Unchanged 2008 Outlook

Market sentiment has improved in recent weeks. This has not changed our full year view. The stock market outlook remains uninspiring even though we expect stocks to end the year with a modest gain.

The improvement in the stock market the past month reflects a squeezing out of excessive pessimism from the economic outlook.

Fears of a deep recession have faded. It is now recognized that the severe weakness in the housing sector has not spread to other sectors of the economy. Manufacturing and consumer spending have been extremely resilient. The problems in the credit markets on Wall Street have not created a widespread credit crunch. Economic trends have been weak, but the economy has not imploded.

The reduction of fears reduces a negative, but does not create a positive. Economic growth will still be sluggish through 2008. That means moderate corporate revenue growth. Profit margins will be pressured by rising costs. Interest rates are not going to drop further. That means stable rather than rising multiples.

Stock prices should end the year higher than current levels, but a large sustained rally is not likely.

The table below lists the key factors affecting stock prices.

Recent Developments

Inflation concerns have begun to overtake recession concerns.

The March economic numbers were much better than expected. That has raised first quarter GDP expectations and indicated that the economy is not experiencing a broad deceleration. Now, the fiscal stimulus is about to kick in. That should boost second quarter GDP. Recession fears will be declining further in the weeks ahead.

Commodity prices continue to rise. That has pushed inflation measures higher and raised broad inflation concerns.

The Fed is perceived to be at the end of their interest rate reduction cycle. It is expected that after the late April meeting they will keep rates stable for the foreseeable future and that the next move might be to raise rates later this year.

Real GDP growth in the first quarter is expected to be slightly on the positive side. At least as important, the component trends will suggest that second quarter real GDP is also likely to be positive. Consumer spending remains flat to up, exports are booming, and business investment has been surprisingly resilient. The economy may well get through this business cycle without a single down quarter for GDP. For more on this, please see our Economic View page.

Earnings growth has been weak. This is due to continued large write-offs in the financial sector. Outside of financials, first quarter earnings growth has been surprisingly good. That measure could be up as much as 10% when all the reports are in. The big question going forward is to what degree do financial earnings recover in the second half of this year? That uncertain outcome will have a major impact on how the market ends the year.

Inflation has become a major concern. The relentless rise in commodity prices needs little mention. It is true that commodities are only a small part of consumer costs and business costs. Nevertheless, they are pressuring overall inflation rates. The core rate on CPI is up to 2.4% for March and 4.0% for total CPI. Rising inflation rates threaten to hold stocks back in the months ahead.

The 10-year note yield has started to increase. It is up to 3.9% from 3.8% at the beginning of the year. It had dropped to 3.5% for an extended period as investor fled stocks into bonds. That flight-to-quality trade is now unwinding.

Valuation is hard to assess at present because the large write-offs in the financial sector distort the overall measure. The write-offs may end soon. The degree of earnings growth after that is highly uncertain. Nevertheless, the P/E of 17 on trailing operating earnings indicates that valuations are not worrisomely high.

Valuation metric: There is a long-term relationship that the 10-year yield runs approximately equal to the forward earnings yield. (The earnings yield is the inverse of the P/E). The expected operating earnings yield for the next four quarters is about 7%. With the 10-year note currently at 3.90%, this simple model suggests that stocks are significantly undervalued. As reported earnings, however, give an entirely different reading due to the large write-offs at financial firms. If these earnings stabilize in the quarters ahead, current valuations will be seen to have been very reasonable. They are not, at least, exceptionally high as in 2000.

Bottom Line

This is one of those years in which long-term investors will need patience. The near-panic of January has faded, but the outlook is moderate at best.

Earnings growth will be sluggish all year. Profit margins will be pressured by rising labor and commodity costs. In 2009, the political climate could shift to policies favoring redistribution over growth. The tax rate on dividends is likely to increase. That will necessarily reduce the current value of stocks.

Nevertheless, we continue to believe that the best way to participate in the wealth creation machine known as the U.S. economy is to own stocks. There are plenty of investors that first got into the market in the late 1990s, and learned that stocks can go down. However, it is wrong to conclude that rising stock markets always mean a bubble and then a crash. Over the long term, the indices march higher.