April 2007 - From Client Review Letters

Click here to view and print in Adobe PDF format.

It is interesting to track the changes in what has constituted the best performing stocks from the market high around March 31, 2000 through March 31, 2007.  In general, larger growth stocks were the place to be for several years prior to March, 2000.  After that date, “growth” stocks have generally not been the best place to be and were replaced by “value” stocks.  Growth stocks by definition have earnings growth rates meaningfully higher than the overall market, higher price/earnings (PE) ratios on average and generally lower than average dividend yields.  Value stocks tend to be in the opposite direction on all three of these factors.

The interesting thing is that such a shift in style has usually been associated with a perceived secular shift in inflation’s direction.  Specifically, growth stocks have their PE’s lowered as inflation rises and increased as inflation declines.

Also, over the past seven years smaller and mid-size stocks have performed better than larger stocks.  In short, it has been a period where large growth stocks have generally not been the best place to be invested.  These things tend to go in cycles with the six basic combinations of “growth” vs. “value” and “small”, “medium” or “large” stocks changing leadership positions.  Attempting to time the market by shifting a portfolio between growth and value (not to mention shifting between small, medium and large) stocks so as to always be optimally positioned is an unproductive, if not detrimental, exercise.  It is proven best to have a good long-term strategy and stay with it while riding out the bumps.

The earnings of larger companies have grown at a healthy rate since 2000, but an increase in their stock prices has been somewhat anemic.  As a result, the PE valuations of larger stocks have compressed dramatically.  As indicated above, in addition to PE contraction, on an absolute basis, larger stocks have gone from trading at a significant premium relative to smaller stocks in 2000, to trading at a discount today.  The combination of attractive valuations and the normal leadership changes that occur during market cycles leads one to believe that a rotation to large, high quality growth stocks is imminent.

Click here to return to the top of this page

The Federal Reserve continues to put a high priority on controlling inflation, even if the economy suffers somewhat over the short term.  There is some concern by investors that the U.S. economy could drift into stagflation where inflation is somewhat of a problem while economic growth is slow.  Currently, the economy is doing well, consumer confidence is high and inflation is far from onerous. 

The effect of the sub-prime loan implosion will continue to be felt for the foreseeable future.  Defaults and delinquencies are up and dozens of sub-prime lenders have gone bankrupt.  Additional problems will surface as rates on adjustable rate mortgages are reset.  Credit standards will be tightened in an effort to avoid future problems.  Potential homebuyers with lower credit ratings will be impacted the most.  The effect on our economy is unknown at this point.  Consumer spending could decline slightly and the cost of credit could go up which might serve to merely dampen inflation.  Widespread mortgage defaults, though not a problem at this point, could undermine the economy.

Private equity deals are at record levels (both volume and size of individual deals).  Low bond yields, tight credit spreads and huge amounts of cash have been the impetus behind the surge in deals.  Most of the activity has been contained to the small and mid-size segments of the market.  Significant takeover premiums are often priced into those stocks considered potential takeover targets.  Recent deals include hospital operator HCA and SLM Corp. (Sallie Mae).

The upcoming presidential election has a lot of sifting to do so far as serious contenders.  The opportunity for a surprise entrant could loom since a clear bet does not seem apparent at this time.  Hillary Clinton may have peaked too soon and she might be too polarizing.  Barack Obama seems to speak words that transcend divisive politics, but he could prove shallow at this time given the scope of the presidency.  Mitt Romney looks polished but religion could be an issue.  Rudy Giuliani seems experienced and decisive but has personal baggage and may have peaked around 9/11.  And so on and so on.

A passion at Eads & Heald Investment Counsel is in regards to retirement savings.  A large percent of Americans put off serious savings for retirement until such time as they do not have adequate time to amass enough money to retire in the style they desire.  The child rearing years through college coupled with the desire to purchase the latest technological gadgets, automobiles, etc. does not leave a lot of spare funds for savings.  With the traditional defined benefit pension plans largely extinct, the burden has shifted to individuals to do their own saving.  It takes a lot of discipline to save adequately.  For those at or near retirement the Eads & Heald Retirement Spending Model on our website at www.eadsheald.com can help to give an idea how much one can logically spend in retirement and stay solvent.  Give us a call if you would like assistance in working through the Retirement Spending Model.

Click here to return to the top of this page