Market Insight: Yes, It's Difficult to Improve on Perfection
July 10, 1999
NY Times
By KENNETH N. GILPIN
NEW YORK -- Wall Street is a natural habitat for bulls and bears.
But it is a precarious place for pigs.
After a strikingly strong first half, stock investors might be well advised to
remember that in the final six months of 1999.
According to Birinyi & Associates, the gain in the Dow Jones industrial
average from January through June was its sixth-best ever. The Nasdaq
market also registered its sixth-best first half. By comparison, the
Standard & Poor's 500-stock index was a real stick in the mud: its
six-month gain was merely the 12th best in its history.
Six months ago, Edward M. Kerschner, chairman of the investment
policy committee at Paine Webber Inc., was pretty optimistic about
1999, compared with many strategists But the gains recorded thus far
have made him cautious about the future. Last week, he took some time
to talk about how the stock and bond markets are likely to move in the
last six months of the year. Here are some excerpts:
Q. Before we look ahead, let's look back. What has been the biggest
surprise over the past six months?
A. The biggest positive surprise to the market was how good corporate
earnings have been.
Because of the fall meltdown, at the beginning of the year 4 of the 10
major Wall Street firms were forecasting a decline in earnings for the
year.
That view was based on a double-barreled fallacy: first, that a market
correction means a recession, and that a recession means a decline in
earnings.
We didn't see a recession, and after we did the math, thought that
earnings would be up about 10 percent this year.
Q. Still, early this year people were buying stocks because interest
rates were low. And the rise, or backup, in bond yields came as a
surprise. Has it surprised you?
A. We have been bullish on interest rates since 1988, but the rise in rates
we have had so far this year is more than we thought. But there is no
reason for bond yields to back up much more from here.
Q. Why don't you expect much higher bond yields?
A. In our view, for the foreseeable future the inflation outlook is nil.
Prices are falling due to technological innovation. That doesn't mean the
Fed will start to ease again, but anyone who thinks they will be
aggressively tight is mistaken.
Q. Still, many people are worried that rising rates will hammer a
stock market that is seen as highly overvalued. What potential do
you see for a substantial correction?
A. In terms of valuation, in every sense we can quantify the stock market
is nowhere near the excesses seen in 1987. On a price-to-earnings basis
back then, the market was between 35 percent and 40 percent
overvalued. Based on our models, today we are about 10 percent
overvalued. Based on our work, there is a minimal probability of stocks
falling 30 percent from these levels. And it is a 50-50 proposition that
there will be a 10 percent to 15 percent correction.
Q. So you are looking for the market to trade in a narrow range,
near current levels?
A. The market can stay in this narrow range for as long as things stay as
they are, and things are perfect. Perfect is not a word I use often. The
upside is fairly limited, because if you have paid for perfection, all you
have gotten is a normal return. The other negative thing with perfection is
that things can only get worse.
Q. It sounds as if you would be happy to close the books on 1999
right now.
A. You are going to have to work hard in the next six months to do
better than you did in the first half of the year.
In a flat market, reasonably good stock selection should give you a return
of 5 percent to 10 percent.
Q. Which stocks have the potential to provide that sort of return?
A. We have a highlighted list of 31 names, most of them bigger
companies, which really have an advantage because they are actually
raising prices without creating inflation because they are making better
products.
We like a lot of big technology companies, including America Online and
Microsoft, drug companies like Warner-Lambert and Pfizer and
consumer-oriented companies like Wal-Mart, Carnival Cruise Lines and
Bed, Bath and Beyond.
Q. Still, compared with the past few years those sorts of returns
sound puny. Are the years of double-digit annual gains in the stock
market ending?
A. I would advise someone who has been asleep for the last 20 years to
get their yield from the bond market and expect 5 percent to 10 percent
gains from equities. Those people missed the opportunity of a lifetime.
We have gone through a repricing of financial assets that has run its
course. Going forward, there is no fundamental reason we can support
financial assets that return 20 percent annually.
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