Friday, April 27, 2007

Economic Poker

The recent run-up in the market has had me questioning my judgment that cash is the best place to be right now (review: cash accounts currently pay just over 5% risk free).

The stock market used to be a great indicator of economic health, showing the collective guesses of millions of people on profits and growth. This is why the stock market is part of the Conference Board’s index of leading indicators. And yet over the last 3 months the leading indicators have declined (on a year-to-year basis) while the market climbs -- basically most of the economic indicators except the stock market show weakness.

David Rosenberg, chief North American economist at Merrill Lynch & Co., thinks there is a "disconnect between how the economy is doing and the way the equity market is doing." The U.S. economy has just completed four quarters of annualized growth below 3%, which has never happened in 60 years without being followed by recession.

This morning first quarter GDP was reported at 1.3%, below even the pessimistic predictions of 1.5%. Trade and inventories reduced growth significantly, business and government spending growth was tiny – almost all the growth was driven by consumer spending. Consumer spending, however, seems to be giving mixed signals. Reuters and the University of Michigan reported their consumer sentiment index came in at 87.1 at the end of April, compared with readings of 85.3 midmonth and 88.4 at the end of March.

So what does this mean for the future? The quote above from David Rosenberg shows one economists view. Meanwhile Ed Hyman, chief economist at ISI Group, a New York investment dealer expects economic growth to slow further -- to an annual rate of 1.5% in the last nine months of this year -- and the Fed to cut short-term interest rates by three-quarters of a percentage point. But then says “The boost to stocks from lower rates should more than offset the drag from weaker growth and profits”. So this investment dealer says growth will weaken but you should buy stocks anyway.

The Hyman argument bothers me. It suggests he believes stock prices will go up because the returns from cash and bonds will be low, forcing people to buy stocks if they want returns. But this sort of logic ignores profits and stock values completely. Personally I am a fan of rock solid value investing using present value analysis. And it works! My buy list of value stocks blasted market returns last year, and they’ve been climbing like rockets this year too.

I still hold my buy list stocks (this is a real money portfolio after all), but I also still think that cash is a better place for money not specifically in a target stock. I believe the indexes will not outpace current 5% cash returns during this year. It’s stressful to be holding cash while the market climbs, but will feel good during the drop.

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