Goldilocks still defies the bears
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Investment managers do not generally believe in fairy tales, but there is one that dominated all discussion as 2007 began. Unless a lot of investors are wrong, Goldilocks is alive and well and impervious to the bears who believe the US and world economies are on their way down.
A “Goldilocks” is the now almost universal tag for an economy that slows down without going into a recession, bringing a moderation of inflation with it.
Such an outcome would allow the Federal Reserve and other central banks to cut rates, although not as fast or as aggressively as if the economy seemed to be in serious trouble. And it would allow companies to continue increasing profits, albeit perhaps at a reduced rate. It would be a great outcome for the year.
Economic data of late have done little to contradict that rosy scenario, although bears can still find figures to back up fears of overheating – core inflation remains stubbornly high for the Fed’s liking – and of a sharp crash, mainly thanks to weakness in the housing market.
In the markets, there are several indicators of trouble ahead. A rise in the gold price is normally an indicator that inflation is on the way, and it rose 20 per cent last year. The dollar fell dramatically. And the Treasury yield curve is inverted.
In other words, long-dated bonds are yielding less than short-dated bonds, which implies strong confidence that the Fed will be cutting rates sharply. That, in turn, generally implies an economic slowdown. But, on balance, some of the market’s cannier investors believe the Goldilocks scenario is looking good.
Even Bill Miller, who last year suffered the end of his record 15-year streak of beating the S&P 500 index, is strongly bullish for 2007. His $21bn Legg Mason Value Trust returned 5.9 per cent last year, according to Morningstar – a full 9.9 percentage points worse than his benchmark S&P 500. “With the Fed stopping interest rate rises, price/earnings ratios will rise in the next 12 months,” said Mr Miller at Legg Mason’s annual talkfest just before the holiday break.
“We expect 7 to 8 per cent earnings growth and, when you take into account other factors, such as dividends, and include our non-consensus view that the US dollar will rise not fall, that means that if you are a European investor, you could earn 30 per cent from the US stock market next year.” Mr Miller added: “The current account deficit will get better and assets will flow into the US. The last time everyone thought the US dollar would fall, it rose for four years.”
Exchange-traded funds now offer a relatively simple and isolated way to bet on a resurgence of the dollar against the main currencies.
Mr Miller said he recently returned from London, where he spent a day looking at residential and commercial properties.
“In Belgravia there were places that were £2,000 a square foot. Go to Park Avenue, you will pay $1,200 a square foot maximum,” he said, indicating that he thought London was overpriced by comparison with the US.
“We are in the early to mid stage of a bull market,” said Mr Miller, whose big miss last year appears not to have diminished his stature in the industry.
“US large-cap stocks, which have been one of the worst performing asset classes [they have underperformed larger companies seven years in a row], will be one of the best asset classes in the next few years.”
Among sectors, he made distinctly contrarian calls, saying that homebuilders and
technology companies would both do well in the US market. Homebuilders suffered a terrible 2006, as did many of the best-known names in the technology sector.
He said he would buy homebuilders if he did not already own several, such as KB Home. They had played a key role in the end of his index-beating streak.
Mr Miller believes Yahoo in particular is heavily undervalued and could rise by 50 per cent in the next year. He owns Yahoo, along with several other technology stocks, and was an early investor in the Google initial public offering.
He said Yahoo’s recovery would be underwritten by the launch of its new technology, which will improve the way it displays internet search advertisements. However, Google would also rise next year, because Yahoo’s developments would lift valuations in the sector, he said.
Yahoo shares fell by 35 per cent last year, helping pull down the Value Trust portfolio. Other bad stock picks included Amazon (down 16 per cent), United Healthcare (13 per cent lower after a stock options backdating scandal) and Aetna (down 8 per cent). Mr Miller declined to blame his downturn on bad luck. “It was probably bad stock selection,” he said.
He remained upbeat. Pointing out that he ranked last in his category for 2006, he joked that this showed that nobody else owned the same portfolio as him. And since the average mutual fund had a turnover of 110 per cent, he said: “Other investors have to buy my stocks in the next 12 months.”
Mr Miller’s fundamentally optimistic view seems to be shared by the hedge fund community. John Hodge is the president and chief investment officer of Permal, the world’s biggest fund of funds, with $27bn. He says that the consensus among the 200 hedge fund managers that Permal invests with is that there will be a “soft landing” (the Goldilocks outcome) for the US economy this year.
Their view is that in Japan, “the recovery is real”. Small-cap stocks in particular were due for a rise, as prices had been depressed there by the Livedoor scandal, Mr Hodge said, referring to the accusation of that company’s 34-year-old founder of falsely inflating profits.
Meanwhile, the European economy “will continue to be growth challenged”. Investors’ best bet in Europe would be to follow corporate activists such as Christopher Hohn, who heads the sometimes controversial Children’s Investment Fund, said Mr Hodge. Activist investors had suffered a few notable defeats in the US last year, but plentiful cheap credit had helped private equity buyers to propel stock prices forward in Europe.
What about emerging markets, which enjoyed spectacular success last year, surfing on the back of US investors’ dollars? They “are no longer dirt cheap”, Permal’s fund managers believe. They had largely become stockpicking markets, Mr Hodge said, where individual stock selection counted for more as the market overall could no longer be expected to rise automatically.
“They don’t like China or the Indonesian market. Those are stock selectors’ markets. One market they do like a lot is Thailand,” he said.
Among sectors, Permal’s fund managers believe that small-cap stocks in Japan are ripe for a rise. “They are also loading up on a lot of biotech. They believe it is time for that cycle to come back in,” he said.
What is the greatest cause for worry? There are many. While there is a plausible case for the Goldilocks scenario, it would be easy for the economy to miss it in either direction (particularly if world politics springs an ugly surprise).
But perhaps the most worrying sign is that so many people are confident that Goldilocks will survive her encounter with the bears. Ken Leech, chief investment officer of Western Asset Management, believes there will be a soft landing in the US economy next year. But if everyone thinks that, as they seem to, “then that might be a bad sign”.
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