Integrity     Performance     Service               
Search:
 
 
 




   


Prospects for the Stock Market

The stock market is facing the sobering test of an economy which is changing rapidly. The old environment was characterized by easy money, low inflation, limited international growth and solid but recovering domestic activity. Unemployment was high and there was excess capacity in manufacturing. Energy costs, while under upward pressure much of the time, did not meaningfully impact growth or inflation. This halcyon environment came to an end gradually in late 2005. Ultimately it caused its own excesses, primarily related to mortgage financings, increasingly risky hedge fund activity, and heavy reliance on emerging markets in investment portfolios. The U.S. stock market was largely free of the speculative fever that often accompanied economic recoveries in the past.

In its place, the new economic path is one of sharply accelerating growth and development on a global scale. The transition to a new growth model is causing its own problems, but of a different kind. Rapid economic growth in the U.S. over the past four years has used up most of the available slack, reducing the capability of the expansion to continue without boosting inflation. Over this period our economy has created over five million new jobs, unemployment has declined to 4.6%, and capacity utilization has risen to 81.9%. Growth in China and India has accelerated from its previously strong levels. Japan, the world’s second largest economy, has turned positive, and other countries of Asia are also expanding at high rates. The euro area, led by Germany, is enjoying its best economic prospects in many years. The relentless rise in energy prices over the past year is directly attributable to the rapid global industrial expansion.

The Federal Reserve Board raised its target rate in May for the sixteenth consecutive meeting to 5%. A further increase in June is virtually assured. The Fed recognized early that the intoxicating environment of very low interest rates could not persist as the expansion progressed. Its policy has been to raise rates at a “measured pace” to restrain inflation from taking hold. In Fedspeak, the goal of the gradualist monetary policy was to achieve neutrality in interest rates, loosely defined as the real interest rate corresponding to historical levels. With the severe uptick of CPI inflation in recent months, the financial markets have concluded that inflation will be significantly higher than anticipated. The panic, especially visible in the stock market, reflects fears that the Federal Reserve will be forced to continue to raise rates significantly higher than earlier expectations.

We recognize that this is a time of confusion and exaggerated fears, but disagree with the apparent deduction that we are at the beginning of a new inflation spiral and endless increases in interest rates. Some of the current market malaise also reflects an uneasiness about the new Chairman of the Federal Reserve. Succeeding a person of legendary repute is never comforting to a financial audience, and chairman Bernanke’s public comments initially served to create confusion. This short-term sensitivity will fade away. Similarly, fears of an overshoot of interest rate increases, as well as a collapse of the dollar caused by our large foreign deficit, are illusory.

Worldwide, countries are in a mode of growth through development. This is a welcome trend. It brings a healthy balance and lengthy time frame to global economic progress, which were formerly dependent on very few pillars. With this rising tide it is not surprising that inflation prospects would occupy a prominent place in investor thinking, and we expect domestic inflation to remain worrisome for a time. Housing and consumption are gradually pulling back, however, and productivity trends remain powerful. In a coordinated response to the inflation threat central banks in most of the world are raising their interest rates. As rates rise throughout the world commodity prices will recede. Inflation is likely to be viewed as a lesser threat later this year and into 2007. When the financial history of this period is written we believe investors will look back on the era as a time when domestic high quality stocks were highly attractive.

Investment Policy Committee
Alfred A. Lagan, CFA, Chairman
Daniel A. Lagan, CFA, President
June 14, 2006


This information is intended solely to report on investment strategies and opportunities identified by Congress Asset Management. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell of any financial instrument.

2 Seaport Lane
Boston, MA 02210
www.congressasset.com

Printer Friendly Version