Wall Street's All Charged Up

Source : The Business Times, September 26, 2007

Sub-prime? What sub-prime? Post-Fed cut, strategists are in bullish mode, buying into energy, industrial and tech companies that gain from global growth

THE Federal Reserve has driven most stock-market bears into hibernation. From UBS AG to Deutsche Bank AG and Citigroup Inc, Wall Street strategists are the most bullish they've been since 2000 after the US housing slump erased US$5.6 trillion from global equity markets and prompted the Fed to cut interest rates.

Wells Capital Management and MFS Investment Management, which together oversee US$375 billion in assets, are adding or looking to buy shares of banks, retailers, and technology companies on expectations lower borrowing costs and expanding economies across Europe and Asia will spur profit growth.

'You couldn't mix a better drink for the stock market,' said James Paulsen, who helps oversee US$175 billion as chief investment strategist at Wells Capital in Minneapolis.

Investors have been celebrating since the Fed's surprise half-point rate cut Sept 18 sent the Morgan Stanley Capital International World Index of 23 developed markets on its biggest two-day rally since June 2006. They snapped up shares of commodity producers and industrial companies that will benefit the most in a growing economy and became cheap last month after global stocks fell to the least expensive in 12 years.

The bears haven't all retreated. Balestra Capital Ltd's Jim Melcher and the Leuthold Group say the bulls are ignoring the reason for the central bank's rate cut - concern that the world's largest economy is heading into a tailspin.

Policy makers 'realise that there's a real economic threat of recession if we're not already in one and there's a brewing financial crisis', said Mr Melcher, whose US$260 million Balestra Capital Partners LP hedge fund in New York has returned 124 per cent this year with bets against financial shares and bonds backed by sub-prime mortgages.

The rebound in prices 'should be viewed as the eye of the hurricane', Steven Leuthold, whose US$1.72 billion Leuthold Core Investment Fund has beaten 97 per cent of like funds this year, wrote in the September issue of the firm's monthly research report. The Minneapolis-based Leuthold Group is concerned the economy will contract next year and cut its equity allocation to 30 per cent from 50 per cent on July 17, two days before the Standard & Poor's 500 Index reached a record.

Trading in Treasuries shows bond investors expect the Fed will lower rates again before year-end as the economy comes to a standstill. The yield on Treasury two-year notes is almost three quarters of a point below the designated 4.75 per cent funds rate. In the three previous occasions during the past 20 years when that has happened, policy makers have cut borrowing costs.

'The US economy needs to grow at 2.5 to 3 per cent or else it stalls,' said Bill Gross, manager of the US$104.4 billion Pimco Total Return Fund, the world's biggest bond fund. 'Historically every time we get close to stall speed the Fed lowers short rates.'

Mr Gross, who is chief investment officer of Newport Beach, California-based Pacific Investment Management Co, has predicted lower borrowing costs for a year. He said the funds rate will drop to at least 3.75 per cent as housing causes the economy's growth rate to slow to between 1 and 2 per cent from 4 per cent in the second quarter.

While recession concerns helped push the MSCI World Index's price-to-earnings ratio down to 15.99 last month, the lowest since at least 1995, the Fed's decision to lower the benchmark lending rate to 4.75 per cent persuaded more investors the economy won't start contracting.

The S&P 500 last week climbed 2.8 per cent to 1,525.75, the biggest advance since March. The Dow Jones Stoxx 600 Index of European companies gained 2.4 per cent, while the MSCI Asia- Pacific Index jumped 2.3 per cent.

Perth-based Woodside Petroleum Ltd, Australia's second-largest oil and gas producer, added 7.4 per cent since the Fed's rate cut. US Steel Corp, the biggest US-based steelmaker and located in Pittsburgh, rose 15 per cent. Munich-based Siemens AG, Europe's largest engineering company, gained 9.6 per cent.

More optimistic

The rally has left the S&P 500 within 5 per cent of strategists' average year-end forecasts of 1,595, the most bullish since December 2000, data compiled by Bloomberg showed.

'If you've been an equity investor and gone away for the month of August and not read the paper, you'd wonder what all the fuss was about,' said Alan Brown, who oversees US$276 billion as head of investments at Schroders Plc in London. Mr Brown said the firm favours adding to stocks instead of government bonds and expects the S&P 500 will reach 1,600 by year-end.

None of the Wall Street strategists tracked by Bloomberg cut their 2007 S&P 500 forecasts through the sell-off, even as credit costs between banks surged to the highest in six years and sub-prime mortgage defaults deepened the worst US housing slump in 16 years. They have become more optimistic during the year, bringing the average estimate up from 1,550 in January.

The two most bullish firms, St Louis-based AG Edwards & Sons Inc and Frankfurt-based Deutsche Bank, on July 17 raised their year-end forecasts for the S&P 500 to 1,650 and 1,610, respectively - three days before the index began its 9.4 per cent plummet from a record. Six forecasters, including David Bianco of UBS and New York-based Citi Investment Research's Tobias Levkovich, expect the index to end the year at 1,600.

Strategists such as Mr Bianco of Zurich-based UBS say that stronger economic growth outside the US will mitigate any slowdown in the US and boost earnings at the biggest companies with businesses that span the globe.

'Housing just doesn't matter for the S&P,' said Mr Bianco, the New York-based strategist for UBS. 'End of story. The concern about the spillover and what it means for energy companies, tech companies, industrial companies' is overblown because they benefit from global growth.

UBS recommends San Jose, California-based Cisco Systems Inc, the biggest provider of computer-networking equipment; Houston-based ConocoPhillips, the third-largest US oil company; and Fairfield, Connecticut-based General Electric Co, the world's second-largest company by market value.

Cisco received 47 per cent of its revenue from abroad in the year ended in July 2006. ConocoPhillips last year got 30 per cent of its sales outside the US, while GE got 46 per cent.

The Washington-based World Bank this month raised its forecast for China's 2007 economic growth to 11.3 per cent from a May estimate of 10.4 per cent. China grew 11.9 per cent from a year earlier in the second quarter, the fastest pace since 1994.

China, India and Russia together will account for half of global growth this year, according to the International Monetary Fund. The Washington-based IMF in July raised its 2007 global growth forecast to 5.2 per cent from an April estimate of 4.9 per cent because Europe, Japan and emerging-market economies were proving stronger than expected, compensating for a weaker US.

James Swanson of MFS is also looking to purchase shares of the largest technology companies, along with regional banks. He says now is a time to buy equities even though cheaper credit may exacerbate the risk of higher inflation in three to four years.

'I am concerned about it, but what the heck,' Mr Swanson, who helps oversee about US$200 billion as chief investment strategist at Boston-based MFS, said from Truro, Massachusetts. 'It's four years down the road.' - Bloomberg