Abbey Cohen Q&A on investment strategy

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Abby Cohen, chief US investment strategist at Goldman Sachs, will answer your questions in a live Q&A on Monday from 2-3pm GMT.

Ms Cohen became synonymous with the stock market bull run of the late 1990s, having called the bull market and technology boom. She believes that US economic and profit expansion will continue in 2007 with corporate America remaining in robust condition.

In 2007, Ms Cohen will continue to focus on equities as a preferred asset class. She sees equity valuations remaining attractive relative to competing assets and providing a reasonable cushion should bond yields continue to rise.

Profit growth should remain strong, and liquidity and bid activity remain a further support for a structural bull market, in her view. Ms Cohen’s outlook for commodities remains moderately positive. Read more on Abby Cohen’s forecast for 2007


When do you think will there be a correction to the recent bull run in the equity markets? Q1 or later this year? Which sectors will be sold most? Services, commodities, or finance?
Rustum Boyce, Singapore

Abby Cohen: Rustum, your question is one that we hear from many investors. For some, it is due to worry that a decline in the US equity market would have unhappy implications for other markets, such as the emerging debt and equity markets that have benefited from US portfolio inflows. But, we also hear this question from investors who are hoping for a decline in US share prices. Specifically, many institutional investors in the UK and Europe are underweight in the US markets relative to their benchmark indices.

A correction would create an opportunity to establish new positions in the US markets, and to do so after the dollar has declined in value relative to both the pound and the euro.

A good rule of thumb is that a well-anticipated correction usually doesn’t last long, as many portfolio managers use it as an entry point into the market. We believe that US shares are currently about 10 per cent undervalued and that this will also offer some buffer against disappointing news. Of course, the catalyst of the correction is critical in the analysis.

If the source of the share price decline is something that calls into question the fundamental underpinnings of the economy or equity valuation, the price declines can be meaningful and longer lasting. For example, if the sustainability of economic and profit growth have been called into question, high quality bonds are likely to outperform both corporate bonds and corporate equities. Within the equity market, high quality companies with dependable earnings growth are likely to offer good relative performance.


Do you think that technology stocks will pick up strongly in the next few years as the communications network is rebuilt (IPv6, networx) and new Vista and Apple programs, along with greatly enhanced computer power, starts to enter the workplace?
Dwayne Hines

Abby Cohen: Dwayne, it’s interesting to note that the specific products in your question might not have been mentioned a year or two ago. The key here is that technological innovation is continuing at a rapid pace, and corporations and households continue to be interested in new products and capabilities in communications and information technology.

The macroeconomic data in the US and many other nations show that new business investment remains dominated by spending on equipment, computer software and related services. This is reflective of a true restructuring of the developed economies and is likely to continue. But the companies demonstrating leadership in these categories may change over time.

Some of the best managed companies will evolve, but others will fade from the scene as newer companies take their place. Hence, this important investment theme must be continually updated with attention paid to the most promising products, services and companies.


What is the most likely means by which global liquidity will be reduced?
Douglas R. LaBossiere, Washington, DC

Abby Cohen: The question from Douglas is clear and direct, and the answer, which is critical to all markets, is less clear. There are several possibilities. The usual means by which liquidity is reduced is through the actions of central bankers. Given the currently low inflation in most nations, we expect central bankers to undertake monetary tightening only in a gradual and incremental manner. In 2007, we will be watching Asia carefully in this regard.

Strong corporate balance sheets are another important source of liquidity. For example, the companies in the S&P 500 have more than $2,500bn available, the equivalent of 20 per cent of their aggregate stock market capitalisation, or about double the historical average. We project a modest deceleration in the growth of corporate cash, but not a decline.

Notable risk appetite, in many asset categories and countries, has been another critical factor in the availability of liquidity. There has been a powerful combination of ample liquidity, high risk tolerance, and low asset price volatility. We assume that this will begin to shift, at least on the margin, in 2007. At present, an economic shock seems less likely than one in the geopolitical sphere. The other possibility might be an issuer or transaction specific problem.


Do feel the growth in energy and commodity stocks we have enjoyed so far this year will continue?
Robert Davidson, Washington DC

Abby Cohen: Robert, our industry analysts expect good returns from these industries in the coming quarters. although not at the high levels seen at various points over the last couple of years. It is important to note that some investors have been making their decisions on these shares based on changes in the spot prices of the commodities themselves. This sort of price momentum investing now seems to be giving way to the more standard and appropriate approach related to the underlying earnings and cash flow of the companies and valuation of the shares.

Our industry teams expect the companies in energy and other commodities to boost their spending on new production capacity in the coming years, and this presents another way to participate in their growth. Example include companies that provide the equipment, construction and services to the energy and commodity producers.


Looking ahead and beyond this year, what is your take on the retirement-related equity sell-offs by wealthy baby-boomers, whose assets one would have thought should be well diversified, and which countries in particular (besides the US and Japan) are most likely to be affected? What are the key driving forces to absorb this and what are other major challenges and risks you might see on the horizon? Or to the contrary, any positive boosts?
Alina, London

Abby Cohen: Alina, your question has several interesting elements. First, the status of the US pension system is reasonably sound. For example, the defined benefit pension plans of the companies in the S&P 500 are close to being fully funded. We do not expect either the corporate plans, or most individuals, to be forced into uncomfortable portfolio liquidations over the next few years.

Second, thus far, the parents of the baby-boomers (let alone the baby-boomers themselves) have shown little inclination to sell their financial assets. The usual demographic argument that older individuals sell shares to buy bonds has not been particularly apt in recent years.

Rather, these individuals continue to focus on market conditions and expected returns when making portfolio decisions. Of course, this could change in the coming years. The median baby-boomers will reach their 65th birthdays in about 15 years.

Third, nonetheless, it is always useful to consider where Americans have been investing, and could reduce their involvement, should there be a change in their portfolio emphasis for whatever reason. Over the last two years, US portfolios have been increasingly diversified into non-US markets, especially in Asia. Japan has been the largest recipient of these flows, but it is also the single largest market in the region and can handle the inflows without much disruption.

The smaller markets have benefited not only from the favourable views on long-term fundamental growth, but also from the liquidity flows heading their way. One interesting historical note: US investors were extremely enthusiastic about smaller equity markets in 1993-1994, with Hong Kong and Mexico being the largest recipients of US inflows at that time, despite their small market capitalisations.

When the Federal Reserve tightened monetary policy in 1995, and US investors reduced their holdings, these markets fell more in price than did the US equity market and took much longer to recover.


The investment community always listens to your opinion and forecasts. I believe the US economy is heading for a storm, primarily due to housing. I believe cash is the king and have moved most of my assets in to it. What is your opinion on cash and what is your cash allocation suggestion for near term?
Roman, London

Abby Cohen: Even without a storm, cash is more appealing than it has been in some time for dollar-based investors. The Federal Reserve has raised short interest rates substantially over the last couple of years. The inverted yield curve in the US bond market means that holders of cash are receiving relatively attractive yields when compared to longer-maturity securities.

However, please consider the following alternative scenario suggested in your question. If housing is far weaker than we have assumed in our forecast, and leads to a more dramatic disruption of the overall economy, the better fixed income alternatives may be longer-duration bonds. If the economy gets notably weaker from current levels (which is not our forecast), and yields on intermediate and longer-term bonds move lower (and the prices on these bonds rise), you may prefer to own more of these securities relative to cash.


What sectors do you recommend for 2007 and why?
J. Nigel Smitheram MD, Mexico

Abby Cohen: Our sector recommendations are based on several factors, including underlying demand, growth in earnings and cash flow and, of course, valuation of the shares. From an economic perspective we see several areas of interest.

The two fastest growing sectors in the US economy are (1) domestic capital spending, including new investments in equipment and nonresidential construction, and (2) exports. The most important US trade customers are other developed economies, and the improved economic tone in both Europe and Japan is helpful to US exporters. The major export categories are capital goods such as industrials and transportation equipment, information technology and related services, and other high-level services.

Shares related to some types of discretionary consumer spending may also benefit from economic trends, especially on the service side, as household spending rotates away from housing and autos and is redirected elsewhere. Beneficiaries may include travel-related categories, such as hotels and cruise lines, restaurants, and media and entertainment.

Now is an interesting time in the US market, as we see less than the usual dispersion in relative valuations between economic sectors. Hence, our analysts are more focused than ever on other themes, for example, large capitalisation vs. small capitalisation, and individual security selection.


How do you see financial markets evolving in the next decade or at least in the next few years taking globalisation, emerging economies and the lack of risk awareness into account?
Zsofia Molnar, London

Abby Cohen: My Goldman Sachs colleagues have done thoughtful analysis on the growth potential of the so-called Brics, or emerging economies, and conclude that much of the incremental growth in the global economy will come from these nations in the coming years. Significant progress has been made in the development of their capital markets, regulatory structures and accounting systems, but much work and maturation is still required.

There is currently notable risk appetite on the part of global investors, benefiting the flows of investment capital into these markets. From a long-term perspective, we expect good returns from investments in these economies, but recognise that short-term volatility will likely rise from currently low levels.


Abby Cohen’s forecast for 2007

The US economy and capital markets are in a state of flux. The pace of GDP expansion has slowed largely due to weakness in new housing construction, and there are signs of strain in some parts of the mortgage markets. But other sectors remain quite robust, including export growth and capital spending. Recession seems extremely unlikely in the coming quarters. Even personal consumption spending has remained above trend, thanks in part to strong labor markets and gains in household income.

The spending growth of households is decelerating from above-trend levels, but it is also rotating. Both of these are common cyclical phenomena, and have implications for stock selection. For example, there is a shift of new consumer spending away from housing and autos but towards other discretionary items, including services such as travel, media and entertainment.

The S&P 500 appears to be moderately undervalued, although it is not as cheap as last year when shares returned more than 15 per cent in dollar terms. To be conservative in our 2007 valuation models, we assume that interest rates will rise above consensus expectations and that earnings growth will decelerate. Even so, we project a year-end 2007 price target of 1550, compared to 1418 at the beginning of the year.

We are less sanguine on the relative valuation of credit markets, especially lower grade corporate bonds. US corporate balance sheets, in aggregate, are in outstanding condition, but this is not necessarily the case for some of the lower-grade borrowers.

A significant factor in the financial markets will continue to be the strength and direction of cross-border flows of capital. The US has been a large importer of capital, especially into the fixed income markets. The US is also a large exporter of equity capital through foreign direct investments and portfolio flows into non-US markets.

US corporations have used their strong cash positions, totalling $2,500bn for the companies in the S&P 500, to expand their businesses both at home and abroad. US investors have sought favourable returns and diversification in non-US markets, specially among emerging economies.

An important question for 2007 will be the path of investors’ risk appetites. While liquidity remains flush, and asset price volatility remains low, there is willingness to extend out along the risk curve. Examples include the strong demand for lower quality bonds, the favourable share price performance of smaller US companies, and the substantial flow of funds into emerging markets, both debt and equity.

At some point, however, volatilities will rise from the current extremely low levels and liquidity will become less fluid. Valuation, both absolute and relative, will then become increasingly critical to investment decision making.

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