Broker Check

Quarterly Newsletter January 2003

Quarterly Newsletter January 2003

It was a strong fourth quarter for stocks though the stock rally fizzled out in December. But the fourth quarter was small consolation in a brutal year. For the first time since 1941 stock market investors have experienced three straight down years, and 2002 saw the worst single-year loss since 1974. Every single Standard & Poor's sector was in the red and eight of ten sectors experienced a double-digit loss: there was nowhere to hide in the stock market.

Who Can We Blame?

Bad bear markets tend to be blamed on a variety of factors, depending on who is doing the blaming. In my opinion there are a number of factors that contributed to the bear market. Probably the biggest was the stock market/tech bubble as investors forgot about risk and piled into internet/tech stocks. Terrorism and war fears didn't help, and exaggerated the magnitude and length of the bear market. Corporate governance also contributed putting the final nail in the coffin.

The question we now face is whether it will take years for investors to regain their appetite for stocks. In the past, investors have remained cautious for several years after the end of a major bear market.

Intellectual Integrity, One-Year Forecasts and the Future
It's almost a tradition for investment professionals and the financial media to issue a forecast at the beginning of each year. But in any particular year there are many factors that may play out differently than expected, and other potential issues that simply can't be foreseen. This makes accurate short term forecasting very difficult.

Arguing along with the bulls, monetary and fiscal policy is stimulative and should allow the economy to build on its slow recovery. The recent economic news is becoming increasingly positive and even manufacturing is showing signs of improvement. Inventories are lean so corporate spending should rise. Moreover, capital investment has been cut so far that the capital stock (the non-depreciated portion of capital assets at work in the business sector) is actually declining. A rebound in capital spending is inevitable and appears imminent and that will combine with continued consumer spending to put the economy on sound footing. This will encourage investors who are sitting on a mountain of cash and have an opportunity to buy stocks at a discount. Depending on the evaluation method used, the S&P 500 sells at 12% to 30% below fair value, even if we assume interest rates move up by one percent. The broader market is even more undervalued. As for war with Iraq, if a war starts soon investors will begin to look past the uncertainty.

The bears would respond that investor sentiment has been seriously damaged and therefore investors will not pile back into stocks anytime soon. In the past, stocks were much more undervalued after a serious bear market than they are now. Moreover, falling interest rates have fueled refinancing and auto purchases, helping to support the economy. But with rates so low it is likely that we've seen the last major wave of refinancing for some time. Without more refinancing opportunities and little pent-up demand (unlike other post-recession periods), this will probably mean that consumer spending will grow more slowly. And capital spending will not save the day because even though it might seem primed for a rebound, existing excess capacity and uncertainty over consumer demand will keep businesses from aggressively expanding. Even if capital spending did improve, it constitutes far less of final demand than consumer spending and can't carry the economy alone.

Then there is the risk of war and the unknown of the ultimate cost of waging the war. On top of that is the terrorism wildcard and increased security costs, which weigh on the economy. Uncertainty leads investors to demand a high risk premium as compensation. That suggests a cap on stock prices.

There is truth in both the bullish and the bearish arguments. With respect to the economy the key questions are the strength of the consumer and the timing and strength of the next cycle of corporate spending. The short-term impact and timing of the Iraq situation is also a factor, as is the wildcard of terrorism.

An Investment Strategy Based on Analysis, Not Hope or Speculation
The volatility in the stock market in 2002 caused my view on valuations to shift around as the year progressed. The rebound since the July/October market bottom has not been large enough to eliminate the undervaluation. But it has cut in to the degree of undervaluation.

Valuation work is tricky because it depends on earnings, which are hard to measure, and interest rates, which change. We should also be sensitive to the real possibility that current interest rates are unsustainably low. The deflation risk in the economy has contributed to low bond yields. But over the intermediate term deflation seems like a low risk. My confidence that sustained deflation is unlikely has increased over the past two months because the Fed has been very vocal in expressing that it has many tools, including printing money, that it is willing to use to fight deflation. The tools for fighting deflation are, by definition, inflationary, and therefore any short-term increase in deflation risk equates to a longer-term increase in inflation risk. So it is likely that over the next three to five years interest rates will be higher than they are now. For this reason I believe it is prudent to base any valuation work on an assumption that the 10-year Treasury yield will be closer to 5% than to today's 4% level.

I’ve studied several methods of valuing the market and as a result, I believe that the market is between 12% and 30% undervalued. The conclusion then is that large cap (the data is based on the S&P 500) stocks fall somewhere between mildly undervalued to very undervalued on a long-term basis.

But this is not the last word on stock valuations. The evidence continues to suggest that the broader market, including mid-cap and small-cap companies, is a better bargain. And while the overall weight of the evidence is not strong enough to suggest a clear fat pitch for small-caps, it is strong enough to conclude that the broader market is somewhat cheaper and therefore offers better long-term return potential. One measure which is helpful in assessing this is the median P/E calculated by the Leuthold Group. This measure is based on 3000 stocks. The P/E was 11 as of the end of November and should be lower now given the decline in stock prices in December. This compares to a median measure since 1976 of 14.7. In short, P/Es for the broad stock universe are below the median measure of the past 25 years despite the fact that interest rates are currently very low. This data is encouraging.

Europe continues to look somewhat underpriced relative to its historical relationship with the U.S. In addition, the large U.S. current account deficit continues to suggest the odds favor a weakening U.S. dollar over the next few years relative to the euro. Finally, Europe has the potential to provide more new marginal stimulation from monetary policy than in the United States. Emerging markets, as a group, also look extremely undervalued with Asia offering more political stability now than Latin America. I will continue to assess and watch for an opportunity to take a bigger position.

With a yield of 4%, 10-year Treasuries appear overvalued relative to trailing inflation. Whether they are overvalued compared to future inflation is yet to be seen but with the likelihood of continued sizable fiscal and monetary stimulus I believe the odds are high that Treasury yields will be higher, on average, in coming years than they are now. Other sectors of the investment-grade bond market offer better value but not great absolute value. And with rates very low, it doesn't take much of a move up in interest rates to wipe out a whole year's worth of interest (about a 1% back-up in rates would do it). It is highly unlikely that investment-grade bonds will deliver attractive absolute returns over the next few years.

Looking Ahead

As I look out over the next three to five years I believe financial markets are likely to deliver decent returns relative to inflation. There are risks however including terrorism and inflation and interest rates. In spite of these concerns I think we should be moderately optimistic. There remains lots of liquidity that at some point will begin to move out of cash. And in general valuations provide some cushion. The fact that companies have rediscovered spending discipline is very important and is likely to result in improving returns on capital in coming years. And, I also think it is likely that a higher level of earnings will gradually be paid out in dividends as investors show a preference for dividend-paying stocks, regardless of whether taxes on dividends are cut (this preference is already happening). This will enhance equity returns because, somewhat surprisingly, earnings growth (in general) has a strong tendency to rise when payout ratios rise—something of a free lunch. Generally, I believe returns from equity-type asset classes will fall between the mid single-digits to the very low double-digits over the next five years. It is likely that returns will fall in the upper half of this range with low double-digit returns very possible. Returns from investment-grade bonds are likely to fall between 4% and 5% on average.

Please call me if you have any concerns or would like to review your portfolio or financial situation. It is also prudent to take a look at financial projections and retirement plan contribution limits, which have increased, and make adjustments if necessary.


Mike Durant

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