It may have taken the most extended bear market since 1941 to wring the absurd level of stock market expectations out of the public's consciousness, but the bear has triumphed on that score. A recent survey of investors by OppenheimerFunds found that 43% now think they will never in their lifetimes see two years in a row where stocks return 20% or more.
If one needs more proof that a new bull market may be trying to learn to walk, look at professional investors, who aren't much more optimistic. And their reasoning is grounded in substantive economic changes over the past two years. Stated simply, most institutional investors had assumed that the first decade of the new millennium would be characterized by growing U.S. budget surpluses and strong economic growth, albeit at a slower pace than in the 1990s.
But September 11 changed everything. Since January 2001, the U.S. private sector has experienced a two-year recession and only massive increases in government spending have enabled the economy to limp into positive territory. With the likelihood of a new war in Iraq and increased spending to fight terrorism, the role of government in our economic lives looms much larger than it has for decades. Even though last month's Republican election sweep should create a more pro-business environment for specific industries like pharmaceuticals and defense, the public sector boom will inevitably impinge on the growth prospects for private industry.
With more tax cuts likely in early 2003, the shift from private to public spending can temporarily be offset, but the cost of such transfers will translate into additional U.S. public debt. As Stephen Roach, chief economist at Morgan Stanley, has noted, the combination of asset bubbles, savings dislocations and excess leverage are coalescing to reduce global demand for goods and services. The United States accounts for fully 71% of the current account deficit on the planet, which Roach believes is directly attributable to the anemic U.S. savings rate.
Within the private sector, it has been American consumers who have pulled more than their fair share of the weight for the last two years as businesses have battened down the hatches and adopted a bunkerlike mentality to spending. Many signs are signaling consumers are exhausting their resource and leverage limits. Before the 2001 recession, it was widely assumed that an aging population would start curtailing their spending in the current decade as baby boomers prepared for a fast-approaching retirement. Recent developments with the war on terrorism can only accelerate the shift from spending to saving.
In the long term, such a shift would be helpful for the U.S. economy. But it is likely to shave a percentage point or two off the U.S. GDP growth rate for the next few years. Nowhere is this change in outlook more obvious than in the list of dowdy companies that leading money managers are now purchasing. Tech, biotech and pricey consumer stocks are now viewed as sucker's bets. Names like Washington Mutual, Black & Decker, Southtrust and Illinois Tool Works are a few of those that have replaced the more glamorous darlings of the last decade.
"Beware of high-multiple stocks" is suddenly the watchword in many money management firms. In the 1990s, professional and retail investors got rewarded for getting in on the ground floor of small companies that would scale great heights and enter the Fortune 500 before the decade was over. Today, they are rewarded for avoiding companies that blow up.
The process of building a base for the next bull market may already be underway, but it will take time to restore confidence. "We'll see double-digit earnings gains in the first three quarters of 2003," predicts Kurt Wolfgruber, head of domestic equity investing at OppenheimerFunds, "but strong gains need to happen. It appears that we have seen the lows [in earnings]." The correlation between the stock market and corporate profits is 0.85, but sustainable bottom-line expansion will need to become obvious before a real bull market gains any momentum.
The economic recovery so far in 2002 may seem almost nonexistent, but it felt that way in the early 1990s, too. "So far, this recovery is stronger than average," Wolfgruber says, adding the economy has averaged better than 3% growth in the first three quarters of 2002.
Wolfgruber notes that there is now "a terrorism discount" priced into the equity market. "But we've been able to work through this and adjust to a different world," he explains. "Investor disgust and distrust mean they will listen to conservative people, and they see 5% or 10% returns. The number of companies that can support a leveraged buyout is very high right now, but there is no bank financing."
Just the mention of leveraged buyouts recalls the salad days of a young bull market in the early 1980s, when corporate executives were so disenchanted with the stock market that they often tried to repurchase their shares and go private, lest a corporate raider spot the stock and pledge the company's own assets to take over the business while assuming little risk themselves. The world in the early 1980s was still wrestling with high interest rates and inflation, not deflation, and U.S. companies were widely viewed as bloated and not competitive in many global markets.
In early November, there was still a lot of talk about the potential for a double-dip recession triggered by a slowdown in consumer spending. "If consumers don't hold the economy up, it's hard to see what will," notes Rick Drake, senior managing director and head of equity research at ABN AMRO.
The 20% rally in stock prices between October 7 and early November left Drake shaking his head about its durability. "When the market focuses on earnings, it's down," Drake says. "When people focus on missing out on the rally, it goes up."
A look at growth-oriented Drake's top holdings provides a glimpse of how much things have changed in the last three years. The list includes Sysco, a food distributor (not to be confused with Cisco Systems); Cardinal Health, a drug and health-care device distributor; Harley Davidson and Illinois Tool Works. Drake believes stocks will remain volatile for the next year. "There will be lots of false starts," he predicts. "There are signs of improved earnings, and the rallies in recent months have shown investors want to buy stocks." But they still have a "show me" attitude when it comes to being convinced any rally is sustainable.
Kevin Conn, associate director of research at Massachusetts Financial Services (MFS), doesn't necessarily believe there will be a double-dip recession, but he expects economic activity to remain subdued for the next 14 months. "Corporations have a lot of debt, and they want to deleverage at a time when they can't raise their prices," he says. "It will probably take until the middle of next year before business spending picks up."
In the interim, he worries that consumer spending will soften, with luxury goods leading the way. And corporate management's eagerness to deleverage their balance sheets makes the probability of a V-shaped recovery a lot less likely.
Even the hope of a modest rebound in business spending could to be just that-a hope. ABN AMRO's Drake says his technology analyst is predicting technology spending in 2003 will be below 2002 levels.
In Conn's view, the equity bubble may have burst, but stocks are hardly cheap. "The market is at 18 times [estimated] 2003 earnings, which is just about 10% over fair value," he argues. "The norm is about 16 times."
And of course, the question of what are normal earnings continues to vex professional investors. Although the Standard & Poor's 500 Index reportedly earned $55 a share in 2000, those figures were inflated by both the tech bubble and accounting fraud. "In past two- or three-year periods of a downturn, the rebound has been pretty sharp," Oppenheimer's Wolfgruber says. Indeed, First Call estimates corporate earnings in the fourth quarter of 2002 will advance 17%. But that figure is down from the 28% First Call was citing in early July.
No one really knows what earnings will look like in the current decade, MFS' Conn notes. The fact that earnings grew in a remarkably stable fashion in the 1990s encouraged multiples to expand, and investors were willing to pay up for predictable earnings. But three years into the new millennium, it looks like corporate earnings are becoming a lot more volatile than in the past. One explanation is that as the post-industrial economy advances, fixed costs have become a much larger part of the total cost structure. When industrial America was at its zenith in the '50s and '60s, more companies could close a factory or idle a plant much more easily than they can today, when plants and factories are a smaller part of the overall economic equation.
Ultimately, the path of the economy and the financial markets is likely to be dictated by events few anticipate. Bill Fries, manager of the Thornburg Global Value Fund, notes that this autumn there has been an October stock market rally, a 0.5% interest rate cut and surprisingly strong October retail sales. "We might have another surprise if Christmas turns out to be better than expected," he postulates. "That could help start an inventory [rebuilding] cycle that gets business back on track by the middle of next year."
Fries acknowledges this is an optimistic scenario but thinks 3.5% economic growth is possible next year. "There's a 50% to 60% probability," he argues. "But if the war [in Iraq] doesn't go well, it could slow the economy dramatically."
Despite the record low level of interest rates, many professional investors continue to gravitate towards financial stocks, partly because of valuations and partly because many of these concerns have managed to make their earnings less resistant to rate swings. Even in this area, there are deep-seated differences. Fries likes property and casualty insurance giant AIG, which he believes is positioned to experience a surge in revenues as it becomes clear that its higher premiums are sustainable and competitive in the post-9/11 environment. Conn thinks AIG is a great company, but its stock is simply too pricey compared with its rivals.
Washington Mutual is another company that has become as much of a favorite in the post-bubble era as Nortel Networks was when the party was still rocking. Yet some are skeptical of this financial institution's stock price. "It looks cheap at nine times earnings, but its earnings as reflected in its return on equity (ROE) are double what's normal because of the housing and mortgage refinancing boom," Conn says. "Its ROE is 25% in an industry where the normal ROE is 12%." Sounds a lot like Sun Microsystems in early 2000.
For the moment, Conn favors playing stocks that are in sync with the Republican takeover of the U.S. Senate. This would include pharmaceutical companies that don't face the onslaught of generic competition, like Pfizer and Wyeth. Defense stocks also look like a beneficiary of the war on terrorism. Stocks with high yields could rank among the biggest beneficiaries of a Republican Congress if lawmakers were to eliminate the double taxation on dividends.
Fries thinks the 7% dividend on American Electric Power is safe, and he also likes Southern Co., which yields around 5%. But he concedes that the energy sector is rife with problems.
Conn goes a lot further. "The problems for the energy group are massive," he says.
But the most dangerous place to be next year may be in the long-term sector of the bond market, particularly U.S. Treasuries. Almost three years after the stock market bubble burst, the bond market has entered the last stage of a secular bull market that has proved even more powerful than the forces that propelled stocks. A serious bear market in bonds may take several years to get going, but it is inevitable. And the carnage could be ugly. "When interest rates go back up, there will be a lot of bankruptcies at companies with fixed-rate assets," Conn predicts.
Improving Economy Puts Bond Prices At Risk
By Alan Lavine
Unless the United States experiences a serious recession or widespread deflation, today's bond prices have little room for capital appreciation. Rates will rise as the economy improves.
Bond fund managers are investing in issues that have wide yield spreads in relation to Treasuries. They are taking a cautious position in relation to the duration of the Lehman Brothers U.S. Aggregate Bond index and other benchmarks.
But the sluggish U.S. economic recovery is not expected to slide into a double-dip recession, according to a forecast by the business school at University of California, Los Angeles. The report from UCLA's Anderson School says that in the end of the third quarter of 2002, the economy was in the early stage of a weak recovery.
"There is no evidence to support the idea that there will be a second dip," says Edward Leamer, the study's author. "In the meantime, I expect continued sluggish growth until we get business investment up and running again."
Leamer says it was still uncertain when businesses would ratchet up investments-a key to sustaining the recovery. The report forecasts the economy inching up to 3.8% growth by the end of 2003. By 2004, the economy should see growth above 4%, Leamer says.
Alan Levenson, T. Rowe Price & Associates' chief economist, agrees we won't have a double-dip recession in 2002. The reasons: Last year's inventory liquidation was the sharpest on record, so companies will not have to cut production. Businesses cut back sharply on plant and equipment purchases, particularly in technology goods. Further cutbacks should be limited.
Levenson says other developments point to a sustained economic recovery. Business profitability has improved sharply. Profit margins should expand because businesses have cut investment spending and jobs. Productivity, growing at 4%, also is helping to boost profits. Corporate profits already have recovered. "Improved profitability provides the means to support renewed but modest capital spending expansion and an end to staff reductions," Levenson says.
Federal monetary and fiscal policies are injecting significant stimulus into the economy. The 1.25% federal funds rate is slightly below the rate of inflation. Federal government spending increases and income tax cuts also are boosting aggregate demand.
All things considered, Levenson says, we should have a better-than-expected economic recovery in 2003. His forecast calls for Gross Domestic Product growth of 3% to 3.5% and inflation at 2.5%. Intermediate-term interest rates should be about 100 basis points higher than they are today. He expects corporate profits to rise 10%. The Fed should maintain a 1.75% Fed funds rate through the first quarter. Then it will increase.
The reasons the economic recovery won't be as strong as some believe: There is a large trade imbalance, and a war with Iraq could bring rising oil prices and reduce economic growth. Plus, the continuation of the bear market could hurt the expansion.
Levenson sees a cutback in business hiring and capital spending as the greatest threat to the economy. "Corporations seeking to free themselves of the taint of 'infectious greed' might choose to hoard cash to signal financial health and honesty," he says. "Alternatively, dilution of expansion plans could result from fears that equity market weakness will reduce demand for goods and services."
But the National Association for Business Economics recently forecast a turnaround in capital spending. It calls for a 5% increase in capital spending in 2003 compared with a 5% decrease in 2002.
Despite the slow-growth predictions of many bond fund managers, they are taking a cautious investment stance going into 2003.
William Gross, manager of the PIMCO Total Return Fund, believes that interest rates will be biased higher, with long-term yields climbing to 6% or more. "Yield curves will remain positively sloped in the face of monetary and fiscal stimulus and more expensive long-term corporate debt," Gross says. "Given our expectations for an inflationary economy with upward pressure on interest rates, PIMCO's investment strategy will be to limit price risk and take exposure in bonds that offer extra yield with a margin of safety."
Bonds that offer a premium above Treasuries are investment-grade corporate, mortgage and top-tier emerging-market bonds, he says. PIMCO is also positive about the global bond market. The euro has appreciated against the dollar. This should take the pressure off of inflation in Europe. In addition, capital is shifting out of the United States into overseas bonds as international investors keep more money at home.
Thomas Silvia, manager of the Fidelity Government Income Fund, also believes interest rates could go higher. So 2003 may not be a great year for bonds. Larger federal budget deficits could lead the Fed to tighten monetary policy.
"I am concerned that the ballooning federal budget deficit may put pressure on Treasury securities initially-ultimately, perhaps, the entire bond market if the government issues significant amounts of new debt," he says.
In the last quarter of 2002, mortgage rates broke below 6% and homeowners refinanced in droves. Connice Bavely, manager of the T. Rowe Price GNMA Fund, said she saw the earnings power of her fund decline.
It's been reported that mortgage securities with stated rates of 7% returned principal to investors at a rate that would pay down half the principal amount in one year.
This puts the mortgage bond fund managers in a difficult position. They have to reinvest proceeds at lower rates. But if interest rates rise as the economy picks up steam, mortgage bond prices should decline. In 1994, for example, the average GNMA fund lost almost 3% when rates rose that year.
Bavely says she is not concerned about the possibility of rapidly rising rates in 2003. "Since we think long-term rates will be fairly stable to slightly higher, a future refinancing wave is unlikely," she says. "The extra yield on high-quality mortgage securities could translate into favorable returns in this kind of environment."
Thomas Marthaler, senior managing director of ABN AMRO Asset Management in Chicago, expects short-term and long-term rates will be 4% and 5%, respectively, as the economy improves. As a result, the yield curve will be flatter in 2003 than it was last year.
"The consumer will continue to spend at an adequate rate to provide positive growth to the GDP," Marthaler says. "Business will engage in more capital spending than anticipated by the market. That will be a huge positive for economic growth."
Marthaler says he is keeping the duration of the Chicago Capital Bond Fund neutral to the Lehman Brothers U.S. Aggregate Bond index. But he is barbelling his portfolio, overweighting both the long and short ends. He says intermediate-term bonds that mature in two to ten years will register the greatest losses when interest rates rise.
He favors corporate bonds. They will benefit as the spreads tighten against government and mortgage bonds." Corporate returns look pretty attractive if we don't have a double-dip recession," Marthaler says. "We like both investment-grade and high-yield bonds. You are getting paid to take the risk in high-yield bonds because we believe the stock market will stabilize and the recovery will be positive."
Marthaler, however, is avoiding bonds in finance, banks and brokerage firms. The reason: He expects more problem loans.
He says industrial bonds, which are more closely correlated to the economy, are a better value. As the economy improves, this sector of the bond market should perform well. He also owns regulated electric utility bonds because of their stable cash flows. There are values in convertible bonds. Convertibles pay high yields and should appreciate when the stock market rebounds, Marthaler says.
On the municipal bond side, George Strickland, manager of the Thornburg Intermediate Municipal Fund and the Limited Term Municipal Fund, is bearish. The majority of states have budget deficits; some of them are bleeding red ink. He expects to see more credit downgrades in 2003.
"There is not much change in the budget deficit situation," Strickland says. "Individual- and corporate-income and sales-tax revenues are flat. States have used up their outstanding fund balances. They have to increase taxes, cut spending or both."
Strickland expects interest rates to rise in the second half of the year. The increase, coupled with state budget problems, means municipal bonds may have a flat year.
Strickland takes a cautious stance with his funds. He primarily buys noncallable bonds selling at a premium to par. Premium bonds do not decline as much as par or discounted bonds when interest rates rise. He ladders maturities from one to ten years in the limited-term bond fund and one to fifteen years in the intermediate-term bond fund.
He is picking and choosing his credit carefully-mostly in Midwestern and Southern states, which have the strongest economies. His average holding has an AA credit rating. He likes school-district bonds in Texas and Illinois because they represent stable credits at cheap prices. On the revenue side, he favors central services bonds, like those of the New York Triborough Bridge and Tunnel Authority, and sewer and water services bonds nationwide because of their stability. He also favors strong health-care issues.
Junk-bond fund managers are more concerned about the outlook for equities and the economy than rising interest rates, which often signals an improving economy and rising credit quality. Margaret Patel, manager of the Pioneer High Yield Bond Fund, expects healthy business conditions by the beginning of 2003. But she doesn't see interest rates rapidly rising.
A rebounding economy should help much of the corporate bond sector. She sees the baby boomers, who are nearing retirement, putting more money into bonds than stocks. And with short-term rates at historic lows, savers will look to taxable and tax-free bonds. As the economy improves, interest rates have nowhere to go but up But she doesn't see that hurting the high-yield bond sector. "This looks like one of the most attractive periods for high-yield investing in the past dozen years," Patel says. "But a dynamic high-yield rally will have to wait until the recovery spreads to more sectors."
Patel is focusing on industries with improving results, such as autos and trucks, paper and forest products, basic materials and capital goods. She has a large stake in health care. She also owns some battered technology bonds in the semiconductor, storage and software sectors.
Louise Rieke, manager of the Waddell & Reed Advisor High Income Fund, is less sanguine about the outlook for high-yield bonds. "The barometer is what equities are doing," Rieke says. "The last six months, high-yield bonds have tracked equities religiously. If the economy gets better, there will be good values in stocks."
For things to improve, rates have to stay low and additional government spending must boost the economy. Last year, 10% of high-yield bonds defaulted. But she expects the default rate to be lower in 2003. "If the economy continues to remain weak, we will continue to have defaults, but not at record levels," she says.
Rieke is sticking with B-rated and BB-rated issues that have good management and stronger balance sheets than their peers. She is shying away from BBB-rated bonds because she believes many will be downgraded. And she has limited the fund's exposure to telecommunications and commodity issuers because of overcapacity in those areas. Her largest industry holdings are in health care, gaming and broadcasting.