Happy New Year’s – good-bye 2006 – hello 2007; expect even more good news. Three important forces will characterize global financial markets:

  1. The continuation of decent profit growth and a “soft landing” for the global economy,
  2. Disinflation
  3. A transition away from tightening monetary policy

These elements of better growth and low inflation will prove to be bullish for stocks. Unfortunately, from a contrarian viewpoint, most analysts have turned bullish as share prices have risen. This optimism is not a positive, but rather could lead to increased market volatility; therefore, along the way to higher equity valuations, a sharp correction is very possible.

Relative to other securities, global equity markets are already priced for bad economic news with a relatively low PE multiple of 14 and an earnings yield 2.7% above global 10-year governments. Based on the current yield gap, low equity volatility, and high equity risk premium, stocks ought to trade at higher multiples (lower yields) for any given interest rate and in contrast to the very low level of credit spreads. Therefore, equities should rebound by expanding their earnings multiples.

Global bond yields will likely be range bound by excess savings (holding rates down) and steady real economic growth (pushing rates up). The downside potential of already low yields is limited and current market expectations for Fed easing are excessive. The U.S. dollar should steady or even strengthen against the major currencies, but could weaken against the “minor” currencies (China, India, etc.).  The pertinent event that some are insuring against is a strong inversion of the yield curve.

Most economic pundits and Wall Street advisors are focused on geopolitical risk as the largest economic threat: terrorist attacks, continued war in a failing Iraq, nationalization in Venezuela, an angry Kim Jong Il, genocide in Darfur, an ailing Castro, a strengthening Iran, continued destabilization between Lebanon and Syria, Muslim tensions in Thailand, power plays between Russia and its neighbors, and an unstable Afghanistan. However, we believe that the greatest risks are those garnering the least attention, such as agricultural commodity inflation and social-economic disruption from natural disasters.

Michael Ashley Schulman, CFA
Hollencrest Capital Management