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The first half of 2007 was a good period for the stock
market as the S&P 500 advanced by almost 7% with almost all the gains coming
during April and May. However, while the second quarter was characterized by
a strong advance in April and May, it concluded with volatile price
movements in June that reflected a level of uncertainty that will continue
into the third quarter in our opinion.
Interest rate uncertainty
While the Federal Reserve issued a typically hedged
statement after its June meeting, it maintained that its “predominant policy
concern remains the risk that inflation will fail to moderate” while noting
that the economy continues to moderately grow despite the “adjustments in
the housing market”. We believe that this uncertainty regarding the Fed’s
next move will continue to put a pause on any market advance as the more
likely scenario would be for the market to price in a potential hike in the
face of continued strength in the economy as measured by the June
unemployment report, non-farm payrolls, and ISM manufacturing index, just to
name a few indicators. Also, we see potential increases in inflation that
will not only be limited to the headline number but we believe it will
spillover to the core measures of inflation used by the FED (that exclude
food and energy) if oil prices continue to persist at these levels. With
almost a 9% advance in the S&P 500 as of July 6 we believe that many money
managers will start taking money off the table over the typically slow
summer months in anticipation of a more lucid picture in the Fall.
While our short term outlook for the market in the
third quarter is somewhat muted, we continue to believe that 2007 will bring
in high single digit returns for the major indexes. This is supported by the
continued expansion in the economy, albeit at a slower rate than last year.
The employment picture seems strong and resilient and the adjustments in the
housing market, while a negative for the economy, seem to continue at a
gradual and manageable pace. Oil prices in the mid $70 range are another
negative for the market but a closer look shows that inventory levels are at
very comfortable levels and the primary reasons for these price levels
appear to be a discounting of geopolitical risks. Hence, we see oil prices
falling in the back half of 2007 (absent any geopolitical events) giving
further impetus to our forecast of strong high single digit returns for the
year.
Given our outlook, our favorite sectors are Information
Technology, Healthcare, and Consumer Staples. In IT we continue to believe
that the sector will continue to benefit from corporate spending in addition
to the infrastructure needs for all the new innovations in the industry. In
Healthcare we are focusing on the big pharmaceutical players as we believe
these stocks offer a safe haven in a volatile market. In Consumer Staples we
are focusing on the pure agricultural players as we believe they will
continue to gain pricing power (look no further than your grocery bill). We
also have increased allocation to Airlines as we see many airline companies
benefiting from reduced capacity, a lower labor cost structure, and a strong
economy.
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