The final estimate for GDP growth for the first quarter of 2007 solidified the fact that it was the slowest quarter of growth in the United States since the final quarter of 2002. While consumer spending remained resilient through the recent soft patch, the fallout in the housing market continued to put a significant drag on the economy. Export growth slowed to a near standstill, while tepid overall government spending also contributed to the relative weakness.

And the stock market’s reaction?

There were strong returns for the quarter virtually across the board. U.S. stocks fared well, with growth leading the way — in some cases by considerable margins for such a short period. International stocks also provided strong performance and now boast double-digit returns year to date.


Source: PMFA

Does this signal that the long-anticipated resurgence in positive sentiment toward growth stocks has begun to surface?

Possibly, but we still believe it’s far too early to call a turn in the market cycle. Nonetheless, relative valuations increasingly favor large cap stocks — especially the “mega caps” that have been out of favor over the past several years. Small cap stocks have performed comparatively well since the prior market peak in 2000. Their valuations, measured predominantly by their price/earnings ratio, have been bid up accordingly. This current valuation relationship cannot persist indefinitely, and we believe that large cap stocks appear well-positioned to outperform small caps over the next leg of the market cycle.

Is equity market strength in the face of a recent economic weakness a signal of investor irrationality?

Not at all. Rather than dwelling on trailing indicators, investors have already begun focusing on the second quarter, which is showing signs of a mild resurgence in economic activity. While the housing market remains very soft, inflation is showing some signs of slowly receding. Retail sales rebounded in May, and consumer spending held relatively steady, supported by strong employment and personal income gains. Consensus expectations suggest that the first quarter may represent a short-term bottom in the economy.

On June 28, Federal Reserve policymakers provided a cautiously optimistic outlook as well. Not only did the Fed leave their benchmark fed funds rate at 5.25 percent as widely anticipated, but their accompanying statement indicated that they expect continued moderate growth over coming quarters. They also reiterated that while the recent easing in core inflation is a positive sign, a “sustained moderation in inflationary pressures has yet to be convincingly demonstrated.”

In short, the Fed is not yet convinced that inflation concerns can be put to rest. A moderate softening in the labor market would actually be welcome news to the Fed, as labor cost pressures remain one of the primary inflationary forces still at work. Unless the pace of economic growth softens unexpectedly, it appears that the Fed will be content to leave the fed funds rate unchanged and let the inflationary cycle play itself out. While the market would certainly prefer a rate cut, even the indication that inflation is gradually cooling and the prospect that the Fed can avoid further rate hikes may be enough to keep equity markets in positive territory, all else being equal.