The mid-cycle slowdown we have been forecasting is upon us. A weaker than expected GDP report for the second quarter accompanied by strong corporate earnings reports led to a 3% rally in the stock market last week. The Dow Jones Industrials (+.32%) and Standard & Poor’s 500 (+.62%) finished the month in positive territory, while the tech-laden Nasdaq Composite ended the month down .37%. Healthcare led sector performance, posting a gain of 5.4%. The industrials were the worst performing sector with a loss of 5.3%.

In our May Market Outlook, we forecast that real GDP growth would likely slow to a 2.5-3.0% range, consistent with a mid-cycle slowdown. The stock market responded positively last week when the government reported that real GDP growth declined from the first quarter’s brisk pace of 5.6% to 2.5% in the second quarter. The slowdown in the economy is easing inflation expectations. S&P 500 corporate earnings are again on track for double-digit growth in the second quarter, well ahead of estimates, thanks to strength from the energy, industrial and basic materials sectors. We believe the market rally we have been expecting, ignited by investors’ conviction that the Federal Reserve will stop tightening, is likely underway, with the S&P 500 rallying 3% last week. The bond market is also signaling that the Fed is near the end of its interest-rate hikes, with the 10-year Treasury yield falling below 5% at the end of last week.

As consumers feel the effects of higher oil prices, a deteriorating housing market, rising interest rates, and limited wage gains, discretionary spending will likely plummet in the second half of this year. Oil prices eclipsed their previous high, trading at $78/barrel, and gasoline prices again topped $3/gallon. June existing home prices saw their biggest month-to-month price decline in 20 years, and home price appreciation year-over-year was a modest 1% in June. We think home price appreciation will turn negative year-over-year in the months ahead, leading to a huge decline in mortgage equity withdrawal. Alan Greenspan speculated that half of the money withdrawn from home equity was used for consumer spending. Should this be the case, consumer discretionary spending will decline dramatically. With consumer spending accounting for two-thirds of GDP growth, the economy is likely to continue to slow in the third and fourth quarters.

Market sentiment has shifted from concern that growth was too strong, which would lead to future increases in short-term interest rates, to concern about the economy growing below capacity, leading to lower year-over-year growth rates for corporate earnings in the second half of the year. Earnings growth rates will slow from double digits to mid-single digits as comparisons become more difficult, but stock prices have plenty of room to move higher. Stock price multiples have been declining over the past two and a half years, with the S&P 500 rising a modest 13%, while corporate profits have risen 35% over the same period. A slowdown in economic growth should also lead to lower interest rates and inflation expectations, which, in turn, will allow multiples to expand even as corporate profit growth slows.

During the mid-cycle slowdowns of 1985 and 1995, corporate earnings increased a modest 1%, but the S&P 500 increased an average of 29% due to declining interest rates. Unlike previous mid-cycle slowdowns, foreign growth has been accelerating in 2006, which could help offset a decline in U.S. growth. China’s economy grew over 11% in the second quarter, and industrial production in Japan is accelerating.

We continue to believe the best relative performance will come from high quality large-cap stocks, led by financials and consumer staples. Large-cap stock multiples have contracted more than 50% over the past five years, presenting the greatest upside potential and downside protection as the economy slows.

We are watching the energy and industrial sectors closely. Anticipating weaker U.S economic growth, we reduced our weighting in both sectors in June, while significantly increasing our weighting in the consumer staples sector. We continue to believe the fundamentals for both sectors remain strong, but we have concerns on a number of fronts. There has been a divergence between the price of oil, near all-time highs, and the stock prices of energy companies. This may be attributable to a fear that the global rise in short-term interest rates will lead to demand destruction in the developing economies of China, India, and Russia. It may also be fear that the U.S. mid-term elections will result in a far less energy-friendly Congress should the Democrats take control. We think that strength in foreign economies (China, Japan, India) will help support the energy and industrial sectors, but we are counter-balancing this exposure with our over-weights in the financial and consumer staples sectors. We continue to avoid the technology and consumer discretionary sectors of the market.

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