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The Economy and Financial Markets February 22, 2008 Member FINRA/SIPC The Economy and Financial Markets Economy and Financial Markets: Current Conditions Economy strong in Q3, slow in Q4 and Q1. Inflation contained – core around 2-2.5%. Profits / Earnings big short-term hit – sub prime related. Stock price gains in 08 expected to match earnings growth. Risks are: terrorism, Iraq, oil prices and subprime reaction. Bond market risk moderate due to good inflation outlook. Credit market concerns appear overblown, damage limited. $ exchange rate bouncing off a new record low. Member FINRA/SIPC 2 The Economy and Financial Markets Q3 GDP Up 4.9%, Q4 +0.6% (Lower Due to Housing & Inventory Drop), Employment Growth +0.7% Quarterly % Change in Real GDP % Change - Annual Rate 12-Month % Change in Payroll Employment % Change - Year to Year 12 12 8 8 4 4 0 0 -4 -4 -8 -8 85 90 Sources: BEA, BLS /Haver 95 00 05 0 2 /2 2 /0 8 Member FINRA/SIPC 3 The Economy and Financial Markets ECRI and Dow Barometer Down, Expect Slowdown, Not Recession ECRI Weekly Leading Index 1992=100 Dow Jones U. S. Business Barometer Index 2000=100 160 104 100 140 96 120 92 88 100 84 80 80 90 95 Sources: ECRI, BTMU /Haver 00 05 0 2 /2 2 /0 8 Member FINRA/SIPC 4 The Economy and Financial Markets Real Personal Income Rising, as is Spending: Not Much Housing Impact Real After-Tax Personal Income SAAR, Bil. Chn. 2000$ Real Personal Consumption Expenditures SAAR, Bil. Chn. 2000$ 9000 9000 8250 8250 7500 7500 6750 6750 6000 6000 5250 5250 4500 4500 90 95 00 05 Source: Bureau of Economic Analysis /Haver Analytics 0 2 /2 2 /0 8 Member FINRA/SIPC 5 The Economy and Financial Markets New Orders Surge But Shipments Still Flat – Business Cost Control Shipments of Manufacturing Durable Goods SA, Mil. $ New Orders for Manufacturing Durable Goods SA, Mil. $ 250000 250000 225000 225000 200000 200000 175000 175000 150000 150000 125000 125000 100000 100000 90 95 00 Source: Census Bureau /Haver Analytics 05 0 2 /2 2 /0 8 Member FINRA/SIPC 6 The Economy and Financial Markets Order Backlog Very High, Inventories Low Relative to Shipments Unfilled Orders for Durable Goods: Order Backlog Very High SA, Mil. $ Ratio of Inventories to Shipments: Low - No Inventory Overhang Ratio 825000 2. 4 750000 2. 2 675000 2. 0 600000 1. 8 525000 1. 6 450000 1. 4 375000 1. 2 90 95 Source: Haver Analytics 00 05 0 2 /2 2 /0 8 Member FINRA/SIPC 7 The Economy and Financial Markets Home Prices Weak, Income Up So Housing “P / E” Now Way Down (Especially Given Low Interest Rates) Median Sales Price: Existing 1-Family Homes $ Ratio: Median Price / Disposable Income per Capita Measure of housing P/E 240000 8. 0 200000 7. 5 160000 7. 0 120000 6. 5 80000 6. 0 40000 5. 5 0 5. 0 70 75 80 Source: Haver Analytics 85 90 95 00 05 0 2 /2 2 /0 8 Member FINRA/SIPC 8 The Economy and Financial Markets Home Sales and Starts Now Way Down – After 2 Years of Decline, The Worst Likely Behind Us. Housing Starts SAAR, Thous. Units New Single Family Home Sales SAAR, Thous 2400 1400 2000 1200 1600 1000 1200 800 800 600 400 400 90 95 00 Source: Census Bureau /Haver Analytics 05 0 2 /2 2 /0 8 Member FINRA/SIPC 9 The Economy and Financial Markets Major Credit Threat? No – Total Bank Problem Loans Low. Q4 Residential Loan Delinquency 3.1%, Defaults 0.4%, Low, But Likely to Rise Loan Delinquency Rate: All Commercial Banks SA,% Loan Charge-Off Rate: All Commercial Banks SA,% 7 7 6 6 5 5 4 4 3 3 2 2 1 1 0 0 85 90 95 00 Source: Federal Reserve Board /Haver Analytics 05 0 2 /2 2 /0 8 Member FINRA/SIPC 10 The Economy and Financial Markets US Trade Upturn Offsets Housing Weakness. U.S. Exports Are Three Times As Big As Residential Construction. Growth in Real U. S. Exports % Change - Year to Year Growth in Real U. S. Imports % Change - Year to Year 20 20 10 10 0 0 -10 -10 -20 -20 94 95 96 97 98 99 00 01 02 03 04 Source: Bureau of the Census /Haver Analytics 05 06 07 08 0 2 /2 2 /0 8 Member FINRA/SIPC 11 The Economy and Financial Markets Claims Lead Unemployment Rate (4.9%), Claims Are Up Some, So Unemployment May Drift a Bit Higher. Unemployment Rate SA, % Weekly Initial Claims for Unemployment Insurance SA, Thous 8. 25 600 7. 50 525 6. 75 450 6. 00 375 5. 25 300 4. 50 3. 75 225 90 95 Sources: BLS, DOL /Haver 00 05 0 2 /2 2 /0 8 Member FINRA/SIPC 12 The Economy and Financial Markets Private Sector Employment Cost Inflation at 3% Benefit Costs Under Control Change in Total Employment Cost Index (Wages + Benefits) Private Sector: 4-Quarter % Change Change in Benefits Cost - Has Slowed Considerably 4-Quarter % Change 8 8 7 7 6 6 5 5 4 4 3 3 2 2 1 1 90 95 00 Source: Bureau of Labor Statistics /Haver Analytics 05 0 2 /2 2 /0 8 Member FINRA/SIPC 13 The Economy and Financial Markets Total CPI Inflation Up Due to Oil Prices, Core Still Down at 2.4% Total CPI Inflation % Change - Year to Year Core CPI Inflation (Excludes Food & Energy % Change - Year to Year 7 7 6 6 5 5 4 4 3 3 2 2 1 1 90 95 00 Source: Bureau of Labor Statistics /Haver Analytics 05 0 2 /2 2 /0 8 Member FINRA/SIPC 14 The Economy and Financial Markets Fed Target is (Roughly) Core Inflation + Employment Growth. We Think Rate Cuts are the Right Policy Action Fed Funds Target Rate EOP, % Sum of Core CPI Inflation and Payroll Employment Growth % 10 8 10 Fed funds rate finally below the 3.2% sum of core CPI inflation of 2.5% and job growth of 0.7%. 8 6 6 4 4 2 2 Fed over did it in late 1999 - 2000 0 0 90 95 Source: Haver Analytics 00 05 0 2 /2 2 /0 8 Member FINRA/SIPC 15 The Economy and Financial Markets Risks? Sure – Sky High Oil Prices & Lack of Dollar Rebound Crude Oil Price - West Texas EOP, $/Barrel Dollar Exchange Rate - Major Currency Index Avg, 3/73=100 120 100 112. 5 Record oil price behind us? 105. 0 80 97. 5 60 90. 0 40 82. 5 20 75. 0 0 Record Dollar lows behind us? 90 95 Sources: WSJ, FRB /Haver 00 67. 5 05 0 2 /2 2 /0 8 Member FINRA/SIPC 16 The Economy and Financial Markets Company Earnings Outside Financials Okay, but Big Q3-Q4 Hit on Financials From the Sub-Prime Fiasco. S&P 500: After-tax Earnings with Next Quarter Estimate $/Shr S&P 500: Operating Earnings with Next Qtr Estimate $/Share 24 28 20 24 16 20 12 16 8 12 4 8 0 4 90 95 00 Source: Standard & Poor's /Haver Analytics 05 0 2 /2 2 /0 8 Member FINRA/SIPC 17 The Economy and Financial Markets Current Quarter S&P 500 P / E is around 22 – Spike Due to Subprime Hit Higher Risk on the Value Side, Lower Risk on the Growth Side P/E Ratio: S&P 500 Stock Price Divided By Same Quarters Earnings P/E calculated using current quarter operating earnings times 4 0. 35 0. 35 Higher Risk Region 0. 30 0. 30 0. 25 0. 25 0. 20 0. 20 0. 15 0. 15 Lower Risk Region 0. 10 0. 10 90 95 Source: Haver Analytics 00 05 0 2 /2 2 /0 8 Member FINRA/SIPC 18 The Economy and Financial Markets Record U.S. Net Stock Repurchases $610 Billion Last Four Quarters US Net New Equity Issues: Record High Stock Buybacks! New Equity Issued less Stock Bought Back in $Billions at Annual Rates 200 200 0 0 -200 -200 -400 -400 -600 -600 -800 -800 50 55 60 65 70 Source: Haver Analytics 75 80 85 90 95 00 05 0 2 /2 2 /0 8 Member FINRA/SIPC 19 The Economy and Financial Markets Corp. Balance Sheet – Companies’ Financial Assets Exceed Liabilities by $1.4 Trillion. Now Net Lenders, Usually are Net Borrowers Financial Assets Less Liabilities of All US Nonfinancial Corps. billions - US companies are now net lenders 1500 1500 Total U.S. non-financial companies net lenders 1000 1000 500 500 0 0 -500 -500 -1000 -1000 Total U.S. non-financial companies net borrowers -1500 -1500 55 60 65 70 Source: Haver Analytics 75 80 85 90 95 00 05 0 2 /2 2 /0 8 Member FINRA/SIPC 20 The Economy and Financial Markets Equity Total Return Beats Fixed Income, with Volatility but S&P 500 Total Return EOM Lehman Bond Index: US Aggregate Total Return EOP, Dec-31-75=100 2500 2500 2000 2000 1500 1500 1000 1000 500 500 0 0 90 95 00 Sources: Standard & Poor's, Lehman Brothers/ Haver Analytics 05 02/22/08 Member FINRA/SIPC 21 The Economy and Financial Markets Value Has Outperformed Growth Since 2000 – is Now Reversing Total Return: Russell 3000 Value Index 5/31/95=1000 Total Return: Russell 3000 Growth Index 5/31/95=1000 4500 4500 3750 3750 3000 3000 2250 2250 1500 1500 750 750 95 96 97 98 99 00 01 02 03 04 05 Source: Frank Russell Company /Haver Analytics 06 07 08 0 2 /2 2 /0 8 Member FINRA/SIPC 22 The Economy and Financial Markets About 110% Outperformance of Value Since 2000 Now Reversing Cumulative Total Return of Value Relative to Growth Ratio: Russell 3000 Value / Growth Total Return Indices 1. 8 1. 8 1. 6 1. 6 1. 4 1. 4 1. 2 1. 2 1. 0 1. 0 0. 8 0. 8 0. 6 0. 6 80 85 Source: Haver Analytics 90 95 00 05 0 2 /2 2 /0 8 Member FINRA/SIPC 23 The Economy and Financial Markets Small Caps Outperformed Large Caps Since 1999 – Now Reversing Total Return: Russell 1000 Large Cap Index Avg, 12/31/78=100 Total Return: Russell 2000 Small Cap Index Avg, 12/31/78=100 4500 4500 3750 3750 3000 3000 2250 2250 1500 1500 750 750 94 95 96 97 98 99 00 01 02 03 04 Source: Frank Russell Company /Haver Analytics 05 06 07 08 0 2 /2 2 /0 8 Member FINRA/SIPC 24 The Economy and Financial Markets Last 28 Years Small Caps have NOT Outperformed Large Caps. Back to Underperforming Cumulative Total Return of Small Relative to Large Caps Ratio: Russell 2000 / Russell 1000 Total Return Indices 1. 6 1. 6 1. 4 1. 4 1. 2 1. 2 1. 0 1. 0 0. 8 0. 8 0. 6 0. 6 0. 4 0. 4 80 85 Source: Haver Analytics 90 95 00 05 0 2 /2 2 /0 8 Member FINRA/SIPC 25 The Economy and Financial Markets Large Cap International Equities (EAFE Index) Now Underperforming The U.S. EAFE Total Return Index in Dollars EOP US$ S&P 500 Total Return EOP 8000 8000 6000 6000 4000 4000 2000 2000 0 0 80 85 90 95 00 Sources: MSCI Inc. , Standard & Poor's /Haver Analytics 05 0 2 /2 2 /0 8 Member FINRA/SIPC 26 The Economy and Financial Markets Fast, Deep Short-term Rate Cuts Sharply Lower Recession Probability. Low Long-term Rates Help. 30-Year Treasury Bond Yield Avg,% 2-Year Treasury Note Yield Avg, % 10 10 8 8 6 6 4 4 2 2 0 0 90 95 00 Sources: Haver Analytics, U. S. Treasury 05 0 2 /2 2 /0 8 Member FINRA/SIPC 27 The Economy and Financial Markets High Yield – Spreads Up On Sub Prime Worries High Yield Rate Source: Merrill Lynch Yield Spread: High Yield Rate Less 5-Year Treasury Rate % 15. 0 15. 0 12. 5 12. 5 10. 0 10. 0 7. 5 7. 5 5. 0 5. 0 2. 5 2. 5 0. 0 0. 0 96 97 98 99 00 Source: Haver Analytics 01 02 03 04 05 06 07 08 0 2 /2 2 /0 8 Member FINRA/SIPC 28 The Economy and Financial Markets Shark Chart: Return of Value & Growth Relative to Total Market Ratio: Russell 3000 Value to Russell 3000 Total Return Indices Measures cumulative total return of Value relative to the Total market Ratio: Russell 3000 Growth to Russell 3000 Total Return Indices Measures cumulative total return of Growth relative to the Total market 1. 3 1. 3 1. 2 1. 2 1. 1 1. 1 1. 0 1. 0 0. 9 0. 9 0. 8 0. 8 0. 7 0. 7 80 85 Source: Haver Analytics 90 95 00 05 0 2 /2 2 /0 8 Member FINRA/SIPC 29 The Economy and Financial Markets Conclusions GDP growth for 08 expected to be in the 2% range. $80+ oil knocks 1-2%+ off GDP & cut jobs gain by a million. Total inflation up on oil prices, but core inflation remains low. Earnings are generally okay – expect 5-10% in 2008. S&P 500 P/E spiking up, but expect prices to track 08 earnings. Non-Financial Co. Earnings and Balance Sheet quality look high. Bond risk moderate, subprime problems concentrated. Dollar exchange rate risk now low (recovering from record low). Further fed funds rate cut to 2.5% likely. Member FINRA/SIPC 30 The Economy and Financial Markets Important Disclosures The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The Russell 1000 Index measures performance of 1000 large cap, US companies. The Russell 2000 Index measures performance of 2000 small cap, US companies. The Russell 3000 Growth and Value Indices measure the performance of growth and value stocks respectively. The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries, and widely held by individuals and institutional investors. These 30 stocks represent about a fifth of the $8 trillion-plus market value of all U.S. stocks and about a fourth of the value of stocks listed on the New York Stock Exchange. It is not possible to invest directly in an index. The Lehman Brothers Aggregate Bond Index is composed of securities from the Lehman Government/Credit Bond Index, Mortgage Backed Securities Index and Asset Backed Securities Index. The Merrill Lynch High Yield Index is an unmanaged index consisting of bonds that are issued in U.S. Domestic markets with at least one year remaining maturity. All bonds must have a credit rating below investment grade but not in default. Government bonds and Treasury Bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. High yield/junk bonds are not investment grade securities, involve substantial risks and generally should be part of the diversified portfolio of sophisticated investors. Small cap stocks may be subject to a higher degree of risk than more established companies’ securities. The illiquidity of the small cap market may adversely affect the value of these investments. P/E Multiple: A tool for comparing the prices of different common stocks by assessing how much the market is willing to pay a share of each corporation’s earnings. It is calculated by dividing the current market price of a stock by the earnings per share. Past performance is no guarantee of future results. Indices such as the S&P 500 may not be invested into directly. The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. The Morgan Stanley Capital International (“MSCI”) Europe, Australasia, Far East Index (“EAFE”) is an unmanaged index of over 900 companies, and is a generally accepted benchmark for major overseas markets. Index weightings represent the relative capitalizations of the major overseas makers included in the index on a U.S. dollar adjusted basis. The index is calculated separately; without dividends, with gross dividends reinvested and estimated tax withheld, and with gross dividends reinvested, in both U.S. Dollars and local currency. This research material has been prepared by LPL Financial. The LPL Financial family of affiliated companies includes LPL, UVEST Financial Services Group, Inc., IFMG Securities, Inc., Mutual Service Corporation, Waterstone Financial Group, Inc., and Associated Securities Corp., each of which is a member of FINRA/SIPC. Not FDIC/NCUA Insured Not Bank/Credit Union May Lose Value Guaranteed Not a Bank/Credit Union Deposit Not Guaranteed by any Government Agency Member FINRA/SIPC Tracking# 396827 (Exp 12/08) 31