05 Jan 2007 What Lies Ahead?

Economic reports continue to indicate that theUSeconomy and the global economy are headed for a soft landing rather than a recession, despite the decline in housing and the auto sectors. Today, the Labor Department announced that theU.S.added a greater-than-expected 167,000 workers to employers’ payrolls in December while incomes grew by the most in eight months. The employment gain followed a 154,000 rise in November, also larger than previously estimated and the overall unemployment rate held at 4.5%. On Wednesday, the Institute for Supply Management helped lift stocks by reporting that its barometer of manufacturing business crept up to 51.4 in December, indicating growth after a brief contraction in November.

While these numbers are encouraging they must be taken in the context of a slowing economy. The numbers were much higher when the economy was growing in the 3% to 4% range rather than the current anemic 2% rate. The largest driver in this economy’s future remains the Federal Reserve. And what they will do next is keenly debated by pundits as it is discounted by the markets.Bill Gross manager of PIMCO, the nations’ largest bond fund, expects the Fed to drop the Funds rate a full percent to 4.25% during 2007. He thinks they will be prompted by a further slowing economy as well as rising unemployment. Both will begin showing up in the coming months.

The Fed has recently begun to show some ambivalence in their views on the strength of the economy. The minutes of their last policy-setting meeting suggest that some policy makers see the economy as slowing too fast. But most members still view the economy slowing sufficiently to reduce inflation threats while maintaining adequate momentum to avoid ill consequences outside of housing and autos.

While the bond market and bond managers like Bill Gross suggest the Fed will be compelled to drop rates in 2007, others like Laksham Achuthan of Econimic Cyle Research Institute maintain that the Fed does not need to reduce rates significantly if at all. He points out that they usually move when they are worried about recession. As noted, most think the economy remains on solid footing. His rationale is supported by continued job growth, the recent and surprisingly strong up-tick in service sector growth, and the ECRI Leading Home Price Index which has shown a strong uptrend for the past three months. He says that if it continues a couple more months, it indicates that the bottom in housing may be near.

The job market’s strength puts the Fed in a quandary. Strong growth in jobs (relative to the slow growth in the economy) suggests that incomes will grow enough to keep consumers spending and the economy growing. Conversely, the growth in wages may be sufficient to fuel inflation. Bob Stein, a senior economist at First Trust Advisors LP in Lisle,Illinois, said “We think the economy will come in stronger than people expect. Expectations of a rate cut will be drained out of the market.”

As there is broad disagreement as to what the Fed should and will do in the months ahead there is equal disagreement about what the stock and bond markets will do. While all of the nation’s top 12 brokerage firms are calling for a positive to a good year in stocks, some economists and perennial bears are saying that rising interest rates, wages, taxes, potentially higher commodities prices, and the falling dollar will do to lessen the likelihood that the Fed will reduce rates any time soon. The market’s run-up of the past several months and the continuing optimism of stock strategists may be overly influenced by the belief that rates will fall next year.

Bears have been wrong for months about the market’s direction, but will they eventually get it right, if for no other reason than the bull market is aging? Michael Kahn of Barron’s points to significant technical evidence that suggests the market is due for a rest. He points to a US dollar that is under attack andUSinterest rates that are breaking out of their channels. It is a combination that makes it very hard for the Fed to lower interest rates in 2007 which will be a major disappointment for the pundits, as he puts it.

The Dow Jones Transportation Average has been weak or falling for several weeks now. As reported in Barron’s, Matt Blackman of TradingEducation.com says that the falling transportation sector bodes ill for the economy and for to the stock market by extension. He started by citing a presentation made by Sen. Dick Lugar back in March saying that, “…the transportation sector…accounts for 60% of American oil consumption.” If oil is trading in the mid-$50 per barrel range now and the transportation sector, which is so dependent on energy prices, cannot make it back to its May highs when oil was $70 per barrel, then it must be saying something about the economy in 2007.

Further, the breakdown in the Dow Transports, as the Dow Jones Industrial Average makes new highs is a bearish warning for the market. Dow Theory, created by Charles H. Dow a century ago, requires that new highs in one of these averages be confirmed by new highs in the other. If not, then something is wrong in the market. The NASDAQ, which reflects a major sector of the market has also failed to rally with the Dow Jones Average.

What does it mean for investors?

Valuation is the bottom line. Current stock values are considerably lower than they were at the end of the last bull market. Studies suggest that the stock market is now more than 30% undervalued relative to bonds. An indicator used by the Hays Advisory Group suggests that the S&P 500 is at one of its most undervalued stages in this indicator’s 28-year history. One has only to look at the recent spate of huge corporate mergers and takeovers to see that some very smart people see value where for whatever reason the market chooses to ignore it. What’s more, the numerous billion-dollar stock buy-backs indicate a degree of confidence in their businesses that managers can value their stock prices considerably higher than the stock market currently does.

We think that the Fed, under Ben Bernanke is ready and willing to move aggressively, if needed, to reduce rates to stimulate the economy, should it falter. Bill Gross notes that there is only a short period of time between the Fed’s decision to cut rates and the actual cut. In other words, they don’t usually telegraph it. In fact data indicate that they are already adding significantly to nation’s money supply. Money growth typically starts to accelerate when the Fed stops raising rates. They may continue to talk the hard line against inflation while quietly adding cash to the system. Money drives economic growth, which fuels corporate earnings, which propels stock prices.

We are invested where we believe the greatest values are and where the best opportunities are. In equities it is technology and large cap growth stocks. We also like global markets as we believe several still have the potential to outperform US markets. Finally, in bonds we are shortening our maturities substantially. We are locking in risk-free returns near 5% in maturities of one to three years. We believe that when the Fed does eventually drop rates, the shorter maturities will benefit most in price jumps.