06 Jan 2006 If the Fed Gets It Right – 2006 Will Be a Happy New Year
The economy continues to grow, creating new jobs even as companies produce more with fewer workers. Non-farm payrolls increased by 108,000 in December and the unemployment rate dropped form 5.0% to 4.9%. While the December growth in jobs was about 100,000 less than expected by economists, the number of jobs created in November was increased by the same amount, as reported by the government. Manufacturing payrolls increased by 18,000 for the month. Following sufficient economic growth, the continued high productivity rate no longer stifles hiring. In other words, despite increased output from workers, companies are still forced to hire new ones to keep pace with demand.
With economic growth, improved efficiency, and productivity, corporate earnings continue to rise. Earnings of S&P 500 companies grew about 14% in 2005 and will likely grow in excess of 8% this year. Value Line projects that the 30 Dow Jones Index companies will grow their earnings by 19.5%. During the rather dramatic growth in earnings during 2005, price-earnings multiples actually declined. If P/E multiples increase this year by just 1 point, it would suggest a 13-15% increase in the S&P 500 index this year.
The market’s ceiling continues in place as long as the Federal Reserve remains ambiguous regarding their rate policy. Some analysts argue that the Fed has gone about as far as they will go with rates. Inflation remains exceptionally low and indications are that it will continue to remain subdued as productivity continues to grow impressively. If they cease their rate increases soon (recently released minutes indicate the possibility is increasing) we could see an expansion in P/E multiples as well as increased investment by businesses and individuals.
Housing continues to cool, but no unsettling bubble burst appears to be on the horizon. Prices for new and existing homes are falling as higher mortgage rates exclude larger portions of would-be buyers and slow the growth in re-financings.
All the while, the consumer remains fairly upbeat as indicated by a pretty good Christmas selling season. Confidence is relatively high as jobless claims are falling, chain-store sales are rising, and gasoline and home heating costs are not as burdensome as feared in October.
As to strategy; we expect the best returns will continue to come from abroad, specifically from emerging economies and Japan. We will keep an eye on Europe for growth potential, but without badly needed reforms these markets are not likely to outperform either the US or emerging markets.
At home we look for relative out-performance in the technology, communication, and healthcare sectors. We also expect that large-cap growth companies will outpace the appreciation potential of their value-oriented counterparts. Our portfolios are largely positioned to accommodate our current strategy, but a few changes are expected as opportunities present themselves and as we manage risk due to valuation, competitive threats and the like.