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The first quarter of 2007 was characterized by volatility. After a seven month rally we are currently in a consolidation phase which will last into the second quarter, which is normal after such a strong bull market. There exists now more uncertainty in the market, due to a deceleration of economic growth and corporate profits as well as rising longer-term interest rates.

Residential housing and business investment are both slowing. In the fourth quarter of 2006, spending on new homes fell by 19.8 % relative to Q4 2005, while business investment dropped 3.1%, the largest decline in four years, and investments in equipment and software fell 4.8%. The inventory of existing housing stands at nearly seven months, while new housing inventories are at 8.1 months, their highest levels since 1991, the last recession. While real estate prices have been falling since mid-2006, they are likely to continue to weigh on household disposable income; the construction industry is one of the biggest employers in the U.S, and the unquantifiable, but nonetheless real, “wealth effect” will likely be negatively impacted. Considering the sub-prime mortgage fall-out and the likelihood that in the next few months more homes will be foreclosed, questions have arisen as to how long the residential housing market will be a drag on the U.S. economy. As for corporate profits in Q1 2007, this may be the first time we have not seen 10% year-on-year corporate earnings growth in some time; in fact analysts have revised this figure down to 4.4% growth.

The Federal Reserve is now “on hold” and is not likely to lower interest rates in the second quarter. There is conflicting news from the top; Fed Chief Ben Bernanke stated in March that he thought the economy still had room to grow, which seemed like a choreographed response to his predecessor Alan Greenspan’s remarks days earlier that he saw a recession looming by year-end. Longer term rates are edging up because of significant commodity driven inflation risk, which pushed the ten-year bond yield up 20 basis points since mid-December.

But don’t throw out the baby with the bath water; all is not doom and gloom! Equity valuations are not particularly high, and corporate balance sheets are cash rich. Corporate earnings growths, while slowing, are still growing. World economic growth is not slowing either, which helps provide a tailwind for the U.S. economy. A weaker dollar will help U.S. exports, and business investment may be seeing only a temporary drop as managers wait for more signs of stability. The Federal Reserve may begin cutting rates at the end of this year assuming that inflation resumes a downward path, which should create once again favorable conditions for stocks.

For the first quarter of 2007 the major indexes barely moved; the Dow slipped 0.8%, the S&P rose 0.1%, and the Nasdaq gained 0.1%.
Grant Rogers Elizabeth Allen

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