Earnings Shortage - David Dreman
, 07.07.03, 12:00 AM ET
Euphoric profit forecasts have driven the market up far too high--especially for Nasdaq 100 stocks. A closer look at them is sobering. Go for value.
Is this simply a strong bear market rally or the first powerful surge of a new bull? With the S&P 500 up 13% and the Nasdaq 100 (consisting primarily of large-cap tech stocks) up 23% so far in 2003, this is the big question facing investors today. The S&P now trades at 32 times trailing earnings (versus a historic 15) while the tech-laden Nasdaq 100 goes for an amazing 132. A good part of the spring run-up is based on expectations of an earnings recovery.
But we've been down this sorry road before. The majority of analysts in 2001 and again in 2002 forecasted strong earnings growth accompanied by major stock gains. Instead earnings went nowhere, resulting in two poor years for investors. What's different now? Not much. First Call consensus forecasts put expected third-quarter earnings up 12.7% over 2002 and fourth-quarter ones up 21.1%. Too bad that nothing like that is going to happen.
Investors today are not euphoric; they're punch- drunk. And they will come to their senses eventually. Remember all the wealth they lost after the bubble popped so loudly in 2000? The last mania was not your run-of-the-mill speculative excess. The most recent downturn lost investors $6 trillion, as against $1 trillion in the October 1987 crash.
And with half of U.S. households invested in the stock market, it pays to recall that many consumers are investors. The investment losses will begin to hurt consumer spending, which only low interest rates have kept going. Rates can't go down much more, so Alan Greenspan is about out of ammunition. Rising unemployment will take a toll on consumer outlays. Then the reverse wealth effect--from fewer savings and retirement funds available--will kick in. The new tax cuts should help consumer spending, yet not enough to cause more than a minor pickup over the months ahead.
Higher capital spending won't propel this rally. With consumer spending lackluster, price increases impossible (for most sectors) and industrial capacity utilization low at 75%, only divine intervention could produce a capital expenditure surge. Washington is trying to stimulate plant and equipment spending with accelerated depreciation writeoffs. But no amount of tax breaks will make a good investment out of an idle machine tool or a dark strand of fiber.
Before the music stopped in 2000, many companies grossly overpaid for acquisitions, or started costly new divisions based more on an exciting concept than on a realistic assessment of profitability. Result: The likes of AOL Time Warner, Tyco, AT&T, Lucent and Motorola have all taken massive writeoffs, with more to come. This has cut down their asset base substantially, which increases debt-to-equity ratios, often significantly. Add to that the drag of pension fund losses, courtesy of the bear market. My estimate is that corporate pension plans in the S&P 500 are underfunded by an average of 22% on an equal-weighted basis. General Motors, ExxonMobil and Delta Air Lines have already added to their pension fund expenses, with scads more likely to follow.
For a reality check on the sturdiness of corporate capital structures, look at the ratings agencies. Standard & Poor's this year has downgraded four debt issuers for every one it has upgraded; this is a slight improvement over 2002 (4.5 downgrades for every upgrade) and 2001 (5.5 to 1), but nothing to celebrate. Every time there's a downgrade, it's as attention-getting as a giant pinball machine gone amok, with hundreds of orange and red lights flashing. Under pressure to lower their debt loads, many companies are in no mood to undertake expensive capital projects.
Now the good news. I think we have seen the market lows, and this is no time to be moving from stocks to bonds. Earnings will increase, although at a slower rate than most economists and analysts see. Avoid the Nasdaq 100, where stocks like Ebay, Yahoo and Amazon continue to trade at bubble prices. Instead focus on value stocks that have outdistanced the averages by a wide margin since the bear market began and, because of their low valuations, should continue to do so. |
