Caution on Wall Street – Risks for 2007!

• At the start of the fourth quarter, analysts were

  expecting earnings to grow by 12.8 percent year-on-year for the S&P 500. This estimate has been revised down to just below 10 percent.

• Given the track record shown in the chart, earnings have had an astonishing propensity to surprise on the upside and may still do so. A modest translational benefit from the weaker dollar should accrue for companies in the S&P 500 considering the 25 to 30 percent of revenue that is derived abroad.

• However, if earnings do fall short of the expectations analysts held at the start of the quarter, then, with one exception, this will be the first ‘disappointment’ since the recovery in global equity markets. Earnings fell short of expectations in the final quarter of last year but this was only because of the shock the US economy received from hurricane Katrina, not because of the influence on earnings of a mid cycle slowdown.

• If there is an earnings shortfall this quarter, analysts are likely to revise down further their expectations for earnings growth in 2007. Later next year, when we think the economy will accelerate out of its mid cycle slowdown, earnings may be revised up. But if earnings disappoint in the final quarter of this year, analysts are bound to lower their sights for the next few quarters.

• A mid cycle slowdown does not necessarily warrant lower interest rates. Besides, from what we can tell (see On the Funds Rate and the S&P 500 for 2007! 14^th December 2006), the risks are mostly on the upside for inflation. If core inflation remains stubbornly above the top end of the Fed’s comfort zone, the likelihood is that the Fed will resume tightening.
  

• This latter view is not widely shared. However, a reappraisal of where interest rates are heading could start troubling equity markets. Indeed, that reappraisal has already begun. The Fed Funds futures market has gone off the idea that rates will be cut. It may not be long before it reckons that the next move in rates is up.

• And that brings us to what we see as the risk to our optimistic view of where the S&P 500 - as well as other equity markets - will end 2007. If earnings for the first and second quarters of next year are downgraded, prospective p/e multiples will not look quite as compelling as they have. If, at the same time, a reappraisal of interest rates is underway, the US equity market will then be vulnerable to a sell off and possibly a lengthy bout of consolidation following what has been an uninterrupted run up since the middle of this year.

* The information contained in this report has been taken from public sources and is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. The opinions expressed in this document are not necessarily the views held throughout Brewin Dolphin Securities Ltd. No Director, representative or employee of Brewin Dolphin Securities Ltd. accepts liability for any direct or consequential loss arising from the use of this document or its contents. We or a connected person may have positions in or options on the securities mentioned herein or may buy, sell or offer to make a purchases or sale of such securities from time to time. In addition we reserve the right to act as a principal or as agent with regard to the sale or purchase of any security mentioned in this document. Prices, values or income may fall against the investor’s interests. You should therefore be aware that you may get less back than you invested. Past performance is not necessarily a guide to future performance. If you are in any doubt concerning the suitability of these investments for your portfolio, you should seek the advice of a qualified investment adviser.