Market Outlook: June 2, 2003(A)

While it seems many people haven’t noticed, stocks have been behaving very well over the tumultuous past eight months. In the face of the most daunting array of risks witnessed in a generation, the stock market has risen 23% from the low made last October 9. In the first five months of 2003, the S&P 500 is up 8%.
We have been saying since January that we believe last year’s October 9 low was THE low for the recent, epic bear market. We continue to hold that position. We believe the economic, earnings and geopolitical pictures are all improving and that this has gradually been reflected in the “stealth” bull market of the past eight months. We also believe the recovery in stock prices is in its early stages.
We think the current concerns over a declining dollar and the risk of deflation are overblown. A declining dollar is both a boost to the US manufacturing/export sector (by making US products cheaper to foreign buyers) and a slight boost to inflation (by making foreign products more expensive to US consumers). Both of these should be positive for the US economy and inoculations against deflation. Further, were deflation truly on the horizon the price of industrial commodities and gold—two of the best indicators of future inflation/deflation trends—would be falling rather than rising, as they have over the past month.
Given our outlook, we have been gradually moving out of a defensive posture and towards a more offensive posture since late last year. This means fewer bonds and more stocks (of course, always relative to clients’ asset mix instructions). With the 10-year US Treasury Note paying a mere 3.4% and the S&P 500 paying a dividend yield of 1.7%, you need to make only 1.8% per year in capital appreciation from stocks over the next decade to generate a better nominal return from stocks than from bonds. That seems like a low hurdle to us.
This relative pricing of stocks vs. bonds is testament to just how severely the past three years’ experience in the stock market has depressed investors’ expectations. In light of this we think it only logical that the inevitable “surprises” will be on the upside.
What wouldn’t be surprising in the near term, however, would be for the market to pull back following the very strong run it’s had over the past two months (up 19% since March 11). We would consider that an opportunity to position our portfolios for the improving long-term picture we see forming.