The big story of late in the markets has been the Dow Jones Industrial
Average breaking to new all-time highs. CNBC breathlessly devoted
hours of coverage to the Dow’s run towards record territory – even
to the point of “naming” the days after it, such as “Watchful
Wednesday” and “Threshold Thursday,” or something
like that. It actually became embarrassing after a while as the
Dow refused to breakthrough for several days, but finally on October
3 (after they had dropped
the
naming bit), the Dow complied with its much anticipated new all-time
high.
This has prompted many investors to wonder if they should be increasing
their exposure to stocks. But is this really a cause for celebration?
Investors who have been around for a while might remember November
14, 1972 when the Dow first broke through 1000, reaching its then
all-time high of 1003.16. Shortly thereafter, however, a recession
set in followed by the crushing bear market of 1973/74 that took
the index down to 578. In fact, it would take over 10 years for
it to move past 1000 for good, in late 1982. And of course, its
current new high has come more than six years since the last one
in January of 2000.
So a new high in the Dow alone should not get investors eager
to drain their money market accounts! But we have to acknowledge
that there are some positive fundamentals that are behind the market’s
recent surge to new highs.
Reasonable Valuations
Over the past 25 years, the P/E ratio for the S&P 500 has averaged
roughly 20 times earnings. Many commentators have noted that based
on expected earnings for the next 12 months, the S&P is valued
at just 15 times earnings – a relative bargain. It is even
less than the long-term (80+ year) average of 16 times earnings.
In fact, since the market bottomed in 2002, with a P/E of 24,
the market is up over 70% in price even though P/Es are now approximately
40% lower.
Lower Interest Rates
Longer-term interest rates have dropped nearly ¾ of a percentage
point since late June. The bond market is pricing-in the expectation
that the Federal Reserve is done raising interest rates. In fact, “built-in” to
today’s bond prices are expectations that the Fed will start
cutting interest rates next year (although that expectation has
recently started to diminish a bit). Not only are lower interest
rates good for the economy, all else being equal, but they are
also good for stock market valuations.
Bullish Seasonals
Historically, the fourth quarter has been the strongest quarter
of the year for the stock market, and the last five years have
conformed very nicely to that pattern.
However, there are some real risks to the current rally in stocks.
A Slowing Economy
The economy is slowing. GDP growth dropped sharply in the second
quarter to a 2.6% annualized rate, from the first quarter rate
of 5.6%. While that first-quarter figure was pushed upward by
post-Katrina rebuilding, the 2.6% of the second quarter is also
below the last twelve month average as well as the longer-term
averages.
The primary source of slowing was from a contraction in residential
investment, which was the result of a slowdown in home sales. There
was also weaker growth in personal consumption. Depending on the
statistic used, at best, one could say the housing market is no
longer growing, and at worst, that it is headed for a steep correction.
For example, existing home sales eased again in August, for a fifth
consecutive month, falling to its lowest total since January 2004.
As a result, the inventory of unsold homes rose 1.5% in August,
pushing supply at the current rate of sales to 7.5 months, the
highest level since April 1993. The supply of condominiums is now
at 8.6 months. Also, home prices have fallen 1.7% over the last
year; the worst price performance for single-family housing since
March 1993.
Unrealistic Earnings Expectations
As we noted earlier, the P/E for the S&P is 15x based on expected
2007 earnings. However, if we use actual earnings for the past
12 months, the P/E is 18x. That implies an earnings growth expectation
over the next 12 months of 20%. But earnings growth expectations
by sell-side analysts for the fourth quarter of this year are only
16% and for 2007 they are generally in the single digits (moreover,
sell-side analysts are notoriously over-optimistic!).
Given this earnings expectation, it seems as if the market may
be getting ahead of itself.
This same pattern is observable in the Nasdaq (an imperfect proxy
for technology) and the Russell 2000 (small caps). The implied
earnings growth rates there are 31% and 42% respectively. Again,
both of these implied growth rates are well above long-term averages
and current analyst expectations.
While these sort of earnings expectations might be sensible when
the economy is in expansionary mode (particularly early in the
expansion cycle), they are not so reasonable when the economy seems
to be on the verge of a contraction, even if it is a mild one.
In sum, we expect earnings expectations to fall.
On balance, we do not feel this is the right time to increase
our equity exposure and are comfortable staying with our current
allocations, focusing on those areas in the equity markets we find
most attractive.
Large Caps Still Attractive
While the Dow has made new highs, the S&P 500 is still some
10% below its peak (and the Nasdaq is more than 50% below). Using
some interesting data calculated by JPMorgan, we see that large
cap growth stocks are still down 40% since the last market peak
in March 2000, while mid- and small-cap growth stocks are down
nearly 25%. (None of this should really come as too much of a surprise
given that valuations and sentiment were nearly off the charts
in 2000.) Value stocks meanwhile, particularly the small- and mid-cap
variety are up substantially over this time frame.
That is one reason why we have shifted our portfolios a bit towards
larger caps and away from small- and mid-caps. And we now have
a slight tilt towards large-cap growth over value. Fund flows are
another reason we favor large-caps. Fund flows into small, mid,
and multi-cap funds have been strongly positive this year. Using
data from JPMorgan and Lipper through the end of August, these
funds are bringing in money at an annualized rate of $114b. Large
cap funds on the other hand, are seeing money flow out at an annualized
rate of $39b. In fact, flows into large cap funds have not been
positive on a calendar year basis since 1999. Of course, back in
1999, flows into large caps were over $100b and nearly the same
in 1998, while flows into small- and mid-cap funds were flat to
negative. The cycle always turns.
Energy Down But Not Out
One area that we like has seen strong inflows of late. Annualized
flows into energy stocks for 2006 are running at $17b through
the end of August. Despite these flows, we don’t think
it signals the end for the run in energy stocks. As we mentioned
in prior commentaries, we recognize that commodities and natural
resource stocks are volatile. As we have seen recently, they
may give back some gains — sometimes sharply — before
resuming their upward slope in price.
Our argument for maintaining exposure to this sector basically
comes down to the belief that we are in a long running bull market
for commodities, primarily due to the lack of capital investment
in prior decades, as well as a continued increase in global demand,
especially from emerging economies such as China and India.
In addition, commodity prices don’t necessarily have to
go higher for natural resource firms to make money. For instance,
even though the price of oil has fallen sharply from its recent
peak of about $80/barrel, energy companies are still making a lot
of money with oil currently trading around $60/barrel. In fact,
the current valuations in energy stocks, imply a forward expectation
of less than $50/barrel.
Lastly, exposure to this sector provides a degree of “portfolio
insurance” owing to both its diversification benefits and
its ability to do relatively well when there is geopolitical stress.
All in all, we think it makes sense to maintain positions here.
Internationals Remain Attractive, If Less So
Foreign stocks have also attracted a lot of investor attention.
Through the end of August this year, the annualized inflow into
international stock funds is running at a whopping $154b. Despite
their growing popularity, we still like international stocks,
though we’ll admit we don’t quite have the same degree of
enthusiasm we did a handful of years ago. Along with the fund flow
data, two other reasons for our waning appetite for international
stocks are a narrowing gap in both relative valuations and relative
growth rates. Both factors still favor international over domestic
stocks, just not as much as they once did.
We continue to expect a weaker U.S. dollar longer-term which also
favors non-dollar exposure to international securities. But while
there are solid fundamental factors (deficits) and intermarket
relationships (interest rate differentials) that favor a weaker
dollar, the contrarian in us notes that it seems like everybody
is a bear on the dollar, so we may see strength in the short-term.
Again though, in sum, there are enough factors in place for us
to maintain our positions.
Sincerely,
Eric M. KobrenRusty Vanneman, CFA
PresidentDirector of Research
Portfolio
ManagerCo-Portfolio Manager
