Insightful analysis and commentary for the US and global equity investor
Contributors: Douglas McIntyre Jon C. Ogg

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Monday, September 25, 2006

Four Questions Investors Should Ask In This Market Climate

At this point the market outlooks have become so divergent that two camps have formed a) The Gloom & Doom gang b) Those who expect a year end rally. Before deciding which side you’re on, Investors need to ask four questions: 1) What will the Fed do? 2) What's the outlook for the next earnings season & 3) What does the business & consumer spending tell us? 4) What is the Global outlook?

• The Fed-
1. The Fed will be keeping a close watch on market expectations of inflation, which have edged lower recently due to several months of weaker than expected employment growth & drastic slowdown in the housing sector.

2. Weak growth is likely to become the dominant worry, prompting the Fed to start easing policy in the opening months of next year

What's the market saying? Looking at rates for Fed funds futures, the market is pricing in a short-term interest rate cut next year, implying that market participants believe that the Fed has overshot its mandate to keep inflation at bay, especially with this week's extremely low Philly Fed report. Investors seem to be expecting that the next move by the Fed may be to lower the Fed Funds rate in an attempt to avert recessionary risks.

• Earnings-
1. As the 3rd Q approaches, the total number of downward revisions over the last month now exceeds the total number of upward revisions, for this & next year.

2. The market's preference for large-cap stocks increased marginally, now that signs of the US economic slowdown have become apparent. Investors shouldn't expect that the corporate profit margins will be hurt drastically, but rather will undergo a gradual narrowing.

3. Looking forward to the 3rd Q, investors should expect the EPS growth to slow just over 9%. Much of this slowdown is due to lower commodity prices in the energy sector, which is expected to post growth rate north of 22%. According to Zacks, Utilities & Tech are also expecting a slow down, with growth estimates at 7.8% & 5.7% respectively. Only the materials & telecom sectors are expected to record more favorable 3rd Q growth rates.

• Business & Consumer-
1. The corporate sector is in solid shape in terms of profitability (over 17 Qs of double digit growth!). However, there are mounting cyclical headwinds for business investment because of the slowdown in domestic demand.

2. The Philly Fed indicated a broadening out of the pressure, from the housing market to wider parts of the economy.

3. Investors should note that- With a cash strapped household sector & persistently high energy prices (even with the recent drop they are historically high), companies would find it difficult to pass on rising costs to consumers through higher prices or surcharges.

• Global Outlook-
1. The ZEW survey of analyst expectations for the euro area & the global economy slipped yet again in September. The global indicator is now near past cyclical lows, with the US component notably weak.

2. Just like the climb of global interest rates higher, the developing global growth slowdown will be broad based, with all major regions moderating.

With the market growth scenario tilting towards a generic slowdown globally, short interest in the US approaching towards a 5 year high (as I reported last week) & widening corporate spreads in the fixed income markets, are indicative of growth peaks. As such it is prudent for investors to take a more defensive, market neutral stance.

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