Stock markets, US and international, were choppy in the first quarter. Through February 20th, the S&P 500 gained 2.9%. Over the next two weeks, the S&P 500 fell 5.9%, recovering before quarter's end to a net gain of 0.6%. From the market low of last July, the S&P 500 remains up 16.0%, so hardly a disaster. The trigger of the mid quarter fall was a 9% sell-off in the Chinese stock market, but investors remain leery of recession in the US caused by a contraction in the housing market.
We first discussed the implications of “a bursting of the current real estate bubble” in April 2005, but to recap:
· Construction is one of the few remaining sources of high paying non-exportable manufacturing jobs.
· Mortgage lending is a major source of fee income for certain banks.
· Consumers became dependent in the last 7 years on borrowing against their home equity.
· Naïve home-owners and inexperienced real estate investors took on more risk than they realized with adjustable mortgages.
The rate at which borrowers become delinquent and the rate of foreclosures are both up sharply, with inventories and time on market increasing in most markets. Prices are still mostly up year over year, but there was a modest decrease in prices in Q4 2006. So far, the bubble appears to be deflating gently, but we expect housing prices to remain flat to lower through year end, and flat subsequently. Combined with poor results in the US automobile industry, we expect GDP growth to be a percent lower than in 2006, in the 2.5% range.
Standard & Poor’s projects a sharp decline in earnings growth for Q1 2007, only 3.6%, versus 10.6% in Q4 2006, and the first single digit rise in 14 quarters. The distribution of earnings growth is highly variable, however. Earnings at technology companies and in consumer staples are expected to grow 10%, financials up 7%, industrials, materials and utilities up 5%, healthcare up 2%, telecommunications down 1% and energy earnings down 3%. Consumer discretionary, which includes cars and housing, is expected to plummet 10%. Financial service stocks were down in Q1 on fears of losses from “sub-prime lending.” In fact, the damage is limited to a dozen or so companies which specialize in that area; companies in our portfolios such as Washington Mutual, MGIC (Mortgage Guarantee Insurance Company) and Federal National Mortgage have limited exposure to the poorest quality loans. Meanwhile, our decision to position our clients out of energy and into technology last year appears due to pay off.
S& P 500 earnings projections for the rest of the year include: Q2 up 3.8%, Q3 up 6.7% and Q4 up 12.4%. With earnings estimated at 9% over the next 12 months, and ten year bonds yielding 4.75%, the S&P 500 remains undervalued by 21%.