Global Outlook—June 2008

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Long-term investors have reason to relax. Keeping in mind, the past performance of the markets is no guarantee of future results, every economic contraction in history has been followed by a recovery and a stock market that trades higher. Looking at the 10 recessions since World War II, the stock market tends to bottom six months before the economy. Ned Davis Research studied the recessions since 1945 and realized the average three-, six-, and 12-month return off the bottom was 16%, 24%, and 32%, respectively. My biggest concern is that investors will miss 75% of the market’s move, whatever that number happens to be, if they wait for the economic news to turn positive before they invest. The challenge for investors is to manage the transition from protecting principal to positioning portfolios for the recovery.

The duration and magnitude of a recovery will likely determine asset class and sector performance – and ultimately an investor’s return. The early stages of a recovery are always difficult and somewhat uncertain. With the advent of hedge funds, any market move will likely be even more volatile, as hedge funds try to anticipate the economy’s future path. This volatility can be distracting and lead investors to make emotional investment decisions. In this commentary, I will attempt to cut through the noise and outline the issues that I believe will affect the market’s outcome.

Bear Market Rally
When investors perceive equity market conditions as improving, the market tends to move higher. In mid-March, investors believed the Federal Open Market Committee (FOMC) made the market less risky when they facilitated the JPMorgan/Bear Stearns merger and provided capital to primary banks for the first time in history. What followed, in my opinion, was a market rally that got ahead of itself. Given the rather pessimistic economic data announcements on energy prices, housing, and consumer sentiment, a market retracement was warranted.

A funny thing about bear market rallies is that the sectors that tend to lead the market lower begin to move higher, and at the tail end of the rally, investor sentiment changes to believing this is the beginning of a bull market. That’s what happened, in my opinion, from March 17 to May 19. On May 19, the S&P 500®¹ failed to close above the 200-day moving average, a technical level that would have signaled a new leg up in the market. In essence, investors weren’t ready to take the market higher without better guidance on the direction of energy and housing prices.

Consider the economic picture from March 17 to June 20:

• Oil prices increased another 30%, as measured by the average price of light sweet crude.
• The average price for gasoline increased 24% (according to AAA).
• The unemployment rate increased from 5.0% to 5.5%.
• Increases of a half percentage point or more have only happened 19 times since World War II, as recently noted by JP Morgan.
• The 10-year treasury yield increased 86 basis points or 26% (from 3.31% to 4.17%).
• Financial stocks declined 20% from their May 2nd high. Housing prices continue to fall, with few signs of stabilizing.
• Consumer sentiment and future expectations are at their lowest levels in 28 years (as measured by the University of Michigan consumer sentiment and expectations index).

Market volatility during this period left investors nervous and confused, wondering whether to add to equity positions. “Is it safe to go back into the water?” is a valid question. On one hand, the market has probably priced in most of the bad news. The market’s resilience is testament to generally attractive valuations. We probably haven’t seen the high in energy prices but most of the move is behind us. With consumer sentiment levels at their lowest in 28 years, how much lower can it go? The S&P 500 financial sector index is off 47% from its previous high set on May 25, 2007. Most of the downside is probably behind us. But, on the other hand, we need to explore what issues aren’t already priced into the market.

What Isn’t Priced into the Market?
Energy prices will continue to be the market’s wildcard, in my opinion. Higher oil prices will place downward pressure on the market. We will likely see $150 per barrel before we see $100. That said, oil prices tend to be mean reverting. When prices rise, demand tends to decline, and prices fall as a result. That hasn’t happened in this cycle even though U.S. demand is declining. The reason for this is foreign subsidies and demand. Many emerging market countries subsidize the rising cost of fuel instead of passing the increase onto the consumer. As a result, demand hasn’t declined enough to reduce prices. Recently, a number of emerging market countries, including China, have reduced their subsidies, but not enough to bring prices down significantly. In fact, China’s change in subsidies could actually move certain oil prices higher in the short-run. Chinese refiners’ profits have been capped because of previous price controls. Now that prices are higher for certain fuels, refineries are likely to acquire more oil to process into various distillates.

Supply problems are also contributing to higher energy prices. Call it politics or profit. Supply disruptions have occurred to protect profits amid a weak dollar. The potential for an Israel-Iran conflict isn’t helping matters either.

Another potential problem for the equity market could be hedge funds liquidating stock positions to meet investor redemptions. Investors in hedge funds have until the end of June to submit their quarterly redemption requests. Recent poor performance by many of these vehicles could increase liquidations.

Finally, although a major portion of the financial sector’s slide may have occurred, I believe the sector has the potential to fall further. The ongoing slide in home prices will lead to additional foreclosures, which could translate to another round of writedowns for the financial sector. The financial sector has done a great job in raising capital through stock and bond offerings, but earnings improvement will remain elusive. Housing prices show no signs of stabilizing, which will continue to weigh on consumer sentiment and spending.

The Fed
Rising commodity prices are not likely to prompt the FOMC to move the target federal funds rate higher, despite what the bond futures market is pricing. The FOMC has never increased rates while the unemployment rate is still rising. In my view, unemployment is likely to reach 5.7% to 5.9% by the end of this year. By some calculations, the economy has to grow at 3% to keep the unemployment rate constant.² I doubt the Fed will increase rates until after the housing and financial markets stabilize. Moreover, the FOMC’s preferred inflation metrics, the core consumer price index (CPI) and the core personal consumption expenditures index (PCE), have moved little over the past year. Core CPI has moved from 2.2% to 2.3% and the core PCE has moved from 2.0% to 2.1% over the year ending in May.

Inflation may not be a problem in the United States, but it certainly is becoming a problem abroad. Overseas inflation is likely to lead to higher rates in Europe (where the European Central Bank just raised rates in early July) as well as the emerging markets. I doubt the Fed will cut U.S. interest rates when global rates are rising. We live in a global economy and the U.S. still needs to attract foreign capital to finance its twin deficits. Higher interest rates in a slowing economy could be a difficult environment for significantly higher equity prices.

The Dollar
I am not convinced the dollar has hit a cyclical bottom and will strengthen throughout the year. In the recent past, the U.S. dollar has not changed direction without G7 intervention. That is not to say the Euro/dollar exchange rate wasn’t overextended at €1.60/$1. Fair value is probably closer to €1.45-1.47. Higher Euro interest rates, slower U.S. growth, and potentially higher energy prices could keep the dollar from appreciating significantly to the upside, until 2009. From an investment perspective, it is important to differentiate between the dollar strengthening and the Euro weakening. Dollar strength driven by better than expected economic growth would be positive for the equity markets. However, a weak Euro because of slowing economic growth would probably be negative for U.S. stocks.

U.S. Equities
On a positive note, corporate earnings excluding financials and consumer discretionary stocks still look good. There is plenty of cash on balance sheets. Corporations continue to reduce their share count through corporate buybacks and mergers. We are beginning to see foreign companies attempt to acquire U.S. companies, indicating a higher level of value, as seen in the recent $46.3 billion takeover bid of Anheuser Busch by Belgium’s InBev NV. When energy prices decline, I believe the market will rise more than it fell when energy prices were rising. My counterparts at Lehman Brothers point out that when the unemployment rate previously increased one-half percent in a month, the market generated an average return of 28.2% over the following 12 months. Also, JP Morgan research points out that the past three times consumer confidence hit previous lows, the 12-month subsequent return of the S&P 500 was 14.9%, 18.9%, and 20.8% respectively.

As I mentioned in my two previous commentaries, my views on the U.S. economy have not changed since the beginning of the year. However, since then, the equity market has had more time to price the risks appropriately. Yes, an economic recovery is likely to take longer and grow at a slower pace because of the limited financial resources available to consumers. Net worth and real disposable income are declining, and expenditures are rising. Rising food costs have absorbed $55 billion in disposable income, based on calculations suggested by Morgan Stanley Research. Higher gas prices will take another $130 billion out of discretionary income. The government stimulus package will provide some relief but the effects are transitory.

The economy may have avoided two consecutive quarters of negative GDP growth so far, but the real test, in my opinion, will come in the fourth quarter of 2008 and first quarter of 2009. Just as the financial sector is deleveraging their balance sheets and rebuilding their capital base, the consumer is in the process of doing the same. These factors will take the economy longer to recover and alter the relative performance of asset classes. Hence, the market’s low valuation—it has already priced a slow growth recovery.

Despite the small cap stock indices’ year-to-date outperformance, I believe large cap growth stocks are likely to outperform for the remainder of the year and possibly into 2009, and I point to several reasons for this. First, an extended period of below-trend economic growth would tend to reward large cap growth stocks over other asset classes. Large cap companies tend to have stronger balance sheets with higher free cash flow positions, which allow them to self-finance during tighter financial conditions. In contrast, small cap stocks are more vulnerable to higher inflation and slower economic growth. As such, investors have historically demonstrated a preference for large cap stocks. Furthermore, the large cap growth sector offers investors the best relative valuation, trading at a large discount to their 20-year mean compared to other asset classes.³ Other powerful historical trends suggest that large cap growth companies have tended to outperform other asset classes after a peak in profit margins, which occurred in May 2007, and large cap growth stocks have tended to outperform in periods of rising or high volatility.

Looking at sectors, at some point, the financial sector could have a big run, in my opinion. However, I’m not ready to overweight this sector. It is difficult to overweight financial stocks when the E or the S in earnings per share (EPS) is unknown. I believe the risk/reward opportunity warrants waiting for a stronger sign before establishing an overweight position. Investors may miss the first 5% to 10% of the rally’s gain but acquiring financial stocks too early could result in further losses. For now, I would rather overweight the energy, consumer staples, utilities, and health care sectors.

Additionally, the information technology sector could be the big surprise this year. In the past, tech stocks tended to underperform in periods of slower economic growth. However, the lack of corporate spending has left many companies with outdated and obsolete systems and products. Demand for IT has increased in the emerging markets as companies there strive to improve productivity. Moreover, the technology sector tends to outperform in periods with high raw material inflation because their margins are less sensitive to these input costs.

Japan
If there were one place in the world where higher inflation could be a positive, it would be Japan. Plagued with deflation for over a decade, Japan’s consumers have remained on the sidelines. Why buy something today if prices are lower tomorrow? Inflation could change that modus operandi.

The Japanese market today looks very similar to 2003, when the broader market, the TOPIX, appreciated 50% by the year’s end. In 2003, the equity market was oversold, underowned, and relatively undervalued. Today, the equity market appears oversold, underowned, and undervalued. Since 1990, there has been a positive correlation between foreign money flows and stock market performance, and the flows have tended to be persistent.⁴ Foreign capital flows have been improving and as a result, the Nikkei was one of the best performing developed markets in the second quarter of 2008. The Japanese market appears more undervalued than the U.S. and European markets. Japanese stocks offer investors greater diversification away from the U.S. equity market, with a market correlation of 0.59 for the MSCI Japan Index, compared to 0.81 for the European market (as measured by the MSCI Europe Index). The underweight position in most institutional portfolios suggests the market probably has less downside relative to other developed markets.

Yet, investing in the Japanese market doesn’t come without risk. The economic landscape today is very different than it was in 2003. In 2003, the world was expanding and central bank policy was very accommodative. Despite today’s slowing global economy, I believe the Japanese market will post better relative equity performance for the year, provided that the yen doesn’t strengthen substantially against the U.S. dollar.

Europe
The MSCI Europe index has broken below the previous low for the year, as investor sentiment has turned decidedly negative. The European economy is showing signs of slowing, corporate earnings revisions are declining, and interest rates are rising.

The ECB is talking more hawkish lately, raising rates in the first week of July based on its concerns regarding inflation. Current market headwinds could take the equity market lower over the summer months. However, most of the economic headwinds are already priced into the equity market, in my opinion.

The Euro yield curve has recently inverted, which has flagged previous economic slowdowns and even recessions, with a lag. However, more often than not, when the yield curve inverts the first time, equities trade higher over the following six months. Low valuations suggest much of the negative news is already priced and it would likely take another catalyst to take the market substantially lower, in my opinion.

The market is currently trading at a price to earnings ratio (P/E) of 9 times, using current consensus estimates, a level not seen since 1991 and 50% below the 10-year average of 18 times. At current valuations, the market is only pricing 100 basis points of earnings growth each year for the next five years, according to Goldman Sachs.

Despite the difficult investment climate, opportunities do arise. There are European stocks that have a dividend yield higher than their P/E ratio, a condition which in the past has generated an average return of 44% over the following 12 months. Investors may want to look for managers with more concentrated positions to take advantage of these opportunities. Large cap growth stocks with high dividend yields are likely to outperform over the next 12 months, in my opinion.

Emerging Markets
Rising inflation and rising interest rates in an environment of tighter financial conditions is not the environment that tends to drive equity prices higher. Such is the condition of many emerging markets. Central bank monetary policy has been too accommodative and now it’s payback time. Excess capital tends to lead to overinvestment, putting a strain on limited resources, driving inflation higher. The inflation rate in Russia is over 12%, Argentina’s is over 23%, and China is approaching 9%, whereas a year ago it was closer to 3%. Higher interest rates could offset earnings growth as investors pay a lower multiple for those earnings. Emerging market equity performance continues to track the U.S. stock market almost dollar for dollar. The increased risk of investing in these markets makes them an unattractive risk/reward proposition, in my opinion. Investors may want to underweight this asset class in the short-run. Longer term, stronger economic and earnings growth should lead to better relative equity performance.

Conclusion
In every economic slowdown, it is difficult to see the light at the end of the tunnel. Market headwinds could certainly keep the market on a downward trajectory or in a trading range. However, the recent pullback from the previous market top in October 2007 is consistent with pullbacks in previous recessions. In other words, the bad news has already been priced in. At this stage of the economic slowdown, investors may want to consider positioning their portfolios for the recovery; a recovery that will take longer and move at a slower pace than previous recoveries. In such an environment, large cap growth stocks will likely outperform. Consider focusing on the defensive sectors of the market and companies that can exhibit pricing power. Until the financial and housing sectors stabilize, the FOMC is probably on hold and the dollar will likely remain under pressure.

Overseas, central banks are definitely in motion, increasing interest rates to curb rising inflationary pressures from higher food and energy costs. Rising inflationary pressures and higher rates could lead to lower earnings multiples, producing lower equity returns relative to the U.S. in the short-run. From a risk/reward perspective, in order of preference, I like Japanese equities over the U.S. equity market, the U.S. over Europe, and EAFE over the emerging markets.

In the meantime, I advise investors to relax, be patient; history would suggest the worst is behind us. Try to avoid making emotional investment decisions in volatile times. Use investment strategies that focus on stock picking. There are always stocks that move higher in challenging times, just not all stocks. In other words, don’t buy the market.

Recommended Equity Allocation

This allocation is shown for illustrative purposes only. Investors should consider their time frame and all of their personal savings and investments, in addition to their assets and risk tolerance level. Your financial professional can help you assess your individual situation before you make any allocation decisions.

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.

¹ The Standard and Poor’s 500® Index (S&P 500) is a broad-based index, the performance of which is based on the performance of 500 widely-held common stocks chosen for market size, liquidity and industry group representation. The index does not include any expenses, fees or sales charges, which would lower performance. The index is unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

² Source: Goldman Sachs research, June 20, 2008

³ Calculated by Ned Davis Research Inc. Data as of May 31, 2008.

Investments in foreign markets entail special risk, such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments

⁴ Goldman Sachs Research, July 2008