Commentary – Stock Prices Fall and Bond Prices Rise on Uncertainty Over Economic Growth and Volatile Energy Prices • Stock prices fell and bond prices rose during the month after preliminary Gross Domestic Product (GDP) estimates for economic growth during the first quarter of 2005 were lower than expected. These lower growth rates suggested that the Federal Reserve would slow down on its course of raising interest rates, thus causing the recent fall in bond yields. The latest data on the rate of inflation have been benign as well, supporting the current low level of bond yields. Commodity prices declined during the month with a precipitous drop in the price of crude oil leading the way. The decline in oil prices was attributed to rising inventories and slightly lower demand from China. As a result, the worst performing sectors were among those in energy-related industries. The month’s best-performing sectors were Health Care, Utilities, and Financial Services. Growth stocks outpaced value stocks during the month, reversing the prevailing trend of previous months. Attractive valuations in the Health Care sector drove stock prices higher during April. Large-cap stocks continued to lead during the month and outpaced smaller-cap stocks. Performance in the small-cap sector has been hardest hit due to higher valuations relative to other major stock groups, as well as rising interest rates. The REIT sector posted large gains during the month, an indication that demand in the real estate sector is still strong, and lending truth to the claim that investors are ignoring high valuation levels in the sector. The “state” of the real estate market has been at the forefront of the media, as the overall rate of appreciation in the national housing market has reached record levels and the pace of speculation has risen. U.S. bond prices moved higher during April due to several factors. Benign inflation and strong foreign demand for U.S. securities, especially Treasury securities, have kept bond yields near cyclical lows. At the same time, the Fed has raised interest rates several times over the past several months as indications of higher inflation were becoming more evident. This “conundrum,” as stated by Fed Chairman Alan Greenspan, has perplexed bond managers. May 2005 Lockwood Advisors, Inc.
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Overseas stock prices declined during April, as investors grew more pessimistic about the growth potential of developed Europe, especially Germany, where the local economy has been plagued by weak domestic demand, weaker-than-expected export growth, high rates of unemployment, and political turmoil. Stocks also declined in Japan as the prospects for higher economic gains looked no stronger than a decade ago.
Outlook – Media Focus Shifts From Trade Deficit to Real Estate Market • The media has recently shifted its focus from the potential dire consequences of a large trade imbalance to the current “froth” in the real estate market. Much of this shift in focus is similar to the media’s infatuation with the technology sector during the peak in the bull market in the late 1990s. Previously, Mr. Greenspan had downplayed the rapid appreciation in housing prices, suggesting that, unlike the stock market, the real estate market is not a national market, and, therefore, is subject to price inefficiencies in “hot” residential areas. As part of Lockwood’s investment process, asset valuation is one of the major factors behind determining appropriate forecasted returns. This approach is used for all major asset classes, including real estate. Recently, we have voiced our concerns over the public’s obsession with the residential real estate market to the point of disregarding current real estate market valuation levels. Nearly 60% of new mortgages have been issued in the form of adjustable rate mortgages (ARMs), and almost 25% of recent buyers have never lived in the residences that they are buying. We believe that rampant speculation, combined with higher interest rates and inflated prices, is a recipe for potential disaster. Current stock valuations are still at historically high levels and earnings growth is expected to converge to the average rate of growth. The current dividend yield in the stock market remains below 2%, and the longer-term nominal rate of growth hovers near 6%. With price-to-earnings multiples expected to decline slightly, as opposed to expanding, over the next cycle, it has been our consistent opinion that it is unrealistic to believe that stock returns can exceed a range of 7% to 7.5% over the long term.
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This is reprinted in its entirety with permission from Lockwood Advisors. The summary/prices/statistics contained herein have been obtained from sources believed to be reliable, but we cannot guarantee their accuracy. Please note, past performance is not an indication of future results. This document is for informational purposes only. Neither the information, nor any opinion expressed, constitutes a solicitation by us for the purchase or sale of any financial investments. The statements contained herein are based upon the opinions of Lockwood Advisors, Inc. and the data available at the time of the publication of this report and are subject to change at anytime without notice.