R  I  V  E  R   P  O  I  N  T 

R  E  P  O  R  T

 

 

March 2007

 

MARKET CORRECTION OR TREND?

 

The recent weakness in the stock market, punctuated by the dramatic one-day decline of about 3%, appears to be the result of a confluence of factors rather than a simple knee-jerk reaction to recent events in China.  "I think it's wholly psychological; nothing has actually changed," said Philip Manduca, managing partner at Titanium Capital in London. "The Chinese stock market is not an indicator of the Chinese economy. The Chinese economy is not an indicator of the world economy." Factors that have contributed to the recent pullback include the increase in sub-prime loan defaults, Greenspan’s recession warning, disappointing durable goods orders, Iranian tensions and the general feeling that the bull market of the last 33 months was due for a 3% correction.

 

At RiverPoint, we are paying careful attention to economic events following the aftermath of the recent market decline.  As of this time, we do not recommend any major actions or changes in our clients’ portfolios.  In fact, we believe this correction makes stocks look even more attractive on a historical basis.  A stronger-than-expected preliminary fourth quarter 3.5% growth rate in the GDP and impressive earnings reports have served to widen the gap between company reported earnings growth and company stock prices.  This makes stocks appear less expensive as demonstrated in the following graph in more detail.  Over the last three years, corporate earnings of the S&P 500 companies have grown at twice the rate of the appreciation in the index’s stock price.  Due to the strong earnings growth, these stocks are about 20% cheaper than they were three years ago on a price-to-earnings basis.

 

 

Examples of high quality companies with very attractive valuations at this time include General Electric (GE), United Technologies (UTX), Johnson & Johnson (JNJ) and BP (BP).  All these companies have estimated earnings growth rates above 10% and dividend yields above 2% but price-to-earnings ratios of only 15 to 17 times earnings.  Historically, these stocks are as cheap as they have been in at least 10 years. 

 

CHINESE NEW YEAR – YEAR OF THE BEAR?

 

The recent drop in China’s stock market is fueling the fear that the blistering pace of the giant’s economic growth over the last few years may finally be slowing.   A 9% slide in Chinese stocks on the morning of February 27th set the tone for the opening of trading. Concerns that China's economy will slow sent many investors selling just a day after they sent Shanghai's benchmark index to a record high close.  

 

This Chinese-related decline in world stocks is reminiscent of the quick October 1997 8% sell off in U.S. equities, which was triggered by a sharp, extended decline in Hong Kong stocks.  But the current situation seems only vaguely similar to the 1997 episode.  There is no building global crisis and so far the approximately 10% decline in Chinese stocks is much smaller than the 1997 decline.  In even a moderate up year, several corrections of this size are likely.  In fact, this decline in the U.S. stock market is hardly a correction by historical standards when compared to the declines in 1987, 1990 and 1998, which ranged from 4% to 28% in magnitude.  The case can be made that not only was a correction of 3% in the U.S. stock market past due but also that such a correction was necessary and historically has led to a period of positive stock performance.

Most economists believe that this “sudden” drop in the price of the Chinese market is part of a natural retrenchment that must occur at some point after years of high single and low double-digit economic growth.  There is no evidence, however, that this decline is anything more than just a blip in a secular uptrend.  Based on the last 30 years, China's long-term growth trend is as powerful as any in history, and the majority of the country's consumers and workers are still waiting to get into the game. A reversal in government policy seems unlikely—the disaster of the Mao years is the historic exception rather than the rule.  Most other serious threats to this economic juggernaut such as Taiwan, Japan, overcapacity and class instability would likely have a temporary rather than permanent impact. Even if China's economy stumbles—which, at some point, it will—the opportunities for savvy foreign investors will still be abundant in China.

Although the long-term trend is in the right direction, this does not guarantee that growth will proceed in a straight line.  Fifteen years ago, it seemed all but certain that Japan was going to blow past the United States, buy up all of our companies and real estate, and win a war it had lost half a century earlier. But Japan is now mired in its second decade of stagnation.

 

For now though, it looks as if China will remain a major driving force in an increasingly interdependent and interconnected global economy.  At RiverPoint, we continue to believe that China, India and the U.S. will be the primary drivers of global growth for the foreseeable future.  Nevertheless, because the Chinese government often has significant ownership positions in its own country’s listed companies, if it would sell down its holdings, share prices could tumble.  Risk is one reason why we recommend that clients maintain exposure to foreign equities in their portfolios in a diversified manner by owning high quality mutual funds that invest across many borders. 

 

 

 

          Market Summary

 

2/28/07

 

YTD Price Change

 

Dow Jones Industrial Average

12,268

 -1.6%

Nasdaq Composite

  2,416

                         0%

Standard & Poor’s 500 Index

  1,406

   -.8%

 

For information about RiverPoint Capital Management or to view our report archive visit us at www.riverpointcm.com.