Market Outlook July 15, 2004

Following the Presidential Cycle
So far the stock market is following the script of the so-called “presidential cycle” almost to the letter. History teaches that the stock market will go up–usually a lot–in the third year of a presidential term, take a breather in the first half of the following election year and then rise in the second half as political uncertainty dissipates. True to form, the stock market soared last year and has basically gone nowhere in the first half of 2004. If the markets continue to follow the script we’ll see stocks posting solid gains between now and year’s end.
As typically happens just before elections, the stars are aligning quite favorably for the markets. The economy has been roaring ahead for four quarters with the retail, housing and manufacturing sectors all showing near-record activity. The rub has been job growth, which through February was anemic to nil. Since the beginning of March, however, nearly a million jobs have been created in the U.S., and (despite a slightly soft June) corporate hiring surveys indicate there are more jobs to come. With this final piece of economic recovery falling into place, fears in the market have shifted their focus from recession to inflation.
Inflation and Interest Rates
Inflation has picked up in 2004, however slightly. Of course it was only a few months ago that the Federal Reserve was worried about too little inflation (a.k.a. deflation), even stating that a modest increase in consumer prices would be desirable. Now that the modest increase has arrived investors are worried there’s more inflation coming and with it sharply higher interest rates.
Granted, the Federal Reserve has begun raising interest rates from their extremely low levels. It is doing so, however, not to fight inflation but simply to take away a stimulus needed to get the economy back on its feet. The Fed has all but put up billboards announcing it sees no material threat of inflation and expects a “measured” process of short-term rates rising to more normal levels. We see nothing to suggest otherwise.
While stock investors have been cowed by these developments, stalling the market’s advance for the past five months, bond investors seem inclined to a more balanced view. As we expected, rates along the entire spectrum of maturities have risen from the lows reached in March. But rather than continuing to spiral upward, bond rates have actually pulled back in just the past couple of weeks, with the 10-year Treasury Note’s yield falling from 4.87% to 4.45%. Such moderation doesn’t bespeak a great fear of inflation among the bond-buying crowd, who tend to be the most sensitive and sophisticated on the subject.
In fact, none other than bond guru Bill Gross–head of PIMCO mutual funds, the largest bond manager in the world–went on record a couple weeks ago saying the bulk of the rise in interest rates was behind us and that he didn’t expect the 10-year Treasury rate to exceed 5%. While we wouldn’t bet the farm on the precise “ceiling” level, we agree with the general gist of his argument.
Earnings and Valuation
If Gross is right about the bond market, the threat of spiraling interest rates is a red herring. The central question for stocks then becomes one of earnings growth and there the picture is bright. During the first quarter of 2004 earnings grew by 30% compared to the first quarter of 2003. For the full year 2004 earnings are expected to grow by 18%. It’s worth mentioning that these expectations have been steadily moving higher as analysts’ estimates scramble to keep up with reality (no doubt in compensation for overshooting reality so egregiously a few years ago).
If we look at Fed Chairman Greenspan’s preferred valuation model, which compares stock prices and earnings to the yield on the 10-year Treasury Note, we’ll see that today either a) stocks are 26% undervalued relative to bonds or b) bonds are 26% overvalued compared to stocks. When we wrote last quarter, the imbalance stood at 33%. We said then that we expected this to be corrected by a combination of rising stock prices and falling bond prices. So far, we’ve gotten the falling bond prices. Once again, if Bill Gross is right about bonds, the bulk of the remaining valuation imbalance should be corrected by rising stock prices.
Animal Spirits and the Risk Premium
You may well be asking yourself: If things look so rosy, why are stocks not rising? The obvious answer is: Well, everything isn’t so rosy. The above discussion focuses on purely economic considerations while bracketing the barrage of geopolitical horrors we confront every day. Under more “normal” circumstances the picture we’ve painted above would likely be the current reality rather than an “outlook.” But since 9/11 and the invasion of Iraq we’ve become inured to a level of threat, uncertainty and anxiety that investors haven’t felt in decades. This operates at rational and irrational levels, both of which have a direct effect on investor decisions.
It’s perfectly rational, for example, to factor into one’s risk/reward analyses the fact that terrorist threats are very real, or that oil supplies could be disrupted by a variety of factors. Indeed, by some estimates as much as $10 of the current $38 per barrel price of oil is not the result of ordinary supply and demand factors but rather represents a “risk premium”–a price increase reflecting the possibility of reduced future supply.
All of these risks are extremely difficult to quantify, but even at low probabilities they have a chilling effect on the “animal spirits” Keynes identified as a crucial variable in the economic equation. Currently, there is an abnormally large “risk premium” priced into the relationship of stocks and bonds, just as there is an abnormally large risk premium priced into oil.
We continue to view geopolitical risk–and the premium investors require because of it–as the main impediment to the stock market. This risk premium will dissipate and pricing return to more normal relations only as and when the perceived uncertainty of the geopolitical situation declines. This process is already underway as indicated by the change in the Fed Model’s readings over the past four months (and by the corollary outflow from bond funds and inflow to stock funds so far in 2004).
One point we must make in this regard is that the current U.S. Administration is itself a material factor in the perceived uncertainty. Its willingness to break with allies and longstanding foreign policy principles has injected an element of unpredictability into world affairs. In this light the market’s usual preference for incumbents–and the predictability they usually offer–may not apply in the coming November elections.