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TSC: To start with, what's your synopsis of what's going
on with the market? What do you think is going to happen?
Jeff Applegate: We're still bullish. We think the
correction is behind us. The house view is that the Fed
isn't entirely out of the picture: We're still looking
for the Fed to go another quarter-point -- not at the
June meeting, but the August one. Obviously, it's highly
dependent on what kind of data we get between now and
then. It looks to us like the second quarter is probably
below 4% in terms of local GDP, which we think puts
things below potential. That should take some of the heat
off the Fed.
Obviously, we have a fair amount of evidence now of a
slowdown. Decent CPI, PPI and Greenspan's pretty
market-friendly commentary on productivity. Obviously
he's been on that for some time, but he keeps on
extending his argument. I guess what I found interesting
about this set of comments was that where 18, 24 months
ago he was fretting, "Well, we've had this
acceleration in productivity and how long will it
last?" now it's, "Well, we've made a structural
change here and it looks like this can persist for a long
time." That has enormous implications for how fast
the economy can grow, what that means for inflation, what
that means for profit margins. And profitability can
improve even though you don't have any significant
pricing power.
In a cyclical sense, we do think the worst of the
correction is behind us and it's entirely conceivable
that the Fed is done. If you look at the history, and if
you look at prior periods during extended business cycles
when the Fed has been tightening to slow, but not stop
GDP [not create a recession], there were two examples in
the '60s ('62 and '64), two in the '80s ('84 and '87) and
now one in the '90s ('94-'95). If you look at history,
because markets are discount mechanisms, both the stock
and the bond market tend to trough and begin to rebound
in advance of the final Fed tightening. On average, it's
about four to five weeks in advance, and that's been the
pattern over decades. It's entirely conceivable that the
final tightening was May 16, and the trough in the bond
market was April 10, and the trough in the stock market
was April 14.
If you look what the stock market does forward 12 months
from that trough, historically the forward 12-month
return has been very good -- in excess of 30%. If you
look at where we are at the moment from April 14, the S&P
is up about 9%. I think the markets are in the
process of reprising what they've done a whole bunch of
times. We still think we're in the same bull market that
got under way in October 1990.
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"The key driver of the market is going to be earnings
growth."
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TSC: In terms of a repeat of the '94-'95 scenario, what
do you say to the idea that part of what got the market
further was the fact that bond yields fell about 200
basis points after the Fed was done tightening? They're
pretty low now and there probably isn't that much room
for them to fall further. Do you need to see much lower
bond yields to get the stock market reaccelerated?
Jeff Applegate: No. We've got forecasts that earnings
growth is going to be double-digit. We've got it slowing,
sequentially, because we've got global GDP slowing. So
we've got earnings growth going from about 20% in the
first quarter to about 16% this quarter, then
14%, then 15%. But it's still double-digit
earnings growth. And next year we have inflation
down-ticking a bit. That ought to buy you a little
multiple expansion -- I don't think much, but a little.
To me, the key driver of the market is going to be
earnings growth.
TSC: Is that concentrated in any sector?
Jeff Applegate: It's pretty pervasive. We've had a very
bullish view on profit-margin expansion. At the moment,
we're sitting around with a forecast that next year
after-tax profit margins are going to get higher than
they've ever been before. And if you look at where we are
in that pattern, because we now have the data from the
first quarter, profit margins increased by another 20
basis points. At the end of the first quarter, after-tax
margins are up to 6.8%, which is the highest in half
a century. We've basically got a view that companies can
deliver consistently above top line, because margins are
expanding. We relate that to two things: globalism and
technology, and the impact of both those things on
productivity.
All things being equal, if the Fed's either on hold or
close to being on hold, that should be OK for the stock
market. You've got a few bumps in inflation, just because
of what energy just did, but with some disinflation next
year and double-digit earnings growth, and productivity
that, if anything, looks like it's accelerating -- that
ought to be fairly decent for the stock market.
TSC: Could you talk about why you don't see great risk to
what's going on with energy prices right now?
Jeff Applegate: I think part of it is just going to be a
slowdown here. I think the other part is you get to a
point where OPEC doesn't want alternative sources of
energy coming on stream. We're at that level now. Plus,
the outlook we have for global growth is OK, but it's not
wildly robust. We've got Europe growing around 3%, us
decelerating to below 4%. But we've still got Japan,
which is the second-biggest economy on the planet,
bumping along the bottom at 1%. We've got global
growth around 3%. That's better than it was, but
still not wildly robust. Certainly in the futures market
and the spot market, you probably have some more upside
on energy prices, just because you tend to overshoot on
the way up just like you tend to overshoot on the way
down.
TSC: You're still overweight capital goods,
communications and technology. Even the groups that
aren't technology per se, like communications services --
you have Nextel (NXTL:Nasdaq - news - boards) -- those
are companies that are definitely using technology like
no other companies are.
Jeff Applegate: And if you look at the capital goods
names -- Flextronics (FLEX:Nasdaq - news - boards), Jabil
Circuit (JBL:NYSE - news - boards), Solectron (SLR:NYSE -
news - boards) -- those are the guys who make all the
stuff that Cisco, etc., don't make.
The tech thesis is really pretty simple. It's also pretty
compelling. We've been overweight tech since the summer
of '93, and at the time tech was 7% of the S&P. We
put in place a weight of 12%. Today, tech is about
32% of the S&P, and our weight is in excess of
50%. The ratio in the portfolio is about the same as
it was seven years ago. Obviously the absolutes are much
higher, because the tech weighting is much higher.
The thing that originally got us there seven years ago
was simply observing what was going on with capital goods
as compared to the cost of labor. If you go back about
seven years, capital goods prices in the U.S. were rising
by about zero, and labor costs, as measured by the
Employment Cost Index, were rising by a little over
4%. Just looking at those economics, we came around
to a view where it looks like we've got in place the
economics for a pretty robust capital-for-labor
substitution process. That should mean on the corporate
side that demand for technological products ought to be
fairly consistently good, possibly for an extended
period, because if you go back earlier in this business
cycle, about 30% of cap-ex was on tech.
Fast forward to where we are today.
Overall capital goods prices are now falling by 2% a
year, and labor costs are rising in excess of 4%. So
the spread between these variables is now about 6% --
it's actually wider than it was earlier on in this
business cycle. We would submit that the bunch of
conclusions we came to seven years ago are still valid.
The economics driving the capital-goods-for-labor
substitution process is still intact. That should mean
that workers will continue to get better tools on a
recurring basis, so that will be pretty good for
productivity. Since your increasing capital spending is
generally faster than GDP, prospects remain good for a
long business cycle -- because you're increasing capacity
as you move through the cycle. This is the best capacity
creating cycle that we've had -- you can't find one
better than this. A corollary to that is pricing power.
Since you're increasing capacity, companies don't have a
lot of pricing power, but productivity ought to be good
because of tech. What's chiefly different today, versus
seven years ago, is that 60% of cap-ex is tech, not
30%.
I'm not an economist, but when I look at the economics, I
have a very difficult time dismantling the deflation in
capital goods. The reason you've got this deflation is
the world of semiconductors that we live in, and the big
debate in tech-land these days is not whether Moore's law
is intact, but whether it's accelerating. If you look at
labor cost in the U.S. -- given that unemployment is
bumping around 4% -- I think it's tough to make a
forecast that labor costs are going to start falling a
significant amount.
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"In all the rich countries on the planet, capital
goods prices are low or falling, and labor costs are
fairly high."
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Moreover, this phenomenon is not just a U.S. phenomenon,
it's a rich-country phenomenon. In all the rich countries
on the planet, capital goods prices are low or falling,
and labor costs are fairly high. Relate that back to
tech. For the S&P tech sector, 48% of sales are from
outside of the U.S.
And then of course you have the Internet. Obviously, we
couldn't foresee that in the summer of '93, nobody could,
but that's a pretty interesting metric.
No question we've got a big weight in tech, it's a highly
concentrated portfolio. But we still think that's the way
to go. These are the growth stocks of our era. |
