The
Stock Market and the Economy:
A Look Ahead
by Walter S. Frank
Chief Investment Officer
MONEYLETTER
After the heady gains of last year, the year 2000 has been a difficult one so far. Of course, there is no dispute about the main cause of the difficulty the Federal Reserve and rising interest rates. But, aside from rates, there were other influences operating as well. Uppermost to us was the evaporation of the speculative fever that ran rampant through the U.S. (and other) markets for many months until April of this year. Suddenly the fever vanished, and when it did, the investment world was no longer the same.
Taking A Quick Look Back
We
were wary of the Fed as the year began, and consequently we maintained
a very low allocation to the U.S. stock market and even tilted
the portfolios toward international stock funds in an attempt
to avoid the Fed's effects, among other things. Along the same
lines, we also carried a sizable allocation to money funds in
all but the Venturesome portfolios.
It was not only higher
rates here in the U.S. that concerned us, but also the intended
consequence of those higher rates (namely, a slower growing U.S.
economy). No matter how you slice it, slower economic growth
is bound to result in slower overall profits growth. This led
us straight into the valuation question. The very high valuations
in the U.S. market can only be justified by a high rate of profits
growth. A slower economy by its very nature is a challenge to
the valuations seen in our market for the past 2 - 3 years.
As it happened, we
were right to be concerned about the Fed and Interest rates.
The Fed raised rates even more than we expected when the year
began (though we did warn that the interest rate outlook could
turn out worse than anticipated). And the market responded. Certainly,
the end of the speculative binge was not unrelated to the Fed's
actions. On the other hand, while the U.S. market did swoon in
April, it has recovered a goodly amount by mid-year.
Two Questions
Turning
to the future, the questions now for the U.S. market as we look
out over the next 6 - 9 months, are whether the Fed is at the
end of its rate increase phase and how will profits hold up in
the slower economy, which is now developing.
The first thing to
say about both issues is that nobody knows. Wall Street is split
down the middle on interest rates. As for profits, while the
2001 estimates now being carried are surprisingly good, it is
hard to know how much of an allowance, if any, is being made
by analysts for a slowing economy. Our own view is that we are
very close to the end of Fed increases, if we are not there already.
We do believe that the economy is now on a slower growth path.
We don't see more than one rate increase ahead, if any, and put
the odds of another increase at 50/50.
Right
now this is very much a minority view on the Street. The Wall
Street hawks think the outlook is harsher. First, they do not
believe that the economy is slowing enough to satisfy the Fed.
Even with the slower growth of the past two months, they argue,
the labor market is still tightening. They allude to a favorite
statistic of Chairman Greenspan, the pool of available workers,
and point out that it fell to a new low in June, despite lowered
payroll growth.
Moreover, and this
is the key to the hawks' position, they take the view that a
tight labor market will result in continued wage pressures even
with a slower economy. Unless the economy slows more than appears
likely (to them) at the current level of interest rates, the
unemployment rate will remain at a level where wage pressures
and inflation are bound to rise. The Fed, in other words, has
not done enough. The argument has history on its side, and much
of Wall Street subscribes to it. If it holds, then the U.S. market
is in for a painful period of more rate increases as we move
into 2001.
Our own view is that
we have lived with a very low unemployment rate for a long time
and the wage pressures so far have been moderate. According to
theory (and history), we should have experienced strong wage
pressures some time ago, and we have not. The facts on the ground
so far do not support the hawks' view. History and theory are
one thing, the facts are another. There is no reason, except
theory, to assume that the situation will change.
Accordingly, while
we do not doubt that the Fed will continue to tell us for many
months to come that the balance of risk is weighted toward inflation
(as indeed it is), we do not believe that the economic numbers
will prompt much action, if any, on the Fed's part.
What Does It All Mean For Equities?
For
the U.S. stock market, this is good news, though not completely
so. The upside, of course, is that we are coming to the end of
rising rates. The downside is that we see rates holding at current
levels at least through the first quarter of next year. We do
not believe now, as we did earlier, that the stock market will
get any lift from much lower bond yields than we now have. If
stocks move higher, they will not get much help from interest
rates.
That leaves it up to
earnings, and here we can be more positive. We need to start
off though by pointing out that by the usual standards, U.S.
stocks are overvalued. According to the latest analysts' estimates,
the S&P 500 is now trading at about 25 times this year's
earnings. On that basis, we would put the overvaluation at about
5 - 10%.
When we come to next
years earnings, the conclusion changes. U.S. stocks are now trading
at about fair value, given those estimates. Of course, as mentioned
earlier, we need to be careful about next years estimates being
made today. We just do not know by how much profits will be affected
by a slower growing economy.
How slow is slow? If we do manage to experience a soft landing,
as we believe will be the case, this "slower growing economy"
will still be growing at a historically robust rate. Some members
of the Fed now speak of the economys sustainable growth rate
as being about 4%. This is higher than accepted in recent decades
and reflects the extraordinary technological changes that are
transforming and powering
our economy. While the economy is downshifting, then, it should
not downshift to a crawl, far from it.
As for valuations,
the price-earnings ratios for the S&P 500 used above give
a somewhat skewed view of the valuation situation. As David Wyss,
chief economist for Standard & Poors, pointed out recently,
the ratios are skewed by having a relatively small percentage
of large-cap stocks in the index carrying very high p/e ratios,
while the bulk of the index carries more comforting numbers.
In other words, the U.S. market broadly considered, may not be
overvalued at all. Of course, we cannot ignore the high-fliers,
but they are distorting the reality.
Assuming a soft landing,
we should see profits growth next year in the neighborhood of
10%. Considering current valuations, we would expect to see U.S.
stocks moving in step with profits. While this is much slower
than the gains of recent years, it reflects the valuation heights
to which the market has been lifted by the long bull market.
Our view of the domestic
outlook implies moderate gains ahead for earnings and the U.S.
market. It also assumes that the Fed will be out of the investment
picture for an extended period of time. And it takes no account
of the result of Novembers election.
Its Not Clear Sailing Yet
There
are two major risks in our view. One is that the Fed finds it
necessary to move interest rates higher than we expect. The other
is that the Fed has already overdone and the economy is slowing
more than we expect, with the consequences showing up in poor
profit results.
Neither of these possible
developments can be ruled out. The outlook now is certainly brighter
than it
was during the first half, but the uncertainty surrounding the
U.S. outlook is still high. For this, and other reasons, we sitll
believe that a substantial international allocation is prudent.
Editors Note:
Walter S. Frank is Chief Investment Officer for MONEYLETTER,
360 Woodland St., P.O. Box 6020, Holliston, MA 01746,1 year,
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