Market Outlook – 23 January 2004(A)
When we predicted a year ago that the stock market would recover in 2003 little did we know how strong that recovery would be. Virtually every kind of stock rose last year: small, medium and large company stocks went up. “Growth” and “value” stocks went up. Stocks in every sector of the economy went up. So pervasive were the gains that 459 of the S&P 500 stocks were up last year.
Given the breadth of gains in the market it’s not surprising that the indices showed eye-popping returns for the year: the Dow Jones Industrials gained 28%, the broader S&P 500 rose 29% and the ruinous NASDAQ—home to all things tech and the graveyard for many a speculator’s fortune—increased by exactly half. In short, stocks were the place to be.
This, no doubt, was a cause of some chagrin among the multitudes who “capitulated” in the second half of 2002, dumping their stocks wholesale and fleeing to the “safety” of cash. After taxes and inflation are considered, cash deposits lost money for their holders last year. And yet, as late as the middle of 2003 the level of cash sitting on the sidelines in the US was higher than at any time since 1982.
We referred to this “Cash Mountain” in our July Economic Outlook as perhaps the best indication of the fear and loathing with which shell-shocked investors had come to regard equities. No longer were investors concerned with the return on their money, just the return of it. Hence, the appeal of cash.
Our thesis then was that as the economy recovered and stocks continued to perform well, investors’ extreme fear would gradually be converted to greed–or at least envy–and those cash holdings would start to trickle into stocks, driving stock prices higher and thus inspiring more envy on the part of cash holders. This is precisely what transpired, though cash holdings in the US remain at extremely high levels. We take these continued high cash levels to indicate that the process of converting investor fear to greed has far from run its course.
Indeed, today with the stock market having decisively changed its stripes from bear to bull and the economy displaying indisputable signs of recovery, the sentiment among investors remains wary, cautious, skeptical. And that’s just the way we like it.
This wariness is evident in the prognostications for 2004 issuing from Wall Street. For the most part these fall into one of two camps: the outright bears who think the strong rally of 2003 was just a “mistake” and prelude to further stock declines, and the wary bulls who expect a modest rise (5%-10%) in stocks in 2004 but with clouds forming late in the year.
We take heart from this cautious consensus as it keeps intact the fabled “wall of worry” that bull markets must climb. As long as investors are worried they aren’t fully invested. As long as they aren’t fully invested they have cash—a.k.a. future demand—sitting on the sidelines. This reserve demand is the fuel that bull markets feed on. The time to really worry is when nobody else is.
Over the past year the Federal Government’s full arsenal of short-term economic boosters has been pressed into service. A tidal wave of deficit spending washed across the economy; tax cuts put cash in consumers’ pockets and kept them spending; the lowest interest rates in 45 years kept borrowers borrowing; and a soft dollar lured overseas buyers to US exports as those exports became cheaper in world markets.
The results of these efforts became quite clear over the past three months. Third quarter GDP growth came in at a startlingly strong 8.2%. Productivity for the quarter soared 9%. Corporate earnings raced ahead 30% compared to a year earlier. Capital spending, a key link in the recovery, picked up steam and in December the manufacturing sector grew at the fastest pace in 20 years. All of a sudden, the stock market’s rise since March looked not only rational but prescient.
As we noted a year ago, this is the sort of thing you see in the third year of a presidential term. Incumbents use all the tools at their disposal to insure a strong economy and stock market heading into an election year. This is why the market has gained an average of 23% in the third year of presidential terms and was last down in such a year in 1939 (and then only 1%).
With the economy jump-started by these stimulative measures the question becomes one of the sustainability of the recovery. The bull case holds that the momentum created by the Federal Government’s actions will feed on itself and become self-sustaining. Rising manufacturing will bring rising employment, which in turn will create greater demand, which will spur more manufacturing, etc., thus producing a virtuous cycle.
The bears argue that 1) interest rates will rise significantly with economic growth, creating a stiff headwind for the economy and for stock valuations; 2) the Federal deficit has grown to a size that precludes further dramatic fiscal stimulus; and 3) job growth has remained stubbornly sluggish. They conclude that without job growth to take up the slack created by rising rates and a more frugal Federal Government, the recovery in the economy and the markets will stumble late this year or in 2005.
We agree that there is little room for further fiscal stimulus and that materially rising rates would be a negative for the economy and for stocks. But we’re not convinced that the latter is inevitable–or even likely–or that further fiscal stimulus is necessary. And while we expect job growth to pick up we have underlined repeatedly that the current 5.7% unemployment rate is quite average by historical standards and fully compatible with a continued economic expansion. So while we may have questions and concerns about many aspects of the Federal Government’s policies, we think it’s entirely possible that the economic recovery they’ve engineered will prove durable. Which is to say that in investment planning it’s important to avoid conflating one’s political and economic outlooks.
From where we stand today we see the likelihood of a continued benign inflation and interest rate environment, a recovering economy and strong earnings growth. That, by most analyses, would be considered fairly positive for stocks. While we will be keeping a sharp eye peeled for the risks outlined above, the weather outlook at present seems to us to be favorable and improving.