Market Outlook – April 15, 2003(A)

In our January market commentary we said that we believed the bear market in stocks was over. Specifically, we believed that the market had made its low on October 9 of last year. We continue to hold this belief and do so more firmly given the market’s behavior so far in 2003.
Despite the extraordinary geopolitical risks of war in Iraq, rising tensions with North Korea, oil supply shocks from Venezuela and the continuing threat of terrorist attacks the market has not been able to push below the nadir of October 9. On the contrary, the S&P 500 has risen 9% above that low.
For the market to rise in the face of such daunting threats suggests to us that the supply side of the stock market equation (investors wanting to sell) largely spent itself in the dramatic declines of 2002. As evidence of this we’d note that last year investors withdrew more dollars from stock mutual funds than they put into them. The last time that happened was 1988 when investors bailed out of stocks following the Crash of ’87. This is called “capitulation” and marks the phase when supply is exhausted and loses its ability to overwhelm demand (investors wanting to buy). This is when markets stop going down.
If you step back and look at the market’s course over the past nine months you’ll see that for all the volatility it has nonetheless traced out a largely sideways pattern. The market in April of 2003 is pretty much where it was in July of 2002. Which is to say that supply and demand have struck a grudging balance, though both are fairly weak as indicated by the low trading volumes during the first quarter of the year.
For demand to gain sufficient vigor to overwhelm supply and thus drive the market up, investors will need to see geopolitical risks decline and the economy and corporate earnings continue their recovery. When those factors fall into place the market’s reasonable valuation leaves plenty of “headroom” for rising stock prices.
Geo-Political Factors
With the fog of war lifting in Iraq we can now see that as horrible as this war has been, it could have been far worse. The conflict was contained to Iraq. No weapons of mass destruction were employed. No terrorist attacks occurred in the US. Most importantly, the conflict appears near an end. Consequently the probabilities assigned to many of the most dire scenarios–whose risk had been priced into the market–are now significantly lower (which no doubt accounts for the market’s 9% rise over the first eight days of the war).
Given the hawkish stance of the current Administration, we cannot dismiss the possibility of further military action in Syria and/or Iran. However, given the military and financial demands of rebuilding Iraq, a sputtering economy that further military conflict could tip back into recession, and, finally, a re-election campaign just around the corner, we believe the political calculus strongly favors President Bush standing pat on the military front. If he does, we believe investor attention will return to the economy and corporate earnings and that the view on those horizons will improve. We should underline that this is a very important “if.”
Economic Overview
While the economic news during the first quarter was generally tepid, much of that weakness is directly attributable to war-related factors, specifically: higher oil prices, nervous consumers glued to CNN and a corporate freeze on new capital spending pending resolution in Iraq.
With military action rapidly winding down, the price of oil has plummeted from a high of $40 a barrel to its current $27. We believe the price of oil will fall further with benefits that ripple throughout the economy. We’ve likely already seen some of those benefits as consumer sentiment and retail sales both rebounded sharply over the course of March. And while corporate capital spending has improved somewhat, the effects of falling geopolitical temperatures won’t register there immediately but rather with a natural lag. All in all we agree with Fed Chairman Greenspan that the economy should improve as the uncertainty and indecision fostered by war gives way to more normal economic decision-making.
The main economic concern we have is the long-term effect of the growing Federal deficit and how it will be financed. Due to this we expect interest rates to rise further than they otherwise would have, which must be considered a negative at the margin. With inflation and interest rates at such historically low levels we nonetheless think there will be “cheap enough” money to finance continued expansion in the economy. With such continued expansion we see corporate profits also continuing their recovery and concur with Wall Street estimates that earnings for the S&P 500 will grow roughly 10% in 2003.
What We’re Doing
The President’s military intentions are the wild card in our market outlook. If he attacks other countries, investors will once again “press the pause button” and the markets will again be driven by the news flow on CNN rather than rational six-month to one-year outlooks. If he doesn’t, more normal deliberations will resume. In this latter mode we can say that with market valuations reasonable and absent the tailwind of falling interest rates the long-term trend of stock returns should now be driven almost exclusively by the pace of earnings and dividend growth. As we expect roughly 10% earnings growth this year and a roughly 2% dividend yield, we think it’s reasonable to expect total returns from stocks in 2003 somewhere in the neighborhood of 10%. That looks quite attractive compared to money markets paying less than 1%, a 10-year Treasury Note yielding 4% and inflation running at 2%.
We will point out that 10-year tax-free bonds paying 3.7% look quite attractive relative to taxable bonds, though still less compelling than stocks. Were it not for the risks posed by the Bush Administration’s hawkish stance, we would move more funds into equities and out of bonds. For now, we remain in a posture that reflects our preference for stocks over bonds tempered by our appreciation of the portfolio stability the latter affords.