Economic expectations have cratered. A recent eye-popping drop in the service sector triggered a stampede out of stocks. The door is never wide enough when everyone heads to the exits at once. To be sure, weak incoming economic data presents a challenge to a positive economic stance over the next twelve months. Nonetheless, there are still grounds for optimism. Buyers are likely to defend current equity price levels in the broad averages based on good value, albeit they will be battling additional portfolio de-leveraging if the credit markets remain dysfunctional. Consequently, a volatile churning of securities will persist, which should ultimately be resolved in a positive fashion.

Manufacturing surveys across the developed world have plunged in recent months and soaring commodity prices have kept pressure on input costs, but that has failed to bring down manufacturing-intensive industrial sector stocks. Resilience reflects record backlogs, attractive value, and a robust multi-year earnings outlook. In the face of high commodity costs, industrial companies have maintained profit margins with solid productivity growth and higher selling prices. Thus, industrial securities should sustain their attractiveness, even in an environment of slower overall output growth. In addition, the bull trend in the construction and farm machinery group remains intact; it should continue to demonstrate strong earnings leverage to rising food prices. As food demand grows, order books will stay healthy. Meanwhile, the bonus depreciation provisions for farmers recently announced in the U.S. stimulus plan should boost new agricultural equipment orders. Additionally, global demand for agricultural machinery will continue to offset weak US housing-related construction machinery demand. Aerospace & defense is the main exception to this positive view on the overall industrial sector. But why is this bullish stance on industrials so important? Because it signals that we probably will not enter a recession, and thus that the underlying value of high yield corporate bonds held by closed-end funds (CEFs) should be relatively secure.

Residential real estate remains under pressure. Lower borrowing rates and deep discounting have been the main drivers of recent sales, but the still large inventory overhang in housing suggests that deflationary forces will linger, sustaining downward pressure on homebuilding margins, especially in view of the lack of relief in the high cost of building materials. Additionally, bank lending attitudes are still not conducive to a major rebound in mortgage activity. Moreover, a prolonged period of underinvestment in new residential developments usually follows an overcapacity-induced bust. Thus new home building activity will remain low. Bottom line: The relative performance bear market is not over for real estate.

Michael Ashley Schulman, CFA
Hollencrest Capital Management