Outlook 2007

Well, the holidays are over. Having had a sufficient rest, I'm now refreshed and ready to jump into the fray. But, before I get started here's a sampling of Christmas Eve in Mazzaccaville. An exchange with my youngest son...

So, it's mid-morning. My wife has just finished hard-boiling eggs for an egg salad lunch and we're relaxing, watching a movie. It was great...everything was done except for the wine and soda shopping. All of a sudden we hear the hiss of an aerosol can coming from the entry hall...

"Who is that?", I shout. My son Christopher, "It's me!" I reply, "What are you doin'?"Christopher, "Spraying air spray! This whole house smells terrible! Who went to the bathroom in here?" Through howls of laughter I reply, "Mommy just finished making egg salad. Would you like a sandwich?"

God I love Christmas! Let's begin...

Outlook 2007

I've had a difficult time writing this letter. In fact, on two occasions I got about half way through only to scrap my work entirely. The problem had been two-fold.

To begin with, I was looking at conflicting data. That led to a second problem...too much data. Too many charts, too many datasets. If I was overwhelmed, how could I make sense of it for you? What a mess! Sometimes the best thing to do is stop, wait and listen. Order is eventually restored and progress can begin again. The alternative - to rush to meet some self imposed deadline - is pointless and results in rubbish. That, perhaps, is what we will need to keep in mind as we attempt to invest in 2007.

Mergers and Acquisitions

To me 2006 was more about the movement of wealth rather then the creation of it. No place was this more apparent then in the Mergers & Acquisitions (M&A) arena. In mid-December MarketWatch wrote that M&A announcements hit $3.5 trillion topping the previous record of $3.38 trillion in 2000. Some of the largest deals, for instance the $18.75 billion purchase of Clear Channel Communications, were carried out by private equity firms. Yet, the record for 2006 remains AT&Ts purchase of Bell South for $67 Billion. All of this activity helped the major indexes shake off a summer slump in each case rising more then 10%.

This idea of wealth movement was confirmed to me in an e-zine I read this morning. In the past I've quoted John Mauldin and his Thoughts From The Frontline letter. This week, Mr. Mauldin talks about the flow of global assets: "The Savings Glut has permitted deficit countries (and their citizens) a startlingly benign combination of spending much more than their income, rapid gains in real and nominal asset values, and low inflation."

Home Sales

Apparently, the movement of wealth did not extend to the housing market. Although CNN Money reported, "Housing starts jumped to an annual pace of 1.64 million last month from a revised 1.57 million rate in November...", the article failed to disclose the fact that Lennar Builders and KB Homes reported cancellations rates on home sales of 30% and 43% respectively. Or, for that matter, the fact that 53,000 construction jobs have been lost in the last two months despite a warm winter.

Guerite Advisors reports that, "In the previous seven [housing] cycles since 1959, housing starts have fallen, on average, 50.7%. They continue, " Housing starts have dropped 34% so far since their peak in January 2006. Just to get to the average drop we have another 20% or so drop in starts to go." Guerite also indicates that such falls in housing starts take an average of 27 months to complete. "As of November 2006, we are roughly 11 months or roughly halfway to bottom."

The Yield Curve

The Yield Curve has been - and continues to be - of concern to me. The Yield Curve is basically a plot of interest rates of various durations for government issued treasuries beginning with overnight rates and progressing to 30 years. As you might expect, the longer the duration, the higher the interest rate. When shorter term rates are higher then lower term rates, the curve is said to be inverted.

Perhaps a little history would be helpful here. In June of 1996, Arturo Estrella and Frederic S. Mishkin of the Federal Reserve Bank of NY wrote a paper on inverted yield curves - specifically the difference between the 90 day and 10 year note - as a predictor of economic slowdowns and recessions four to six quarters forward. They included a chart comparing the rates of inversion with the odds (percentage) of recession.

Each month since August 2006 the curve has been inverted. According to Estrella and Mishkin's scale, the rate of inversion indicates a 25-35% chance of recession. In my estimation, the inversion isn't significant enough to warn of recession but certainly an economic slowdown. This warning sign tells me that we should be taking a defensive position in our investments.

The VIX

I also follow the shorter term Volatility Index (VIX) indicator. Trader's Notebook explains this technical indicator thus, "Many traders use the Volatility Index (VIX) to measure the volatility of the U.S. stock market. It is their contention that if the VIX moves above (or below) a certain point, it signals a bottom (or top) to the current stock market trend. When used properly, it is a good measuring device to determine if the market might be overvalued or undervalued."

As you can see from this chart the VIX is at historic lows. Last year's rise from 12 to 20 coincided with the market's decline. And, its decline in the second half of the year matched the market rebound to its current levels. I went back and looked at the VIX's historic charts. The last time it was near these levels was 1996. Then, it's rise to 36 - in 1998 - coincided with dips in the broad market indexes.

P/E Ratios

Last is the P/E ratios for the broad market indices - the S&P 500 at 19 and the Dow Jones Industrial Avg at 24. As I've been writing, these are the P/Es of a mature market. Not one poised for a bull rally. Yet, despite all of this negative news there are reasons to look for positive growth in 2007.

2007

Historically, the third year of a presidential term is a good year for the markets. The Executive branch may get help from the Democratically controlled Congress as both sides are anxious to make a good impression going into 2008's Presidential election season.

Although it didn't get a lot of press, last year small business complained that Sarbanes-Oxley (SarbOx) compliance was too costly. As a result, some business were privatizing. I tend to believe that we'll see some legislation easing SarbOx.

However, the picture is mixed. As mentioned, the rate of Yield Curve inversion does bode some level of economic slowdown. I expect to see evidence of that sometime during the second or third quarter. The curve must return to the norm but, I think that bond market action will be a predecessor of rather then a result of the impending slowdown.

Everybody's looking at the Fed to reduce the overnight rate. But this, by itself, will not solve the problem. I believe the Fed's reduction will spook longer term bond holders to sell because they will be concerned about an increase in inflation. That will increase long term rates.

Again quoting from Mr. Mauldin's letter this week, "Normally, market internals deteriorate in a way that provides more time to establish a defensive position - market breadth lags, divergences develop across various industries and security types, price/volume action shows signs of distribution and so forth." Continuing, "The overvalued, overbought, overbullish syndrome may present none of those warnings, particularly when there is even modest upward movement in Treasury yields."

Bonds are somewhat counter-intuitive. As rates go up, bond value - and your investment - goes down. This year that means that long term bonds are likely to lose value. I'm not really bullish on bonds but, if you feel you need to be invested in them, stick to shorter duration bonds and bond funds.

I think M&A will give us a shot in the arm in two ways. I expect first (and maybe even second) quarter earnings to surprise to the upside as the benefits of M&A are reflected in balance sheets. I also think that, despite the lofty prices of some stocks, we may see some additional M&A deals. While they'll grab headlines, I don't believe records will be broken. One thing has been bothering me though...thus far we haven't really seen any labor reductions resulting from M&A activity. Any rise in unemployment numbers will spook the market.

I am also not at all convinced that we are done with the downturn in housing. By the same token, I'm not sure that I agree with all the doom and gloom hype that we're hearing and reading about. It is evident that houses are staying on the market longer and prices are being squeezed somewhat. So, if you need to sell you may have a problem.

Yet, higher inventory and longer turnover times mean that if you're buying, you can cut a better deal. That's what they call a buyers market.

Since I'm looking for longer term gains I tend to be biased in the sense that I favor value over momentum or growth funds. That is especially true when the markets appear poised for some corrective event. Certainly, with the warning signs that are out there now, I believe that the best place for investment dollars is in value funds such as the iShares Russell 1K Large Value.

Finally, China has indicated that they expected economic growth to slow to 9.5%. I think it's fair to say that investment in global funds that include China stocks in their portfolio continues to be a good investment vehicle. However, I would avoid emerging markets stocks/funds. Based on present value, their rate of return is almost on par with U.S. Treasuries. Why take on the added risk unnecessarily?

Coming Up in The Fund Informer Letter...

In upcoming issues I'll provide additional information on The Federal Reserve Board (the Fed), the VIX, and Bonds. Perhaps you've heard of the first two and probably even invested in Bonds. Still, I think it would be beneficial if I dedicate some time to each of these topics.