The hurricanes roiled the energy markets. Higher interest rates are threatening to put an end to the housing market’s historic boom. Meanwhile, a surging federal deficit could put more pressure on rates and the U.S. dollar.
What’s an investor to do?
The Business Journal canvassed some of Orange County’s money managers to see where they,and their investment companies,are directing clients’ money.
We asked five questions: Where will stock prices be in a year? What sectors are expected to perform best during the next 12 months? What is your outlook for interest rates and their impact on the stock, bond and housing markets? What’s your outlook for the economy? What’s the impact of surging oil prices on the markets?
Responses are varied. Some are more optimistic than others. The federal deficit is seen as a big issue. Many suggest looking at foreign markets to invest. Some market trackers expect the oil sector to cool off.
Others, like Chuck Martin of Mont Pelerin, see the energy sector as a “mega-trend” that will continue to fuel investment gains for many companies.
Local investment advisers turned to their companies’ forecasters in some cases. Merrill Lynch & Co.’s Jodi Rolland, for instance, compiled responses from the company’s investment managers and researchers.
The Business Journal sent out requests in September. At the time the S & P; 500 index was 1,215, the Dow Jones Industrial Average was 10,422 and Nasdaq was 2,111.
Following are edited responses to the Business Journal’s questions.
Where do you see stock prices heading in the next year?
MICHAEL JOHNSTON
Managing director,
investments senior advisor,
Private Wealth Management
Smith Barney, a unit of
Citigroup Global Markets Inc.
Irvine
Tobias Levkovich, chief U.S. equity strategist for Citigroup Investment Research, recently initiated his year-end 2006 equity market targets, using 1,400 for the S & P; 500 and 11,900 for the Dow Jones Industrial Average, which suggests that the market could be roughly 15% higher in the next 15 months.
For year-end 2005, Levkovich anticipates that the S & P; 500 closes at 1,300 with the DJIA at 11,050.
He believes the equity markets have already priced in a rising fed funds rate, inflation fears, geopolitical uncertainty, high energy prices, large budget deficits, growing trade deficits, moderate hiring trends and housing bubble concerns.
JODI ROLLAND
Regional managing director,
Southern California
Merrill Lynch & Co.
Newport Beach
The stock market has resumed its corrective trend after an early-September rally failed to push the averages to new highs, according to Richard T. McCabe, Merrill Lynch technical research analyst. Some further weakness into October, which historically has been a good month for market upturns, could set the stage for a fourth-quarter advance that should attempt to revive the aging post-2002 bull-market cycle.
Concerns about rising energy prices resulting from Hurricanes Katrina and Rita put an end to the market’s September rally. As we see it, the market faces further uncertainty in the coming weeks that could lead to additional weakness, a near-term “relief bounce” notwithstanding. In particular, medium-term measures are likely to require several more weeks of market weakness or choppiness to reach more-favorable oversold conditions.
That said, October has generally been a good month for market bottoms, and the fourth quarter of post-presidential election years has tended to produce gains in the stock market.
GORDON MCBEAN
Director of asset management
Roth Capital Partners LLC
We see total returns of around 5% during the next year driven by a couple of factors: increased business spending as corporations invest more in technology to maintain or improve profitability, and production of industrial equipment that is getting a boost from commodity inflation.
There will be less of a boost from housing as interest rates and tightening lending standards slow that market.
CHUCK MARTIN
Chairman and founder
Mont Pelerin Capital LLC
Newport Beach
Over the 12-month forward time horizon I see the equity markets going sideways with erratic moves up and down. My expectation is that the indexes will move in a band of about plus or minus 5%.
Our economy is actually in pretty good shape but will probably be slowing over the next 12 months as the high cost of energy (oil and natural gas) impacts every sector of the economy. This slowing of the economy is already priced into the market.
VICTORIA COLLINS
Principal, executive vice president
The Keller Group Investment Management Inc.
Stocks are reasonably priced now and can return 8% to 10% over the next 12 months despite interest rates rising and the economy slowing. The old Goldilocks phenom “not too hot, not too cold” has been good for the markets in the past and will be again.
The catalysts that we had banked on to rally the market in this last quarter,oil prices moderating, an end to interest rate hikes and strong corporate profits,have been derailed by Katrina, Rita and a guy named Alan.
When bad news no longer captures headlines and Alan Greenspan stops hikes, the markets are poised for a positive sigh of relief.
MATT HEALY
Senior regional investment manager,
vice president
Wells Fargo Private Asset Management Group
The idea that the stock market will trade in a broad-based multiyear trading range similar to the one between the late 1960s and early 1980s seems to have become the consensus thinking of investors today. We are of the opinion that continued evidence of stronger-than-expected economic and profit momentum will lead stock prices higher.
During the next 12 months we believe the S & P; 500 will break through 1,300 as corporate earnings continue to surprise on the upside. Looking back on second-quarter earnings this year, 71% of companies reported earnings that beat estimates. Fifteen percent of companies missed earnings estimates and 14% met earnings estimates.
Clearly, earnings have surprised many analysts and we are of the opinion this trend will continue into 2006.
What sectors are expected to perform best during the next year?
Johnston of Smith Barney
We are overweight the semiconductor and semiconductor equipment industry groups due to an improving capacity and pricing environment in 2005. The software and services industry group is the most attractively valued area within the information technology sector.
Other overweight sectors include media due to attractive valuations, low earnings expectations and being out of favor; diversified financials due to promising fundamentals given deal activity and attractive valuations; and pharmaceuticals and biotech due to compelling valuations and the belief that many of the risks of this sector already have been priced into the market.
In terms of the energy sector, we remain wary of the dramatic rally in many of the sector’s stocks this year. Moreover, we continue to suggest underweighting the utilities and telecom services sectors.
Rolland of Merrill Lynch
Slower economic growth also means that earnings gains will be harder to come by, according to Merrill Lynch’s 2005-Year Ahead report. Experience shows that quality should be the watchword under those circumstances. Historically, higher-quality assets outperform lower-quality ones when the rate of earnings growth slows.
With that in mind, we think that investors generally ought to concentrate on higher-quality companies with excess cash and become more defensive and more diversified across asset classes and regions. The best way to do that in the U.S. equity market, in our view, is to focus on the utility, consumer staples, defense and energy sectors.
In our view, energy stocks may be overdue for a breather. Energy prices have appeared to stabilize, and, in fact, oil prices fell last week. Additionally, Hurricane Rita did less damage than feared, which should help contain oil and gasoline price increases.
McBean of Roth Capital
I like the macro trends in biotechnology (more biotech drugs coming to market and Big Pharma is investing in biotech again) and specialty pharma (increased generic demand and greater emphasis on more specific disease focused therapeutics). Overall, though, we expect it to continue to be a stock pickers’ market.
Martin of Mont Pelerin
The fact that the indexes are likely to move sideways does not mean that there will not be some strong sectors and some great stocks to own. There is an abundance of very good companies that are performing very well and their shares will appreciate, even in a down market. There are perhaps a dozen mega-trends that are providing certain companies and sectors with a “tailwind.”
Energy is the most notable and obvious one. While energy prices have been cyclical in the past, gradually the world’s demand has increased, while the supply and infrastructure for refining and delivery have remained stagnant. The gap between supply and demand has narrowed to a dangerous point where price is the only “adjuster.” Furthermore, the oil supply chain is at great risk of disruption due to natural disasters (hurricanes) and geopolitical instability in those countries that control most of the world’s supply. One oil investor described the seven principal national sources of oil to be the “seven psychos.” Those producers have us “over a barrel” and they are going to squeeze money out of us. High energy prices are here to stay. Only a worldwide recession can bring them down. Soon it will cost $100 to fill up your SUV.
The Asia growth phenomenon is another mega-trend. China, India, Korea, Taiwan and others are on a long-term growth trend and even Japan is showing signs of a comeback from years of stagnation. These are growing threats as competitors, but also represent rising markets and sources for higher efficiency for international companies.
E-commerce is another area that continues to boom. Information technology and communications also offers opportunity, though it is a dangerous place for those that do not know the dynamics of these industries.
Collins of The Keller Group
In the next 12 months we anticipate that financial services and pharmaceuticals will take over the lead from the energy sector. Our bottom-up stock selection strategy determines our sector weights.
We are currently over-weighting select companies in consumer cyclicals, financial services, technology and consumer staples because we see more upside potential here going forward.
Healy of Wells Fargo
At this point in the business cycle we are recommending an overweight in industrials, basic materials, information technology and healthcare. In terms of style allocation, we are recommending clients have a 21% weighting in international stocks as valuations and economic growth globally looks very positive.
In the international equity markets, we are emphasizing emerging markets, particularly Brazil, Russia, India and China.
What is your outlook for interest rates and their impact on the stock, bond and housing markets?
Citigroup’s economists currently estimate the Fed Funds rate to be 4% at the end of 2005 and 4.5% by early 2006, with the potential for 5% if the inflation threat persists. We believe that near-term inflation readings are going to be worse than pre-Katrina and Rita and that the Federal Reserve might need to contain inflationary pressures.
Other factors that should keep longer-term interest rates contained during the next year include the amount of U.S. Treasuries being purchased by foreigners due to a widening trade deficit and the very low demand for debt capital from non-financial corporations. Plus, treasuries offer more attractive yields in the U.S. versus government bonds elsewhere.
We do not believe that a price collapse in homes is imminent, but rising rates already have affected affordability indices and home price gains should cool. We remain worried about the seemingly overheated condo market in many resort areas.
As expected, the Federal Reserve recently increased interest rates by another 25 basis points to bring the fed funds rate to 3.75%. The accompanying message, however, was a surprise to many in that the Fed indicated that it is likely to continue raising rates to combat inflation, according to Bob Doll, Merrill Lynch chief investment officer.
In response, the equity markets sagged. The U.S. stock market has significantly lagged foreign markets so far this year, but could likely experience a rally once the Fed stops increasing rates.
Interest rates play a pivotal role in house price inflation. Interest rates have six times more impact on home prices than income growth, according to Merrill Lynch senior economist Sheryl King and economist Claudia Lokody.
And even though we have not seen a rise in long-term mortgage rates (30-year rates have declined in lock-step with Treasuries since last June), the recent trend toward shorter term mortgages,over 30% of mortgages are now adjustable rate mortgages,implies that home prices may be more vulnerable to rising short term rates than they have been in the past. Mortgage rates would have to climb significantly above present levels to get home prices to roll over.
The current Fed seem focused on the heated housing market and gradually deflating that bubble. Its tightening will probably persist over the next few months and should begin to slow down real estate volumes.
Recent commentary from leading subprime lenders would suggest that the Fed may begin to get its wish, as pricing sensitivity in the secondary market is forcing subprime mortgage rates up. I would expect to see the impact of that on home sales in the not-too-distant future.
I would hope to see the economic slack picked up in business and industrial spending. If that does happen, it should have a positive impact on our trade deficit as our exports of industrial and technology products grow and housing driven imports of consumer goods slow.
An improving trade balance would help the dollar and the capital inflows to our stock and bond markets.
The Fed has often commented that they are puzzled why long rates stay down as they raise the discount rate (short rates). What is happening here is that a symbiotic relationship has evolved between Asia and the American consumer. They sell us a lot of stuff which grows their economy. In the process they end up stockpiling high levels of U.S. dollar reserves. So they buy our long-term debt instruments, which keep rates low on mortgages, bonds, etc. U.S. consumers refinance their homes, pull money out and buy “stuff” (much from Asia.) This is a mutual dependency or vicious cycle that is like a drug addict (U.S. consumers) and a dealer (Asian producers).
So what has to give? Eventually it will be the U.S. dollar. When you combine the trade deficit driven by the “drunken sailor” consumers in this country with the federal deficit arising out of political leaders with no fiscal discipline it only leads to one place: the shrinking value of the dollar versus other currencies.
If Asian nations stop buying our treasuries, bonds and mortgages, long rates will climb and the housing market will turn down. This is a cycle that has repeated itself a dozen times in my memory.
Homebuilders have historically gone from boom to bust over every five- to seven-year cycle. This boom has been a long one and many in the industry have lost their (healthy) fear of a downturn. The housing market is so over-stimulated by the unsustainably cheap financing that it is hard to believe that the present trends can continue.
Ultimately, mortgage debt needs to be paid and mortgage payments must be affordable. While it isn’t exactly like the “tech bubble,” there are some similarities: All those that thought prices could continue to climb indefinitely were shocked when the downturn came.
Given what we’ve seen, we expect the 10-year treasury rate to rise to 5%. Higher rates will slow housing, consumer spending and the economy, and that is part of what Greenspan has in mind. However, we don’t expect this slowing to cause the economy to roll over into recession. We anticipate that the stock market will rise moderately over the next year in this slow growth, low inflation environment.
Most anticipate a slowing in economic growth during the next year, which is expected to flatten profits and eliminate the stock market’s primary catalyst. The slowdown case is based on crude oil prices shutting down the consumer, the lagged impact of the Fed tightening beginning to bite and an expected moderation in growth from Europe.
In past oil crises, it was not so much the rise in oil prices that hurt, rather it was the rise in other prices in conjunction with oil,auto prices, mortgage yields and service price inflation. Today, oil prices are up substantially but are offset by other forces like low mortgage rates and electronics prices, auto price discounts, and higher real labor compensation.
We believe interest rates will be range bound as investors grapple with an economy that has both inflationary and deflationary elements to it.
What’s your outlook for the economy?
Johnston of Smith Barney
Due to the hurricanes and higher energy prices, we expect the economy to grow more slowly in the near-term with fourth quarter GDP growth to be in the low 2%-range. Even before Katrina, we were looking for growth in the economy to decline in 2006 from its more torrid pace of the past couple of years. Specifically, we expect growth to slow from a 4.2% GDP growth rate in 2004 to an expected 3.5% GDP growth rate in 2005 and a 2006 GDP growth rate of 3.3%.
While the hurricanes in the near term could slow the economy, over the longer term economic growth could be higher due to reconstruction activity in the Gulf Coast region.
Consumer spending is expected to moderate as well in view of higher energy prices, but job growth and modest wage increases should sustain spending trends.
Rolland of Merrill Lynch
While the Fed’s decision to raise rates was not exactly a surprise, it was somewhat unprecedented for the central bank to tighten interest rates in the wake of such a significant natural disaster as Hurricane Katrina, according to Bob Doll, Merrill Lynch’s chief investment officer.
Similarly, it was an unusual move in that the economy has been showing signs of slowing for several months, particularly as the rising short-term rates and higher energy prices have taken a toll on consumer sentiment.
The Fed remains more concerned about the threat of inflation and believes that the economy is resilient enough to withstand additional increases.
In the near term, the Fed faces a challenging balancing act given the potential for weakening economic growth and continued high energy prices, which could be fueling inflation.
In our view, the economy can probably absorb one additional rate hike to 4%. After that, we would become concerned. Until the Fed changes its view (and we believe that it will, as we expect to see additional evidence of slowing economic growth), equity prices could be at risk.
We have been saying for some time that when the Fed does change its tune, that could be a catalyst for a resurgence in equity prices, especially if we also witness a correction in energy prices.
Looking ahead, we expect to see only a moderate slowdown in economic growth, hopefully followed by a few more years of expansion.
McBean of Roth Capital
We have a fairly optimistic outlook for the economy as we see business spending and investment picking up. Should this offset the drop-off that we expect to see in consumer spending, the outlook is extremely rosy. We do not foresee lingering effects from the hurricanes.
Collins of The Keller Group
We are optimistic about the U.S. economy. However, we are concerned about the twin deficits.
Federal dollars targeted at the recent hurricane damage in the Gulf will help propel our economy over the next few years. But the deficit spending to fund it adds to our long-term U.S. economic concerns.
Healy of Wells Fargo
Currently, we think there is a healthy global economic recovery that will be far more sustainable than widely perceived. Earnings growth will continue to surprise and inflation and interest rates continue to remain low in a world of solid real growth.
Investors need to rethink how they approach the equity markets. U.S. businesses are sitting on a powder keg of cash and dividends are becoming more important. Investors need to look at equities from a yield or income perspective as well as capital appreciation.
Many investors today view the equity markets strictly from a speculative perspective due primarily to the market downturn at the beginning of this decade. This is slowly changing as investors continue to look for yield.
We are of the opinion U.S. companies will continue to increase their dividend payout making equities more appealing from a yield or income perspective.
What’s the impact of the oil price surge on the markets?
The energy sector of the S & P; 500 represents about 14% of the net earnings of the S & P; 500 versus representing 4% to 5% of the national economy. However, higher energy-related profits are likely to offset weakened earnings expectations in other sectors, especially within consumer-driven industries.
Overall, labor costs account for roughly 70% of corporate expenses versus about 4% from energy and 5% from commodities. So as long as energy prices do not creep into wages,as they did in the 1970s,the impact of higher oil and gas costs should be manageable.
The Gulf Coast is an important region in terms of oil exploration and refining, and the damage and disruption caused to oil pipelines and refining capacity raised fears of severe supply shortages across an already tight oil market, according to Merrill Lynch’s Doll.
Although these concerns drove oil prices up to a new peak of more than $70 per barrel in the week following the storm, the announcement that the U.S. Strategic Petroleum Reserve would be tapped helped to stabilize the market. For now, we believe oil will remain in a trading range of between $60 to $70 per barrel.
So far it seems that companies have been able to pass much of the effects of the oil price hikes on to consumers. Third-quarter results will tell us if that trend is continuing but you have to believe that it will eventually show up in consumer spending.
One positive that may bode well for future generations is that there seems to be a real focus on alternative energies on the parts of the legislature and our capital markets.
The recent rise in energy prices along with our forecast for higher interest rates will work together to trim economic growth. If anything positive comes from slowing U.S. growth, it is that it will dampen growth around the world, putting downward pressure on energy prices.
While the oil spike is a significant negative development for specific industries such as airlines and perhaps for lower-income households, we believe it will prove far less contractionary compared to historical standards.
