Market Outlook for Apr 2004 (A)
While stocks roared out of the starting gate this year, gaining over 4% in January alone, by February the sprinters had lost their legs. Concerns over weak job growth in the US and terrorist attacks in Spain sapped investors’ enthusiasm as the quarter unfolded and the major indices worked their way back to December 31 levels.
Having risen over 40% in ten months without so much as a hiccup, the market was due for a pause. Such a steep and unbroken rise is typical of the initial recovery phase following a severe bear market. But nothing goes straight up forever and a consolidation of the prior gains was both healthy and unsurprising.
Healthier still was the widespread anxiety provoked by this modest pullback. It seems the bruises left on investor psyches by the Great Millennium Bear are still quite tender. For at the first hint of market softness in almost a year all sorts of calamities were predicted, whether for the economy (“jobless recovery threatens expansion”) or the stock market (“Dow 5000 ahead”).
As we’ve said before, skepticism in the face of a strengthening economy and improving earnings is precisely what keeps a bull market alive. Why? Because skeptical investors hold cash back from the market. As earnings continue to improve and skepticism is worn down, that cash is gradually lured into stocks, pushing prices higher. Hence the old saw, “bull markets climb a wall of worry.”
As we saw in 2000, on the other hand, it’s over-confidence that kills the bull. By the time investors are wholeheartedly convinced about stocks they’ve already put all their cash to work, leaving no pent-up demand to drive future gains. Seen in this light, the skittishness that investors displayed in the first quarter bodes well for stocks as the economy continues to improve.
ValuationWe’re well aware of the arguments that say stocks can’t go higher because they’re overvalued. Our response is: Compared to what? Stocks are not priced solely in relation to their underlying companies (earnings, book value, dividends, etc.). They’re also always priced relative to the alternatives, namely cash and bonds. With cash earning less than 1%, the 10-year US Treasury Note paying 4% and the stocks in the S&P 500 yielding almost 2% in dividends alone, stocks need appreciate only 3% per year to outperform the alternatives. That seems a pretty low hurdle to us. And when you factor in taxes the bar for stocks is even lower.
A more precise look at this relative pricing of stocks and bonds is offered by the “Fed Model,” so-called due to its preference by Chairman Greenspan. We’ll spare you the math but suffice it to say that the Fed Model today sees stocks as 33% undervalued relative to current interest rates. To be fair, you could also read the Fed Model as saying that bonds are 33% overvalued relative to current stock prices. So the markets can move to fair value by either stock prices rising or bond prices falling (interest rates rising) or some combination of the two.
We expect some combination of the two. Our educated guess is that stocks will show low double digit gains in 2004, in line with corporate earnings growth. What we are most confident about is the relative performance of stocks vs. bonds. On every reasonable scenario of corporate earnings, inflation and interest rates we’ve examined, the Fed Model suggests that bond prices should fall and stock prices should rise from current levels. Given that the “herd” spent three years fleeing from stocks and into cash and bonds, it seems reasonable to expect that the latter remain the pricey assets today.
While concerns over jobs have captured the headlines this political season, from the point of view of corporate profits the economic news has been quite strong. The manufacturing sector, so hard hit by the last recession, is humming along at levels not seen in 20 years. Capital spending, particularly on technology, has revived and is estimated by some to hit levels in 2004 above the high water mark reached in the boom of ’99. Consumer spending is solid. Productivity is surging. And inflation at the producer and consumer levels remains quiescent. All of this is very positive for corporate earnings, as we should see when the first quarter’s earnings are reported.
The missing piece in the recovery, of course, has been job growth. The current economic recovery has benefited capital far more than labor. Indeed, the spoils of recovery have thus far been more unevenly divided than in any recovery since World War II. Productivity enhancements from outsourcing to technology no doubt play a role in this imbalance. But it’s also true that jobs are the last piece to fall into place in a recovery. With the announcement that 308,000 jobs were created in March, the strongest showing in four years, hopes are rising that labor’s piece of the pie may be about to expand. If so, one of the bears’ main arguments–that without a recovery in jobs the economy must falter–will be laid to rest.
Aiding US domestic strength are rapid growth in China and India, a Japanese economy pulling out of its decade-long slump, and sluggish but still positive expansion in Europe. So while the US took the lead in pulling the global economy out of recession, it’s no longer the only horse pulling in the traces. This, too, raises the odds that the current expansion will prove sustainable.
With the strong March jobs report market pessimists will switch their case from one based on a return to recession (too slow growth) to one based on a return to inflation (too rapid growth). While we reserve the right to worry about inflation at some point down the road, with excess capacity still sloshing around the globe–in terms of both idle plant and unemployed people–it’s hard to get worked up about inflation at present. Supply constraints are a crucial piece of the inflation equation and these are nowhere on the horizon.
As long as inflation remains in check the risk of sharply rising interest rates is minimal. In the context of a strong economy, sharply rising rates are the chief threat to stocks. Granted, the US budget deficit will create incrementally higher interest rates over the long term. And in the coming year the Federal Reserve will likely raise short-term interest rates from their current very low levels. But as long as these increases occur in a low-inflation environment, they should be moderate and pose no major threat to stock prices.
On our view the greatest risks to stock performance remain geopolitical. Terrorism and the war in Iraq are wild cards that will be on the table for some time to come. Consequently our favorable view on the economy and equities is tempered by these concerns. While we remain firmly convinced that equities will outperform bonds and cash for the foreseeable future, we are maintaining a slightly higher bond exposure and slightly lower equity exposure than would otherwise be dictated by our economic outlook.