Sunday, September 24, 2006
By the time you read this, the Dow Jones Industrial Average may be sitting at a new all-time high. At the close today, the Dow was within 50 points of its old high and the momentum feels like it will carry us beyond the previous high, which was set in early 2000. As usual the market has been climbing a wall of worry, and the 30% of American's who believe the US economy is in bad shape -- including many on Wall Street -- are going to have a heck of a time trying to figure out how stocks can be hitting new highs in the face of such a "lousy" economy. There must be a conspiracy here somewhere. Our stock market model indicates that the "fair value" of the Dow Jones Industrials is closer to 13,000, so from a valuation perspective, the market would seem to have a long way to go. Unfortunately, we also have an inflation model that suggests a little different story. With the 30-year T-Bond at a yield of 4.75%, our model calculates that core inflation should now be slightly under under 2%. With the core inflation rate running at 2.7%, getting down to even 2% in the next 12 months would seem to be a tall order. The only way I can see such a fall is on the back of housing. One reason for this is that food and energy are excluded from the core CPI, so falling oil prices won't help much. Since housing is one of the largest components of the core CPI, if current bond yields are correct, it would seem to presuppose that housing is going to be a bigger problem over the next 12 months than the market now thinks. Since housing is directly tied to banking and since banking and finance are nearly 23% of the S&P 500, it is very difficult to project a continuation of the recent record pace for the S&P. Ahh, but here is were the compositions of the Dow Jones 30 and the S&P 500 come into stark contrast. Financials represent only about 15% of the Dow, with none of the companies being a mortgage driven regional bank or a pure mortgage broker. The S&P 500, on the contrary, is loaded with mortgage driven regional banks, mortgage brokers, mortgage insurers and many more companies tied directly to housing. In this regard, as it relates to housing, the Dow is much less sensitive to the unwinding of the housing bubble than is the S&P 500. Having split this hair, I believe it is quite possible that the Dow will continue to move higher over the next few months, while the S&P 500 may not do as well. This is not idle mental castle building, we have sold almost all of our regional banks and cut back modestly on some money center banks with big mortgage holdings. This is a significant action because Sunbelt regional banks were our largest holdings at the beginning of the year. We still like banking, but US money center banks and strong foreign banks look like better values to us over the next couple of years. Their portfolios are diversified worldwide, and their investment banking divisions are minting money with all the mergers and private-equity buy outs. It will be good for the Dow to take out the old high. In my mind, it should have happened a long time ago. The values have been there to support much higher prices. But let's face it, the psychology has been lousy. Today, I believe the value are so compelling that, even in the face of lots of unknowns, the path of least resistance is up.