007, declining 9.5% year-to-date through July 27.
For all the excess liquidity and M&A activity propelling stock valuations of late, we remain unwavering in our belief that the true drivers of long-term stock market performance are interest rates on U.S. bonds (as a risk-free investment alternative) and corporate earnings growth. The earnings yield on the S&P 500, or the inverse of the market p-e, is a useful metric for determining the attractiveness of stocks vs. bonds, and continues to imply to us that stocks, on a risk-adjusted basis, remain the better investment.
S&P's equity analysts continue to focus on the growth at a reasonable price (GARP) approach, which we believe works well over a long period of time since it is not subject to market drift (growth vs. value, small-cap vs. large-cap, etc.), prevents analysts from chasing the latest fad, and favors companies only if they trade at reasonable discounts to their long-term intrinsic value.
We suspect fewer investors will be disappointed so long as those investing today have realistic performance expectations due to the more subdued earnings growth environment, and aren't buying on hype about the next takeover target. We think the one positive thing from the latest market turmoil is that interest rates and earnings will again take center stage to the benefit of long-term equity holders.