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Economics: Is It Different This Time?
New York: December 11, 2006
By John R. Stephenson

Housing data from the U.S. is starting to look ugly. Last week, Lennar, the third biggest homebuilder, said that cancellation rates for its new home sales were running at 30 percent annually and KB Homes, another homebuilder, said their cancellations were running at 43 percent. With Americans using their homes as ATMs and with house prices starting to swoon, can a U.S. recession be far behind? Perhaps. Yet, the stock and bond markets continue to surge. So, what gives?

The stock market is hitting new highs at a time when the bond market is also soaring. Across the globe, stock markets have remained stubbornly robust. Emerging markets have regained some of their luster as investors have piled back in. Initial Public Offerings ("IPOs") in Asia and Europe are on an upswing as is global private equity activity — in spite of a spate of worrisome economic news.

Both the bond and stock markets seem to be in agreement — inflation and interest rates are heading lower. If the markets are correct, we could be witnessing a rare event in the financial markets — a bull market in the bond and equity markets. If so, this is an event rarely seen.

The reasoning is simple. The bond market tends to jig when the stock market jags. Why? Because falling interest rates are the biggest driver of the bond market. When rates fall, bonds soar. But falling interest rates are a symptom of a slowing economy — a negative for stocks. On the flip side, when the economy is roaring and inflation is under control and interest rates are low or rising modestly, stock investors are partying as corporate earnings begin to trend higher.

Commodities are also on a roll. Gold prices remain strong and the energy complex is rebounding strongly. Base metals look to put together a strong performance, as global demand remains strong. Not only that, but Orange Juice just hit an all-time-high.

But the good news doesn't appear to be limited to just that. The world's major stock markets appear to be reasonably valued on a price/earnings ("P/E") basis and getting cheaper all the time. This in spite of a raft of private equity transactions where private equity firms have been taking some of the biggest publicly listed value plays (low P/E's and strong fundamentals) private and therefore out of the stock market in their entirety.

So how can this be? Stocks are doing well, and getting cheaper on a valuation basis. Bonds are doing well at the same time. The U.S. housing market remains a major worry in an economy that is largely (73 percent) dependent on the consumer for growth.

As famed economist Milton Freidman once said, "money matters most". Today, we are witnessing something unprecedented. A massive change in global capital flows with smaller under-capitalized bond and stock markets the biggest beneficiaries of this new trend.

Said another way, we are awash in money (capital). While interest rates have rallied over the last four years, they still remain relatively low. Not only that, but increasing global trade in goods and services has allowed the economies of India and China to surge. All of this has created enormous investment opportunity as huge pools of global capital are being directed at the developing economies globally. We no longer live in a U.S. centric world where capital and investment opportunity are limited by borders.

The rich do seem to be getting richer. In the U.S., the third quarter company conference calls revealed something unusual. WalMart, the nation's leading discount retailer, showed sluggish third quarter growth while Tiffany & Company and Saks Fifth Avenue (two luxury retailers) saw a dramatic increase in third quarter earnings. For the top wage earners, these times are grand.

With the freest trade in capital that has ever been witnessed, the role of the Federal Reserve (U.S. central bank) is less important than it once was. Many corporations globally are relatively independent of the banking sector as they are reliant on the capital markets rather than the bank market as a source of capital. With the world's capital markets awash in money, there is an ample pool of investment dollars available to companies. Capital will go where the opportunities are the largest and the risks minimal. In an increasingly global world, those opportunities are likely abroad.

For investors, this could be a boon. While the possibility of a slowdown looms in the U.S., this might set the stage for a tremendous future bull market in both stocks and bonds. If the U.S. economic data shows several quarters of negative or zero economic growth, then the Fed will likely cut interest rates. This would be a boon for the bond market and, in particular, long-dated zero coupon bonds.

So if interest rates tumble and inflation remains modest, the stage could be set for a strong rally in stocks shortly thereafter. Stock valuations are currently reasonable and an upswing in the economy (after a few quarters of lower interest rates) could send the stock market on an upward trajectory over the next several years. With interest rates and inflation benign, a strong bull market in both bonds and equities might occur.

For our money, we continue to favor a portfolio approach that is tilted toward the utility and base metal sectors and towards long-dated bonds and dividend paying stocks. In a declining interest rate environment, bonds and utilities should soar with the base metal stocks and commodities following later in the cycle as investors realize that while interest rates may be local, the economic drivers for commodity producers are global.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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