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Market commentary October 2006

By October 1, 2006No Comments

The Dow Jones Industrial index has caught the headlines as, at time of writing, it is within a whisker of it’s all time highs.  But don’t get too carried away, as this index is largely irrelevant, being focussed on just 30 stocks.  What is relevant for US and global investors, and their sentiment, is the performance of the more representative and widely traded S&P 500 index, which remains 13% below the highs of March 2000.

These numbers mask other facts.  The fall in US house prices last month was the first in a decade, and the US bond market, as you might expect, responded positively, anticipating interest rate cuts in 2007 to bolster an economy expected to endure a broadly based slowdown.  Yet the S&P, let alone the Dow Jones, also greeted this news warmly, apparently ignoring the risk of corporate profits taking a hit in 2007.

While in recent months we have expressed the view you should not panic about the prospect of a slowdown, the reaction of the US stockmarket appears far too relaxed.

Experience suggests that some trigger (“shock news”?) is required for the US stockmarkets to break to lower levels.  As we have often pointed out over the years, such falls are important as they have a cleansing effect, and provide the foundation for the next bout of profitable stockmarket moves.  If we don’t get regular falls it increases the risk that an awful lot of bad news will have to be discounted very quickly, with a “crash” risk.

The latest research from HSBC doesn’t fall into the “shock news” category, but does underline why it remains right to be cautious.  Analysing the US housing market they calculate that those States where housing is 35-40% over valued (bubble territory) account for 50% of US economic growth.  This expanding house price bubble has enabled the consumer, and the consumer alone, buoyed by booming house prices, to hold together the US economy in recent years.  The optimism it engendered caused a huge spike in consumer debt, and US consumers are now more stretched than they were in the 1980’s when mortgage rates reached 16%.  Even if US interest rates fall in 2007, providing some comfort for consumers, the support for economic stability is very thin.

And we care because the US accounts for 32% of global ecomomic growth, and the rest of the world has not (yet) developed to the point where this slack can be taken up elsewhere, whether EU, China or India.

To summarise, we would welcome moderate price falls in the short term, to complete the correction which began in May 2006 after a very profitable 3 year bull run.  Such falls should lay the foundation for profitable opportunities in 2007.

Dennehy Wealth