Goldilocks is in the House;
But What if the Three Bears Foreclose on Her?

Barring any unforeseen events that would derail global stock markets before the end of the year, stock investors have a lot to be thankful for this year. For those who ventured overseas in 2006, there’s even more reason to celebrate.

The Standard & Poor’s 500 Index, an oft-sited proxy for “the market,” is up 16.4% year to date, while the record-setting Dow Jones Industrial Average is up 18.8%. This robust performance by US stocks, in 2006, is particularly noteworthy when compared to all of 2005 and 2004 (see table below). And as strong as this performance is, the Morgan Stanley Capital International Europe Australasia Far East (MSCI EAFE) Index is up 29.1% (performance cited above is on a total return basis as of December 15, 2006, source is Bloomberg). As the table illustrates, even the MSCI index has outdone itself this year.

The performance of the broader S&P 500 Index looks especially attractive when you consider the steep “wall of worry” that stocks skillfully scaled at times this year, in particular during the short-lived late-spring sell off. In fact, nearly all of the upside in the S&P has come since mid year when fears of a slowing economy amid growing inflation expectations triggered an 8% correction in the S&P 500 in May and June.

Not surprisingly, the low point for stocks in 2006 was just weeks before (and perhaps in anticipation of) the Federal Reserve’s decision in August to keep short-term interest rates unchanged at 5.25%. Since then, the Fed remains on hold, apparently ending an orchestrated campaign of 17 consecutive quarter-point rate hikes over a two-year period beginning in 2004. One of the few remaining worries continues to be the ongoing slow-motion collapse in the once-booming housing sector (more on that later). For the time being at least, Wall Street seems satisfied to adopt the “Goldilocks” view — expecting an elusive “soft-landing” scenario for the economy. In other words: they expect the economy to be just right — without a bear in sight.

Overseas Markets Outperform

Despite the more-than-respectable performance of US stocks, the real story for equity investors this year is the stellar performance of international markets. Evidence: the MSCI EAFE Index, which tracks major international markets (ex-US) as well as the MSCI Emerging Market Index, are outperforming the S&P 500 by more than 50% on a total return basis (as of December 15, 2006).

Drilling down to individual regions and countries, it’s clear that the countries of Latin America, collectively, were a great place to invest in ’06, as supported by the MSCI Latin America Index gaining 40%. And of course the perennial growth story in China is helping to propel Hong Kong’s Hang Seng Index up nearly 33% so far this year (as of December 15, 2006).

Emerging Markets, China in Particular,
Have Outperformed the S&P 500 Index in 2006

The trend in overseas outperformance is nothing new, but rather a continuation of a secular movement that began in 2002, and looks to continue for a fifth straight year. A combination of low interest rates and ample liquidity on a global basis, combined with a weaker US dollar and strong economic growth in many emerging markets have been the main catalysts. And most of these factors remain in force as we move into 2007.

For bond-market bulls, 2006 is turning out to be a more difficult year. Because of the inverted yield curve (when short-term interest rates are higher than long rates), cash and short-term treasuries proved to be the sweet-spot for investors in government bonds as six-month US Treasury bills produced a year-to-date total return of 4.76% as of mid-December. Also, cash is king in 2006, returning 4.67% to investors so far this year. By contrast long-dated 10-year US Treasury bonds have gained just 2.35% on a total return basis so far this year. ⁱ

Investor Outlook 2007:
Goldilocks Should Watch Out for the Three Bears

At this time of year, it’s commonplace to try to forecast the financial landscape for the new year and beyond. Barron’s Online (December 13, 2006) recently revealed it survey of Wall Street analysts — all nine are bullish on stocks, although the range of expected market returns is just 2% to 13%, with an average gain of 8% predicted for the S&P 500 in 2007.

The experts are similarly subdued about the prospects for bonds, with all of them seeing a yield on 10-year US Treasuries between 4.5% and 5.1%, in the year ahead. This would represent a narrower trading range than investors navigated this year.

Still, it seems the consensus-Wall Street view remains true to the belief in the “Goldilocks” scenario playing out for the US economy in 2007. Currently, this also seems to be the overriding, unifying theme among investors: growth that’s not too strong, which might push up inflation and not too weak (spillover from the housing bust) that might trigger a retrenchment in consumer spending.

To find an alternative view of what might go wrong with this perfect-world scenario, it’s worth traveling far from Wall Street, to Chicago’s Northern Trust, and economist Paul Kasriel.

Recent comments in Kasriel’s aptly named column “The Econtrarian: Your Alternative to the Econsensus”, [December 1, 2006] paints an unhappier ending to the story of the housing slump. Even though former Federal Reserve Chairman Alan Greenspan recently commented that the worst of the housing slump may already be behind us, Kasriel points out that history suggests more downside could lie ahead.

As the chart below illustrates, there have been nine periods of housing-sector contraction since the end of WWII, and the peak-to-trough decline in residential investment during the previous nine slumps has averaged 24.6%. But so far, in the current housing contraction, residential investment has dropped a relatively modest 7.9% from its peak. This suggests that, either the current cycle will be much shallower than the historical average, or we may still be in for a lot more pain from the housing sector before bottom is realized.

In fact, we may only be one-third of the way through the current slump, assuming an average decline of almost 25%. And when you consider the amount of speculation and leverage involved in the recent housing boom (consider A&E’s reality TV hit “Flip This House,” or 0% teaser rates on home mortgage loans), we may well experience a steeper than average retrenchment in housing this time around.

In his column, Kasriel further notes that bloated inventories of unsold homes on the market compared to homes sold, stands at a higher level than in any prior housing slump on record. That’s not a very good indication that the worst of the housing meltdown is behind us.

Oh! Incidentally, those gray bars in the graph above: they indicate economic recessions, which coincidentally line up pretty well with the later stages of most housing slumps in the past. That’s the flip side to Goldilocks: the “hard-landing” scenario that the consensus on Wall Street doesn’t seem too worried about at the moment. Perhaps they should be.

The opinions expressed are those of the author, Michael Burnick, Investment Research Analyst at Weiss Capital Management, Inc., and Weiss Capital Management, Inc., are subject to change without notice and may not come to pass.

ⁱ Comparative total returns on fixed-income indexes from Ryan Labs and Reuters as published in the Wall Street Journal.com market data section 12/18/06.