Jersey Benefits Advisors Newsletter Summer 2007
Market Watch The Federal Reserve ended its June Federal Open Market Committee meeting on June 28th, and the only change indicated for the foreseeable future is that the Fed sees core inflation as somewhat less of a risk, while overall inflation is still a concern. Interest rates remained on hold at 5.25%, where they have been for a year now, and investors hoping for a rate cut have capitulated. This surrender by bond investors has provided a slightly positive slope to the yield curve, as long term rates are modestly higher than short term rates. This leads me to believe there may be another way to view the inversion of the yield curve, which happened last year. While many view an inversion of the yield curve as a precursor to recession, historically we have not had a recession every time the yield curve inverts.
This last inversion did precede the first quarter economic slowdown of 2007, so perhaps the inversion of the yield curve in 2006 was indicating the mid cycle slowdown which occurred earlier this year. The US economy has been expanding since November of 2001, so based on the length of the last two economic cycles, the first quarter slowdown of 2007 occurred right in the middle of the cycle. However, it should also be noted that the last two US economic cycles have been records, stretching from November 1982 to March 1991 and March 1991 to November 2001, when analyzed from the bottom of one cycle to the bottom of the next cycle, or trough to trough. There were 10 economic cycles from 1945-2001, and the average duration from trough to trough was 67 months. Nobody can really say, with any certainty, how long the current cycle will last, but given all of the shocks incurred over the last five years, the economy has been quite resilient.
Of course, as long as the economy is growing, the stock market will react in a favorable manner. Although the indices are off their peaks set in the second quarter, as the books were closed on the first half of 2007, the DJIA stood at 13,408.62 which is a gain of 7.6% year to date. The NASDAQ closed at 2,603.23 for a gain of 7.8% thus far for 2007. The S&P 500 finished at 1,503.35 which is an increase of 6.0% for 2007.
While the S&P 500 is off its record close of 1,539.18, the fact that it finally surpassed the old record of 1,527.46 set back in 2000 is a significant technical feat which bodes well for a continuation of the current bull market. The consensus of economic forecasts for the second half of 2007 predict GDP growth of between 2%-3%, which is what should be expected for a mature expansion. How much strength remains in the economy depends on a number of factors. Maintaining healthy growth without increased inflation is paramount. While core inflation seems to be under control, the increases in the prices of food and energy are being felt by everyone. There is also a great deal of concern regarding the subprime mortgage market and the collateralized debt obligations and collateralized mortgage obligations on which many hedge funds feed. With mortgage foreclosures in the subprime market increasing, which lowers the value of CDO’s and CMO’s, there is a fear many hedge funds could incur significant losses, like those at Bear Stearns, as the value of their portfolios are rebalanced at the end of the quarter. As with most aggressive investment bets, when fundamentals change, things can go south in a hurry.
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