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Legg Mason June Commentary: Is This a Bear Market or a Correction?

July 27, 2006

At this time, we believe the conditions are right for a transition in market leadership from small and mid-cap stocks to large/mega caps. Small and mid-caps have been great performers and everyone loves them, but they have gotten expensive relative to their history, and earnings expectations are elevated. In contrast, large/mega caps have been performance dogs and investors are worn out on them, but they are now cheap and expectations for them are modest.

The first solid evidence that this transition may be in progress wasthe relative performance of the two groups during the market correction in May and June, and for the second quarter as a whole. So, step one of the leadership shift has been accomplished—the large caps held up better than small and mid-caps on the downside. It’s an open question whether they can establish a leadership position on the upside. So far, they have not. From the recentlow on June 13 through the end of June, small and mid-caps bounced back more sharply than large caps. Stay tuned.

We regard the current market environment as an especially difficult one to navigate. There seem to be more than the usual number of questions and uncertainties. Are we in a bear market or a correction? Will the Fed pause in August or not? Is the economy slowing or not? Will earnings growth disappoint or continue to surprise on the upside? Is the market attractively valued or isn’t it? Is a change in market leadership in process or not? Whatever one chooses to believe, one can find company in that belief and reasonable evidence to support it.

Space does not permit a full discussion of all these questions here, but briefly, our current thinking is as follows. We think the recent market weakness was a correction—which could have further to go on the downside—rather than the start of a bear market. We think the Fed is near the end of itstightening regime, but will probably bump the Fed funds rate one more time by 25 basis points to 5.50% in August. We think a leadership change from small and mid-cap stocks to large/mega caps is in process, but may take more time to become apparent. We expect the economy to slow, but not collapse, and we expect earnings growth to slow, but hold up well enough to support higher stock prices once it becomes apparent that the Fed is done tightening. Finally, we believe that the market is increasingly attractively valued, as it goes more or less sideways while earnings continue to rise. In the space remaining, we’d like to more fully address the questions of the likely course of Fed policy and whether we’re in a bear market or not.

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