Percentage forecasts for 2007 stock market gains

US Stock Market

The S&P 500 gained 6.2% in the second quarter and is up 6.9% for the year.  Coming in to the April earnings reports, stock analysts were universally pessimistic about US corporate earnings growth, expecting only 3.9%.  The actual growth rate came in at 7.9%, reflecting strong overseas sales for US corporations despite a domestic slow-down.  Earnings growth for Q2 is expected at 5.7%, Q3 at 2.4%, but accelerating into Q4 at 13.3%.  The largest drags on the US economy right now are: a sharp reduction in new home construction, a sharp drop in large (and more profitable) car and truck sales, and the high cost of energy.

The bond market, anticipating higher economic growth later this year, drove the 10 year treasury rate from 4.5% at the start of the year to nearly 5.2% - the highest level since 2002.  This in turn drove up mortgage rates. Combined with tighter credit standards, mortgage applications have plunged since the peak of the housing market in 2003.  Existing home sales are down 10% year over year, prices are down about 2.4% year over year, and inventories continue to build even as home-builders reduce production.

However, the rest of the US economy is doing fine, as reflected in an unemployment rate remaining at 4.5%.  Aside from a brief period in 1998-2000, the last time the unemployment rate was consistently below 4.75% was the 1960’s into 1970.  The US economy, growing at a $13.6 trillion annual rate through Q1 2007, is 43% larger today than at the end of the giddy 1990’s.

Fed Policy

Many observers expected the Fed to cut rates this spring to prop up the housing market.  We thought otherwise.  The Fed’s mandate is to promote steady economic growth with little or no inflation.  It is not the Fed’s job to prevent asset bubbles from bursting, whether stocks as we saw in 2000-2002 or the more recent housing bubble.  The Fed held rates unusually low through 2004 to help the US economy recover from the post 9/11 recession.  In hindsight, rates were held too low for too long.  The Fed’s focus right now is energy driven inflation.  Oil rallied from a low of $25/barrel April 2003 (following the downfall of Saddam Hussein) to a recent high near $70/barrel.  While energy prices are a smaller component of the USeconomy compared to the 1970’s, all commodities are at high prices, reflecting world-wide demand.  We don’t see the Fed raising rates for the rest of the year as the economy remains weak, but we also don’t see the Fed cutting rates as the risk of an increase in the inflation rate remains high.