2006 Review and New Investment Themes for 2007

Posted on January 10, 2007 by David Laidlaw 

Stocks continued to rally throughout the fourth quarter as inflation slowed. The main reason for moderating inflation was the decrease in energy prices which peaked during the summer, fell through the third quarter and stabilized at the end of the year at about $60 per barrel of oil. Even though energy is less important to the overall economy than in the past, the unabated increases in oil and gasoline prices over the past few years rippled through the markets. When this trend reversed itself, many investors felt comfortable bidding up stocks since underlying corporate profits continued to grow.

Stocks generally performed very well and high-quality bond returns were lackluster. The large developing markets of China , India , Brazil and Russia provided stellar returns as they continued to attract investment capital from the developed economies. On the other hand, the oil-based markets in the Mid-East lost significant capital as energy prices stabilized.

On the domestic front, 2006 was the year of turnarounds and cyclical companies. Telecommunications was the best performing sector increasing over 30%. GM, even though it continues to hemorrhage cash, returned 64% and was the best performing company within the Dow Jones Industrial Average. We do not believe these sectors of the market will provide sustained growth since high capital expenditures and competitive pressures will deter future gains.

The consensus view for 2007 is that the economy will continue to grow at a slower pace early in the year, but will accelerate in the second half as residential housing construction and sales rebound. We believe the housing market will stay weak longer than expected. Housing price increases were so strong for so long that the market is in need of a more significant correction. Six years ago, a majority of market strategists opined that the technology sell-off would end as 2000 came to a close and that the NASDAQ would begin increasing again in 2001. However, the market excesses were so substantial that technology stocks continued to decline for two more years until the last bulls capitulated in late 2002. Similarly, we expect housing inventories to stay high and prices to remain depressed longer than expected. The slump could become severe if mortgage rates rise above these still historically low levels.

We view stocks as fairly valued, but expect corporate profit growth to slow. Compensation expenses will most likely increase due to the tight labor markets with 4.5% unemployment.

The huge amount of liquidity surging around the world may also support stock market levels. Global mergers and acquisitions during 2006 were valued at over $3.8 trillion which is 38% more than during 2005. Private equity investments represented 20% of this volume and these firms are interested in buying larger and larger public companies. Corporate balance sheets are also very strong and should support a favorable market for mergers and acquisitions. Finally, foreign capital usually comes to the US markets after double digit (pre-currency) market gains.