2007 Stock Market Outlook
As far as the US stock market and most other stock markets are concerned, the current monetary situation is probably close to being as good as it gets. To be specific: credit spreads are near all-time lows, indicating that even poor-quality borrowers can obtain credit at low rates of interest; yield curves are flat or inverted, which is indicative of a strong desire to borrow short-term in order to speculate in longer-term assets/debt; the global supply of currency is expanding at a rapid rate; and bond yields remain near 20-year lows despite the obvious evidence of inflation. It's impossible to predict exactly when this utopian situation will end, but in our opinion there's little chance of it persisting throughout 2007.
We expect to see a reversal in the liquidity trend -- from expanding to contracting -- during the first half of 2007; a reversal signaled, first and foremost, by the widening of credit and yield spreads.
In addition to a very supportive monetary backdrop, the US stock market has received great assistance over the past few years from rising profit margins. As discussed by John Hussman in his 22nd January and earlier commentaries, the primary driver of the rise in US corporate profit margins to extreme highs has been stagnating labour costs. Profit margins are mean reverting, however, and the way they will most likely revert to the mean is via labour taking a larger slice of the pie.
There's no guarantee that the mean reversion of profit margins will occur during 2007, but it represents a substantial risk given that a) the rate of increase in labour costs has already begun to accelerate, and b) house price gains aren't likely to provide as much of a psychological offset this year as they have in years gone by to the absence of real gains on the wage front.
Further to the above, we expect that contracting liquidity and falling profit margins will weigh the US stock market down over the coming 12 months.
But what about the potential for Fed-sponsored inflation (money-supply growth) to keep the liquidity expansion going and propel the stock market upward in the face of deteriorating fundamentals?
We don't think this as a major threat to our overall outlook for 2007, but before we explain why it's worth quickly reviewing the way money-supply growth operates.
Incredibly, some people believe that the central bank can create prosperity by simply expanding the supply of money. This is despite the US stock market's worst performance over the past 5 decades having occurred during the decade with the highest money-supply growth (the 1970s); and despite the highest rate of year-over-year money-supply growth of the past 20 years (December-2001) being followed by a 12-month period during which the US economy was in recession* and the S&P500 Index fell by more than 20%.
If a central bank could create prosperity by expanding the money supply then no country would ever be poor and Zimbabwe would have the world's strongest economy, but the reality is that money-supply growth can only have the effect of reducing the purchasing power of the money. The main issue from a longer-term perspective, though, stems from the fact that this loss of purchasing power occurs in a non-uniform -- and often deceptive -- way. As a result: price signals become inaccurate; investment is misdirected; productivity growth slows; there is an eventual net reduction in real wealth; and the asset rich benefit at the expense of savers, salaried workers, anyone on a fixed income, and the asset poor. Needless to say (but we'll say it anyway because it's such a widely misunderstood concept), the capital gains that stem from inflation have absolutely nothing to do with capitalism.
It is certainly possible for rapid expansion of the money supply to lead to gains in the stock market because company shares usually represent claims on real assets and because profits will tend to be boosted until the point is reached where the effects of inflation have rippled through the economy (that is, until the point is reached where labour is grabbing an ever-increasing slice of the pie and the debt markets are factoring-in rapid future currency depreciation). This describes what happened over the past 6 years in that over this period there was sufficient inflation to push the Dow Industrials Index to new all-time highs in terms of greatly depreciated dollars. In real terms, however, the Dow's performance was poor. This real performance is reflected in the following chart of the Dow/gold ratio.
If the total supply of US dollars grows at a quick pace during 2007 then the US stock market will probably have an 'up' year in nominal dollar terms IF there's only a modest increase in labour compensation and IF the bond market fails to react in a meaningful way to the on-going currency depreciation. These are, however, big 'ifs' because with bond yields so low the bond market is acutely vulnerable to a significant rise in inflation expectations and, as mentioned above, it looks like labour compensation is about to begin increasing at a faster rate.
In any case, if inflation (money supply growth) proves to be the main driver of stock market gains during 2007 then our gold stocks should still do OK and the best-performing sector -- one in which we also have significant exposure -- would probably be base metals. Therefore, although it would make our intermediate-term stock market outlook wrong we don't view the possibility of inflation-related stock market gains as a risk to our overall position.
In conclusion, then, we are expecting 2007 to be a 'down year' for the US stock market due to a combination of contracting liquidity and falling profit margins, but are effectively hedged against the possibility of liquidity remaining abundant by virtue of our core long-term position in the industrial metals sector.
*According to the NBER (the institution that determines the official start and end dates for US recessions), the recession ended in November of 2001. However, it didn't actually end until at least the middle of 2003. Discrepancies between official and actual often occur due to the gross misreporting of the effects of inflation.
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