Bartlett Commentaries
Market Commentary, 06 / 2007
The stock market steadily ascended to record levels during the second quarter, buoyed by robust business performance and significant merger activity in many industries. Solid growth in foreign economies offset a slowdown in the United States, indicating the continuing importance of globalization for corporate profitability. Market averages were 6-7% higher at midyear.
Notwithstanding stock market tremors in February-March and a bond market shakeout in June, the investing environment has been fairly benign this year, with steady growth following the strong market performance in 2006. Good times conjure up an obvious question: what could go wrong?
Much has been written about weakness in the housing market. Many forecasters believe this will weigh heavily on consumer confidence for at least another year. However, we think this headwind is well discounted by markets, with homebuilder stocks down 40-50% from 2005 highs and economic forecasts generally more subdued. We think the housing problem is "old news" from an investment perspective.
Higher energy prices are a frequently cited headwind. Retailing bellwether Wal-Mart has experienced weaker sales and blames higher gas prices for belt-tightening by its customers. But other retailers are thriving, and the overall economy has adjusted well. Like housing, this issue is well recognized by markets.
We think a more significant developing challenge is recently higher long-term interest rates and resulting stress in bond and derivative markets. Higher rates caused significant problems recently for hedge funds and leveraged buyouts (LBOs), which rely on low-cost borrowing. Though these setbacks have not had a broad market impact thus far, more problems are almost a certainty if rates continue higher. We think our direct exposure to this risk is limited; our bond selections are conservative and our equity investments are not premised on takeover speculation or cheap financing. Nevertheless, in the short run there could be spillover effects on the entire market if confidence is shaken. Some turbulence is overdue; the current bull market started in 2003 and is believed to be the longest advance without a 10% correction.
Our long-term assessment remains optimistic based on the following factors: reasonable stock valuations, healthy corporate profits, excellent dividend growth, stock repurchases, low unemployment, long overdue improvements in Europe and Japan, and continued growth in emerging economies. Nevertheless, risks are prevalent, whether measurable (higher interest rates) or imponderable (terrorism). We expect higher volatility and are always on the lookout for opportunities to upgrade our portfolios. Meanwhile, balance and diversification are our mainstays as we seek a margin of safety.
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