Coming
Together
The 2003 Mid-Year Outlook
by Walter Frank, CIO
MONEYLETTER
A
recent Barron's cover shouts "BULL RUN! This rally is for
real." Who dared to dream that such a cover was possible
only six months ago? That is the, oh so different, background
for our mid-year outlook.
Going back a moment
to our New Year 2003 outlook (MONEYLETTER, January 10, 2003),
we wrote then, "This is the year the bearish sting will
be broken. The question in our mind is not whether stocks will
rise in 2003, but by how much." We then went on to say that
we thought the S&P 500 would gain 18% during 2003.
Well, here it is mid-July
and the S&P 500 is already up 12%. Our bold 18% forecast
doesn't look so bold after all. (We'll take it.) Do we think
the S&P 500 will pick up another 15% before this year is
out? It could, but we wouldn't bet on it. We are getting a lot
now, and we may be borrowing some from the future. Put it this
way. After a bear market, stocks always come out of the chute
with a rush. The early days of a new bull market are often the
most dynamic and pack a lot of gain in a minimum of time. That
is what we are experiencing now. Getting back in is the important
thing for many institutional investors, with little regard for
the fundamentals. But then the tug of the fundamentals reasserts
itself and the rally slows as investors winnow the values from
the illusory. That phase is coming up next. Still, even if this
rally follows the traditional script, we are going to wind up
with a good gain for this year.
Looking out over the
four quarters ahead, we see the same thing. The economy is poised
to give us sustained growth rates such as we haven't seen during
the bear market. Corporations are poised to transform those growth
rates into hefty profit gains. This is an investor's Shangri-la.
Gaining Traction
The
foundation for our market optimism is the economy, just as it
was six months ago. So far this year, the economy has sputtered,
even somewhat more than we expected. We see the sputtering easing
with the economy finally gaining traction as we move into the
summer and fall.
There are at least
three forces working to get the economy finally operating smoothly.
First, and most important in our view, is the Federal Reserve's
twin goal of stimulating the economy and preventing deflation
from arriving (however remote the possibility).
Because of these twin
goals, the Fed has brought short term rates down incredibly low
and the bond market, itself, interpreting pretty blunt Fedspeak,
has driven long term rates (10-year Treasury) down below 3.20%.
We have seen the effect of these low rates both on housing demand
and on the huge wave of mortgage refinancings.
There is another policy
force about to go to work and that is the tax cut. Whatever the
wisdom of the specific cuts, the package as a whole will provide
strong stimulus over the next year. The economists at J.P. Morgan
Chase Bank estimate that the cut is the equivalent of 1.5% of
GDP over the next year. They write, "Even assuming that
a significant portion of the tax cut is saved, the package should
directly add about a percentage point to growth next year"
Finally, there is the
dollar, which has finally slipped from its expensive perch. The
dollar tends to be overlooked when we look at the economy. But
it has been a barrier to growth in recent years, and that barrier
is being partially dismantled now.
What does this add
up to? Economists are now raising their forecasts for the year
ahead and are now projecting 4% growth over the twelve months
to next July, 2004. We think those numbers are about right.
We need to acknowledge
the counter-argument of the bears (yes, there are bears out there)
who, point out that we need business to start investing in order
for the 4% number to be realized. Skeptically, they point out
business spending has been sluggish, the stars are aligned for
it to pick up. Excessive debt has been substantially worked down.
There are strong incentives in the tax cut. And, as the J.P.
Morgan economists emphasize, actual investment spending is now
running below depreciation. Replacement is becoming necessary.
None of this says that
the bears are wrong. However, there are strong reasons to believe
that they will be.
U.S. Stocks
As
this rally rolls on, the issue concerning the U.S. market is
how much more is left. Looking out over the year ahead, we would
say, a reasonable amount. Just to throw out a number, another
15-20%. This would take the S&P 500 to about 1,200. We arrived
at that number simply using today's estimates of profits through
mid-year 2004 and applying a reasonable multiple to pay for those
profits. (Reasonable, of course, is in the eye of the beholder.)
We think that, if anything,
our target may be low. But, after the last three years, it is
not a point we are inclined to press home. As we've learned,
Murphy's Law has a habit of hitting the market when least expected.
As this first phase
bull run proceeds, valuation becomes an important issue. How
rich is the market and has the rally totally discounted the future?
Our answer is that at this juncture valuations are reasonable,
and, no, the market has by no means totally discounted the future,
if, an important "if", the economic outlook holds
Right now the S&P
500 is trading at about 17.5 times estimated earnings over the
next twelve months. We think this is a moderate multiple given
today's interest rates, and prospective interest rates over the
year ahead. Interest rates alone justify a higher multiple, as
we have been arguing for some time.
Then there are profits.
Gloomy Wall Street was surprised by first quarter profits. That
is what sparked this rally we believe. We also don't believe
that the surprises are over. We strongly suspect that the Wall
Street profit estimates we are now getting have not built in
the kind of economic growth we expect. We look for continued
profit surprises and revisions (upward) over the period to next
summer. That is the basis of out optimism toward the domestic
stock market.
Bonds And All That
Bonds
play a dual role in our portfolios. For our growth portfolios
(Venturesome and Moderate) they serve essentially as a reserve
(when needed) and to some extent as a dampening factor of a portfolio's
volatility. We tend to take an aggressive position, however,
whenever we do hold bonds in the growth portfolios.
Things are different
for the Conservative model portfolios. These are deliberately
low volatility, low risk portfolios. Bonds are normally a key
constituent of those portfolios, providing both income and safety,
and, when the times are right, some price gains as well.
The times have been
right for bonds, but the times will be undergoing changes in
the year ahead. We have lived through an extraordinary period
for interest rates, with yields at historic lows. If the economy
performs as we expect long term rates are bound to rise over
the year ahead. The outlook is less clear for short-term rates.
The bottom line is
that the rally in Treasury bonds is over. But we don't see a
move down in price (interest rates up) as a short-term threat.
Over the year we, though, do see some price erosion. The outlook
is a bit more reassuring for high-grade corporates.
Finally, here are high-yield
bonds, which have enjoyed a substantial rally of their own. Clearly
the rally has lessened their attractiveness now. But the yield
on these bonds is still relatively attractive. As of now the
Merrill Lynch High-Yield Corporate index yield stands at 8.56%.
It could go lower, but the big gains for these bonds are behind
us, in our opinion.
Over the course of
the year ahead, we could see bond prices, Treasuries and high-grade
corporates, begin to move down. This will take place as the economy
strengthens. The challenge will be to find low-risk alternatives
that also offer a reasonable return.
We have neglected the
international markets because we do not see them playing an important
role in our portfolios for some time. However, it may well be
that as we move into 2004, Asian markets (including Japan) will
once again prove to be attractive additions to any portfolio.
Meanwhile enjoy the rally.
Editor's Note: Walter
Frank is Chief Investment Officer for MONEYLETTER, 360 Woodland
St., P.O. Box 6020, Holliston, MA 01746, 1 year, 24 issues, $150.
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