Insight Line—June 18, 2007

The two most closely tracked consumer confidence surveys—from the University of Michigan and the Conference Board—may reveal the mood of Americans when surveyed, but arguably reveal little as to how much consumers might actually spend when they hit the malls. However, research from the Federal Reserve’s economic staff suggests that at least one of these reports, the Michigan Survey of Consumer Attitudes, potentially offers something worth investors’ attention—a forecast of stock market returns.

Recently, Federal Reserve researchers Gene Amromin and Steven A. Sharpe insightfully analyzed the connections between consumer sentiment and investor attitudes about the economy, financial markets and portfolio construction, and concluded, “a more optimistic assessment of macroeconomic conditions coincides with higher expected [stock market] returns and lower expected [stock market] volatility.”¹

This conclusion likely comes as little surprise to investors acquainted with the more widely known theories of behavioral finance. After all, that line of reasoning expects human emotions to influence market prices, returns and asset allocation decisions. However, and more importantly to my second half outlook, confidence levels are once again rising.

The University of Michigan’s expectation index, after falling for three straight months has once again turned upward.

Granted one month does not a trend make. Then again, if confidence levels are poised for a sustained move higher I believe it signals positive implications for market returns in the second half of the year. My Forecast for the Second Half of 2007

The Economy

Housing, inventories, trade flows and equipment outlays were the key detractors from economic growth in the first half of the year. On the other hand, consumer spending, supported by rising incomes and steady employment held up reasonably well in the face of higher food and energy prices.

Granted, while there are indeed signs of some incremental increases to economic activity in the coming months from corporate spending and trade, I am not altering my earlier forecast of gradually receding inflationary pressures and a 2.5 to 3.5 percent real gross domestic product (GDP) growth in 2007.

The Markets Stocks

Might constructing a second-half equity forecast be as simple as the well-worn adage, stock prices follow earnings?

Yes.

Granted, such brevity is unexpected in an industry that prides itself on in-depth statistical analysis supported by impressive probabilities and projections. However, there are times when analysis leads to paralysis.

Analysts’ 12-month composite forward earnings estimates for the S&P 500 are rapidly closing in on $100. Applying the conservative 50-year average price to earnings multiple of 17.52 suggests the index is now poised to continue toward record highs and finish the year at or above 1650.

The forecast for developed international markets is remarkably similar. Higher corporate profits and attractive valuations suggest to me continued upward price action over the remainder of the year.

Bonds

Notably, in December 2006 when I constructed my forecast for 2007, the shape of the U.S. Treasury yield curve (as measured by the yield differential between the 3-month Treasury bill and the 10-year Treasury note) was inverted. That is, short-term interest rates were higher than long-term interest rates. Such is no longer the case as 10-year rates are now slightly above the 3-month rate. However, in that the current slope of the curve remains well below historical norms, I contend it reflects a continued belief among investors that inflationary pressures are receding, thereby giving me reason to project no meaningful rise in interest rates over the course of the next six months. Additionally, my forecast for domestic economic growth would not argue for any meaningful widening of credit spreads between risky and less-risky fixed income investments. As to the prospect for international fixed income investments, rate moves in developed markets seem to be more or less in tandem and as such, I suspect any relative out-performance will be reflective of currency forecasts rather than rate forecasts.

Portfolio Analysis

My research continues to favor a portfolio overweight in stocks and an underweight in bonds. While I favor large value in general as a base equity position for long-term portfolios, there may be reason to consider a tactical overweight to mid-cap growth stocks. Recent interest rate increases aside, I expect merger and acquisition activity to persist, especially among companies with market capitalizations below $10 billion. A break down of the S&P 500 into capitalization quintiles and by credit ratings reveals a larger percentage of companies with strong enough balance sheets to support additional leverage—a key component in any merger or acquisition—in the bottom three quintiles of the S&P 500 than in the top two quintiles. Therefore, for those investors with the appropriate risk profiles*, I suggest a mid-cap growth overlay as a potential way to capitalize on the growing presence of leveraged buyouts.

What Could Go Wrong?

The “wall of worry” always has its bricks, and the second half of 2007 will be no exception.

Energy price spikes, escalation of geopolitical issues, or Congressional action on taxes, trade and regulation are but a few of the bricks. An overzealous (my opinion) Federal Open Market Committee or a financial contagion beyond the known subprime and emerging market exuberance issues cannot be overlooked. That said, I contend such concerns have been already discounted in current market prices as none of them arguably break new ground.

* The stocks of medium-sized companies entail special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies.

¹ “From the Horses Mouth: Gauging Conditional Expected Stock Returns from Investor Survey,” by Gene Amromin and Stephen A. Sharpe, Working Paper 2005-26 Finance and Economic Discussion Series, Federal Reserve Board, Washington, D.C., April 2005.

Factors Driving the Economy

Economic Acceleration

Economic Deceleration

Latest Available Information
(as of 06/15/07)

Employment
^{(Source: Bureau of Labor Statistics)}

Up

Down

The May employment data varied little from that reported in April 2007. The unemployment rate remained at 4.5 percent as job creation essentially matched the increase in the labor force. Payroll employment exhibited modest growth, adding 157,000 workers. In summary, the overall data, including hours worked and wages earned, suggests to me the consumers’ continuing contribution to economic growth in the second quarter of the year. As such, I suggest the appropriate action on the table is to circle Up.

Personal Income
^{(Source: Bureau of Economic Analysis)}

Up

Down

April’s Personal Income data, due to statistical revisions, registered a slight decline from the March 2007 levels. Wage and salary levels, though not a record, remain elevated at $6.304 trillion. The personal income data remains, I believe, supportive of future economic activity. Please circle Up on the tablet.

Retail Sales
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

The nation’s measure of retail sales activity in May 2007 registered a surprisingly strong 1.4 percent increase over the April 2007 level. Total seasonally adjusted sales moved to a record monthly total of $378 billion. Granted, the numbers appear to be improving, but they have yet to regain the year-over-year growth rates seen in 2006. Therefore, I suggest the appropriate action remains to circle Down.

Durable Goods
^{(Source: Department of Commerce, U.S. Census Bureau)}

Up

Down

Durable goods orders showed some encouraging signs in the April 2007 data. Unfilled orders now rest at the highest level since the series inception in 1992. Of particular note, manufacturer’s shipments data registered the first back-to-back monthly increases since late 2005. This suggests the possibility of an improving manufacturing sector. However, the increases, though important, do not present a strong enough argument of continuing contribution to GDP. Therefore, pending further confirmation I am leaving Down as the preferred choice.

Inflation
^{(Source: Bureau of Labor Statistics)}

Low

High

Inflationary pressures remain evident but not elevated. The Federal Reserve’s preferred measure, Personal Consumption Expenditures ex- food and energy price changes, as of April 2007 rested at 2.0 percent year-over-year. Though the Federal Open Market Committee (FOMC) policy directive continues to highlight inflation concerns foremost in the minds of FOMC members, I expect the incoming data to highlight a gradual downward shift in the trajectory of this widely watched metric. Please circle Low.

Government Spending
^{(Source: Congressional Budget Office, U.S. Treasury)}

$In

$Out

The federal government recorded a budget deficit for May 2007 of $67.7 billion. The rolling 12-month deficit, when expressed as a percentage of the nation’s GDP rose slightly to 1.2 percent. As I see it, the favorable trends for meaningful deficit reduction in 2007 remain evident.
Please circle $In on the chart.

Monetary Policy
^{(Source: Board of Governors, the Federal Reserve System)}

$In

$Out

The FOMC continues to set the overnight inter-bank lending rate at 5.25 percent. As inflation data falls within the FOMC’s preferred range of 1 to 2 percent in the coming months I continue to expect the next move of the Committee is to lower the federal funds rate.
Therefore, please continue to circle $In.

Yield Curve
^{(Source: Bloomberg, LP)}

Positive

Negative

The difference between the three-month Treasury bill yield and the 10-year Treasury note yield was 67 basis points on June 15, 2007. Please Circle Positive.

Gross Domestic Product
^{(Source: Bureau of Economic Analysis)}

Above

Below

As the second quarter comes to a close, anecdotal and reported measures of economic activity confirm an uptick in annualized growth from that recorded in the first quarter. Nevertheless, the components of growth do not appear long-lived and as such, I believe the recent trend of below potential growth remains the most likely course of future economic activity. I continue positioning the appropriate circle as Below.