Renewed concerns about a US economic slowdown brought a jubilant market down with a thud in late Feb...
Renewed concerns about a US economic slowdown brought a jubilant market down with a thud in late February only to be resuscitated by the Federal Reserve Board's softer tone at their late March meeting. Inflation risks, particularly wages and gasoline prices, remain a concern. However, with restructuring at the three major US auto companies adding to the slowdown in residential construction and with US GDP having decelerated from a 3%+ run rate to 2.25% in the second half and a preliminary estimate for first quarter US GDP of 1.3%, the Fed now has to be wary of being too restrictive. The good news is unemployment remains at historically low levels, most recently the unemployment rate was 4.5%, bolstering up the consumer income statement. US corporations remain at reasonable leverage ratios and held approximately $2.6 trillion in cash on their balance sheets at year end.
In April, investors' thoughts turned to spring and the markets rose, blooming all over. Core inflation decreased in March although headline numbers accelerated. Home starts and permits rebounded although trending lower on a three-month basis, albeit at not as fast a pace. While the evidence is not overwhelming, there are signs that the Federal Reserve Board is on track for a soft landing while beginning to contain inflation.
Although as many as 30-40 mortgage banks have been taken over or declared bankrupt year to date, their sub-prime woes have not dramatically affected their more diversified financial service brethren. As recently as last week, Federal Reserve Chairman Ben Bernanke said he didn't expect to see sub-prime concerns "spill over" into the broad economy. Nonetheless, US banks and financial service companies have already tightened lending criteria which is removing liquidity for less credit worthy borrowers and further dampening economic growth.
After years of outperforming large caps, small capitalisation stocks may be due for a breather but valuations are not excessive. In fact, price to book and price to sales ratios are at "fair value" or close to historical trend line measures.
The longest lived small cap cycle in the past 30 years lasted nearly 10 years starting in 1973 and the current environment of low interest rates and access to capital may portend more room to go in the current small cap cycle. More recently, we have seen whiffs of large cap relative outperformance. Although small cap valuations may not be excessive, US large cap stocks are underweighted in most investors' portfolios, large cap valuations are roughly a third of their peek levels in 2000 and offer exposure to foreign market growth with reduced currency risk.
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