Stocks could fly higher in 2007

Business Times - 29 Nov 2006

MONEY MATTERS
Stocks could fly higher in 2007

But expectations of a 'perfect landing' could lead to some disappointment and turbulence along the way

By LIM SAY BOON

THE fourth quarter global equities rally I wrote about in this column early August has unfolded pretty much as expected - in tandem with what has hitherto been a soft landing for the world economy.

Global stocks, using the MSCI World as a proxy, have broken back above their May peak. Records are being broken around the world, from the Dow Jones Industrial Average (DJIA) on Wall Street to the Sensex in India to the Straits Times Index in Singapore. Indeed, the US, European and emerging markets have been looking much like the one trade: The same 'risk love' trade. And while equities on many markets are at this stage looking overbought and vulnerable to a near-term correction, the underlying fundamentals still look favourable for yet higher prices into 2007.

To understand the reasoning for - and the risks of - this continued 'bullish equities' stance for 2007, rewind to the assumptions underlying my call back in August that the mid-year meltdown was more likely a half-time hiatus rather than 'end game'.

One, stocks were trading at mid-cycle valuations, not late cycle. Mind you, this valuation argument was valid only to the extent that the market was right on its assumption that any economic slowdown would not take corporate earnings significantly backwards. Which then leads us to the second factor - the assumption of a soft economic landing, with the US easing towards moderately lower but not negative growth, and with the Chinese economy remaining robust enough to absorb some of the slack from the United States.

Well, so far events have played out almost to a 'Goldilocks' ('just right') scenario. That is, the US economy is slowing - as the market requires, to set the stage for lower interest rates. And yet the crucial housing sector's cooling has been orderly.

Meanwhile, over in Asia - against the backdrop of mildly slower global growth led by the US and Europe - the Chinese economy remains resilient. And in response to a slightly slower world economy, oil and metal prices are coming off their highs - a good thing for the economy and equities as this takes pressure off prices and interest rates. And after a counter-end rally, the US dollar looks like continuing its secular downward slide - again, a good thing for the global economy as an orderly (and it has been orderly with strong counter-trend rallies in between to keep the dollar bears on their toes) weakening of the greenback is necessary to stimulate the US economy, improve American competitiveness and redress the global savings imbalance between the US and Asia. And on the stock markets, that will help lift US dollar reported earnings of corporations with global businesses.

Indeed, it has been less of a 'soft landing' than an apparently 'perfect landing' so far - and that's the source of potential turbulence for equities ahead. To repeat, I still favour equities going higher in 2007. But things have been going a bit too well, with extreme lows in volatility suggesting complacency. This apparent expectation of a perfect landing could lead to some disappointment, anxiety, and turbulence along the way.

Multiples expansion

Given that even a soft landing may mean some slowdown in corporate earnings, the market may have to accept valuation 'multiples expansion' just to go lateral, let alone go higher. By extension, valuation multiples have to go quite a bit higher then for prices to continue this rally.

Currently, the US market is trading on average at around 15-16 times forward earnings and Europe is trading at around 13 times. The emerging markets would congregate around the mid-teens with India's Sensex on the high side at 19-20 times, Thailand's SET at the low end at around 11 times, and Singapore's STI and Hong Kong's Hang Seng at around 15 times.

These valuations can in historical terms be characterised as 'mid-cycle'. Not cheap anymore mind you, but not expensive either. And yes, in a cheap-money environment - and you have to remember that PE valuations should be considered against the cost of funds - you can see valuations diverge considerably above the historical average. But along with higher valuations come higher risk. That is, you push further down the road towards late cycle valuations.

However, for now, we are still far from bubble-like conditions and there is indeed more room for valuation upside. Even so, as my colleagues from Standard Chartered Global Research put it: 'Having faith in an eventual 'soft-landing' is one thing, being prepared for likely turbulences in the interim is equally important. They could come in the form of further bouts of risk aversion, aggressive unwinding of carry trades, or simply occasional reminders (data-wise) on the possibility of seeing alternative (less ideal) landing outcomes.'

Indeed, a warning shot of how things can go wrong can be seen in Japan, where the Japanese economy remains on its recovery path, albeit with residual resistance from consumers to open their wallets. Yet, the Nikkei failed at key technical resistances and now appears headed even lower from here. My suspicion is that while the most obvious place to look at for direction for the Nikkei was the Japanese economy, the more likely source of turbulence may be from the signals sent by the yen. That is, the strengthening economy and talk of higher interest rates were suggesting the prospect of yen strength vis-a-vis the US dollar. The Nikkei appears to have taken fright at the prospect of the end of super cheap money and the prospect of a less competitive currency.

False breaks

On the commodities front, oil has eased back from its highs and more recently been range bound between US$57 and US$61, with false breaks above and below correcting smartly back into the range. On fundamentals, you would have expected this near-term softness in oil prices on the slowing global economy and the speculative build up of inventories since 2002 in tandem with price increases. That is, the market needs to work off some of those inventories - and slowing growth is as good an excuse as any. But looking into 2007, oil could prove resilient given the historically low spare productive capacity which is running at less than 2 million barrels per day. This is comparable with the levels reached around the time of the first Gulf War, when China and India were not consuming nearly as much oil.

In industrial metals, there is a threat of significantly lower prices in 2007, with copper's almost vertical ascent early this year looking suspiciously like a speculative bubble.

Precious metals are a different ball game, with gold remaining resilient despite easing oil prices (which should drag on gold through lower inflation). Perhaps a greater factor at work for gold is the market's suspicion that the US dollar could head lower in 2007, giving gold support as a hedge against a weaker greenback.

Speaking of which, the US dollar is currently poised at crucial levels against the euro and the yen, with the bias towards further dollar weakness. Asian ex-Japan currencies are looking particularly strong against the dollar going into 2007.

Lim Say Boon is chief investment strategist for Standard Chartered Bank, group wealth management.

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