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What to expect over the final three quarters of 2007?

Will Earnings Trump Global Fears?

The global equity markets sold off heavily on February 27, 2007, and the selling continued through the end of the week. The culprit? China and its politicians. The Chinese government wants to stem the influx of cheap money into its markets following the recent bull run.

The Shanghai Composite Index fell nearly nine percent on February 27, its worst daily performance in 10 years. The fall came as the Chinese government proposed a crackdown on illegal trading and fears about inflationary pressures within the economy.

Prior to the sell-off, the Chinese markets have been performing very well due to strong economic growth. In fact, the Shanghai Composite Index actually closed at a new high on February 26. However, the fall in China spread across the globe a day later and led to huge declines in the rest of Asia, Europe and the United States.

The key question following the sell-off was, "Is this a short-term correction following a very strong bull run, or is this sell-off due to larger problem?"

Clearly, the global markets were due for a correction following the recent rallies in China, Europe and the United States. Equity markets do not move up sharply without periodic short-term corrections, even in a prolonged bull market. But there are concerns regarding economic growth, corporate earnings and the U.S. housing bubble.

Economic growth in the U.S. seems to be moderating based on recently released economic data. The reports show slower GDP growth and slower consumer spending in the form of retail sales. This trend has carried over into corporate earnings, although the majority of the big companies continue to beat analysts' estimates. Of course, it is only a matter of time before slower consumer spending carries over into corporate earnings, and in the end, it is corporate earnings that set the market's direction.

The U.S. housing bubble is another concern. As housing prices drop and sales moderate sharply, investors have less equity to move into the financial markets. If the drop in housing continues, it is only a matter of time before less capital comes into the equity market, therefore creating a bearish tone throughout the broader market.

Inflation remains a concern as well, although the Fed has done a good job up until this point of stemming any pressures created by the rise in commodity prices. Even wages are increasing sharply, and wage inflation is always at the top of the top of the central bankers' list of concerns.

Ben Bernanke has been at the Federal Reserve helm for over a year now and he has done a solid job balancing a moderating economy with inflationary risks. He and the other Fed governors have tried to steer the housing market to a soft landing, while at the same time not destroying solid economic growth. It has been a fine balancing act, but Bernanke and the other governors will have a tough task dealing with the issues during the remainder of 2007.

The Bank of Japan is set on tightening its monetary policy and that will lead to new challenges when it comes to foreign investment in the U.S. markets. Currently, the Japanese are large investors in U.S. Treasuries and any major move to tighten policy overseas will result in less participation in the U.S. Treasury market. That would certainly lead to higher yields in the U.S., which would lead to higher interest rates charged to consumers.

The Fed will have to manage these risks with the underlying domestic economic conditions. We feel the Fed will remain on the sidelines when it comes to future rate hikes, and we suspect that the next move will be to cut rates, but we do not expect that to happen until later in the year. The only thing we see curtailing that action would be a sharp rise in inflationary pressures, but that is not expected due to our expectations that crude oil prices will moderate over the next few months of the year.

In Conclusion

Our forecast is that 2007 will be a bumpy year when it comes to equity prices. We expect the equity market to struggle throughout the first quarter as the market cleans out the speculative bulls that have led the major indices to new multi-year highs. At times we expect the selling to be severe and to be widespread. However, we also expect that bulls will come to the rescue when they look for their favorite stocks at much lower prices.

We do expect a rebound in the second quarter unless the crude oil market experiences a sharp rise due to the many geopolitical concerns. In fact, we expect the major indices to re-test their recent highs during the second quarter. If the market can sustain those gains and move above the recent highs set in February 2007, look for stocks to close the year strongly, especially if the Fed lowers rates later in the year. While that may lead some bulls to feel the Fed is worried about economic growth, equity traders and investors will always take a rate cut as a sign of economic stimulus, thus buying their favorite stocks and leading the market higher.

Please note: I will keep you posted on any changes I may have to my longer-term views on the markets. I will post a message on the main page of the web site whenever this long-term outlook column changes. However, if you would like us to send you an email message whenever there is a change to this long-term outlook column, please send us an email message at admin@nyfc.net. We will gladly notify you when this column changes and that will prevent you from missing any updates that may take place while you are not on the web site.