The Fat Lady Has Sung

Bill Byrnes — Mon, 20 Aug 2007 13:16:00 -0500

Actually it was a dapper middle aged male with a neatly trimmed beard who spoke. When the Fed chief cut the discount rate Friday morning, the market breathed a sigh of relief. The implication is that Fed will take additional action, if necessary. The liquidity crisis will be contained. Earlier last week, the major averages retreated 10% from their July highs (and all-time highs for the DJIA and S&P 500), an “official” market correction.

The market may bump along for a while, September and October are typically the worst months of the year for the market (although this was not true in 2006). High volatility will be the norm and the market may well test the lows it reached last week, but there will not be another leg down. We should expect more bad news from hedge funds and other participants in the junk mortgage and securitization markets but the damage will be limited to those players and will not drag down the rest of the market.

Corporate earnings, except for financial companies that operate in the effected parts of the credit market, have continued to come through. Morgan Stanley’s current estimate for S&P earnings growth for 2007 and 2008 is 8.6% and 11.6%, respectively. (The consensus is for greater earnings growth in 2008.)

Won’t the slowdown in the housing and mortgage markets drag down earnings growth, you ask? Let’s look back at the late 1980s. The S&L industry was shut down due to insolvency brought about by bad real estate loans. Remember the RTC? The damage to the banking system was greater and more direct then, than now. (There is a difference between a hedge fund, and a Federally insured savings institution, becoming insolvent.) The economy grew in the ‘80s, despite the problems in the banking system, and it will continue to grow in 2007 and 2008 as long as the housing market does not materially weaken.

The stock market was not overvalued (at least not by much) at its July peak. To be conservative, let’s suppose that the market was fairly value at the beginning of the year (See Earnings Matter). Assuming a constant P/E ratio and Morgan Stanley’s earnings estimates, sometime next year the S&P 500 should reach 1,700 and the Dow should reach 15,000. My caveats to this prediction are to continue watching new jobs creation and retail sales. A downturn in either could be a precursor to a recession and the market will react accordingly.

It’s time to rebalance your mutual fund portfolio. Those of you who rebalanced into Treasuries in July are particularly fortunate. Now you should rebalance back into equities.

The MUTUALdecision Blog: The Fat Lady Has Sung

The Fat Lady Has Sung