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Monday, August 11, 1997
Unbullieve-able!
By Andrew Bary
As America's soaring stock market prepares to celebrate its 15th
anniversary Tuesday, perhaps the most surprising thing is that Wall
Street hasn't produced the baddest bull on the planet.
In fact, in percentage terms, the nearly eleven-fold rise in the Dow
Jones Industrials since Aug. 12, 1982, which has pushed the benchmark
average to around 8100, has been surpassed by stock markets in a host of
countries, including the Netherlands, France and even Peru.
But what can't be denied is that the worldwide surge in equities has
been spurred by economic and political developments in the United
States.
Of course, Ronald Reagan deserves credit because of his insistence on
trimming the role of government, cutting taxes and letting free markets
reign. The former President's political initiatives nicely dovetailed
with a more accommodative monetary policy at the Federal Reserve, first
pursued by Chairman Paul Volcker, starting in 1982, and continued until
today by his successor, Alan Greenspan.
The American economic model, emphasizing technology, corporate
restructurings, productivity gains and free trade, has churned out
millions of new jobs and been imitated around the world. How else could
a once-socialist basket case like Peru boast the best stock-market
returns in the past decade and a half?
Other markets may have appreciated more since 1982, but nothing in the
world can compare with the wealth created here. U.S. equities just hit
an astounding $10 trillion in total valuation, up from about $1 trillion
in 1982.
In the 15 years ended July 31, the Dow generated a total annual return
of 20.8%; the S&P 500, 19.7% -- marking the best stretch of this length
in the history of those key stock-market barometers. The next-best
15-year period for the S&P ended in April 1957, with a 19.0% annual
gain, and in August 1929, with an annual advance of 17.4%. Of course,
1929 kicked off the worst 15-year stretch for stocks in this century.
It's commonplace to see the U.S. economy extolled these days. And why
not? Unemployment stands at 4.8%, a 23-year low; annual inflation is
down to 2%; gross domestic product is expanding at a moderate clip;
corporate profits are climbing at a double-digit rate, and the sizzling
stock market has enriched Americans as never before.
In fact, U.S business now bestrides the world as it has at no other time
since the early 1960s, when stock-market valuations were comparable to
those today. Even dour central bankers are using superlatives. Fed
Chairman Greenspan, not exactly known for hyperbole, recently described
the economy's performance as "exceptional."
How different was it on Aug. 12, 1982, when the Dow bottomed at 776.92?
Back then, the nation was mired in its worst recession since the 1930s;
unemployment stood at 9.8%; long-term Treasury yields hovered at 13% and
crushingly high interest rates were throttling the economy; oil
commanded $34 a barrel; the Midwest was rusting away; Mexico was broke;
Reaganomics was widely considered a failure, and blue-chip stocks traded
at only four to eight times earnings. In those dismal, distressing days,
stocks were largely discredited, bonds were deemed "certificates of
confiscation," and popular investments included money-market funds,
commodities, gold coins, collectibles and tax shelters.
"Very few people would buy stocks at any price then. There was a
perception that stocks were high in risk," notes Ray DeVoe, who has
written a market letter for Legg Mason since 1981. "You have to remember
that the Dow traded in the 800-900 range at some point during the prior
18 years."
In '82, DeVoe was one of the few bulls on Wall Street. In '97, he finds
himself an embattled bear, now that stocks are viewed as the ultimate
asset class. "I'm referred to as a brain-dead bear," DeVoe observes.
"People don't want to hear about risk and what might go wrong."
Bears have no sanctuary. Morgan Stanley's Barton Biggs wrote recently
that a stranger, somehow recognizing him in steamy Grand Central Station
last month, launched into a harangue about how wrong the longtime global
strategist had been on the market. "Aren't you afraid you're missing the
new era? It really is different this time," the stranger scolded.
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Where They Stood in '82 | How They've Done
Still on the Fast Track | How They Rank
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In August 1982, stocks were mired in a bear market that had lowered the
Dow by 25% in the prior 14 months. Concern was widespread about whether
the U.S. economy could expand for a sustained period without inflation.
Economists such as Edward Yardeni (the subject of Barron's cover story
last week) thought there was a 30% chance of a depression if the Fed
didn't relent and cut short rates.
On Sunday, Aug. 15, the lead article in The New York Times business
section was headlined: "Dark Days on Wall Street; The long bear market
seems to be entering a final phase. The end could be violent but also
cathartic." Echoing the view of many pros, Robert Farrell, chief market
analyst atMerrill Lynch, warned in the piece that a "capitulation" phase
was needed before stocks could rally.
Now, viewed through the omniscient lens of hindsight, it's clear that
investors not only had capitulated by the time the article was
published; they had been annihilated. But virtually no one realized this
back then.
In this cruel investment world, Peter Lynch, the skipper of Fidelity's
Magellan fund, had gained a bit of fame on Wall Street by producing
phenomenal returns in the prior five years, quadrupling his investors'
money in a stagnant stock market. Yet few outside the fund industry knew
who he was. Mutual funds hadn't been much of a business since the late
1960s, after which many crashed and burned, and many Americans were wary
of them. Magellan's assets stood at $147 million, and all U.S. equity
funds held $57 billion, versus more than $2 trillion today. In telling
contrast, Magellan's portfolio currently is valued at more than $62
billion.
The leading market gurus then were Joseph Granville, a flamboyant
newsletter writer, and Henry Kaufman, the chief economist at Salomon
Brothers (see the accompanying article for a look at some seers of the
past 15 years). Granville periodically rocked the market with his calls,
including his famous "sell everything" bulletin in January 1981, which
produced the busiest trading session until that time -- volume was 92.9
million shares.
Kaufman reigned in the bond market, where his accurate and bearish rate
forecasts in 1980 and 1981 had earned him the nickname "Dr. Doom."
Today's best-known guru, Goldman Sachs strategist Abby Joseph Cohen, was
a total unknown. Then 30, she worked for an economist at T. Rowe Price,
producing quantitative models that sought to peg the correct value of
the stock market, given such inputs as interest rates, corporate profits
and other factors. "I remember that summer very well," Cohen says. "A
lot of our valuation work indicated the market was very attractive. But
it had been attractive for quite some time. There was no catalyst."
The catalyst arrived on Aug. 17, when Kaufman, who had remained bearish
on rates in 1982 even as yields began to come down, reversed course.
"Recent events in the economy and financial markets necessitate a fresh
look at the prospects for U.S. rates," Dr. Doom wrote, predicting that
long-term Treasury yields, then 12 3/4 %, could fall as low as 9%. The
market response was immediate: Bond prices soared and the Dow gained a
record 38.8 points, or 4.9%, on near-record volume. Yes, at the time,
38.8 points was the biggest gain ever.
The 69-year-old Kaufman, who now runs Henry Kaufman & Co., a New York
asset management and consulting firm, has maintained a low profile since
leaving Salomon almost a decade ago. He now sits on the board of
Salomon's long-time rival, Lehman Brothers, and his memory of the birth
of the bull market remains vivid. "I triggered it," he maintains. "I
finally sensed that inflation was abating and that monetary policy would
continue to be eased."
Kaufman might have been a trigger, but credit for the rally goes to the
Federal Reserve Board, which began pushing down short rates that summer.
Immediately after the rally began, this publication spoke with several
prominent Wall Street pros about the outlook. Veteran Barron's
Roundtable member John Neff, then head of Vanguard's Windsor Fund, was
bullish, recommending some major oil companies trading at four times
earnings. But Granville was skeptical. The crusty analyst contended that
the market was doomed. "This Wall Street buying will produce a case of
acute indigestion," he stated, observing that no bull market had ever
begun with "institutional buying."
How cheap were stocks then? One of the tables on page 32 offers a
snapshot of the Dow on Aug. 12, 1982. Some examples:
AT&T, which had a virtual monopoly on U.S. local and long-distance phone
service, traded at just six times earnings and yielded 11%.
General Electric and Procter & Gamble changed hands at nine times
earnings; their current P/Es are closer to 30.
A growth stock like Merck commanded 12 times profits, while industrial
companies like Du Pont and United Technologies fetched just four to six
times earnings.
The Dow's overall P/E was eight; its yield, 7%. Morgan Stanley's Biggs
told the New York Times that the Industrials' price-to-book ratio of
0.78 was the lowest since the depths of 1932. The Dow is now at almost
six times book.
"The thing that most concerned us then was whether the Dow would ever
trade above 1000 and stay there," says Laszlo Birinyi, president of
Birinyi Associates, a Greenwich, Conn., market-research firm. Many
investors noted that the DJIA had topped 1000 several times since 1972,
but always had subsequently faltered and fallen back. The index finally
broke above 1000 for good in December 1982.
What Dow stocks have done the best since 1982? The other table on page
32 shows that, of the original Dow members, Merck has the top return,
gaining 23.9% annually since August 1982, followed by General Electric
and Procter & Gamble. (The rankings are based on Birinyi data through
June 30 and exclude dividends.)
New blood clearly has invigorated the Dow. In August 1982, the index
truly was an industrial average, weighed down by such lumbering
behemoths as International Harvester,Inco, Bethlehem Steel, U.S. Steel
and Johns Manville. Since then, the Dow has been overhauled, with 11 of
its 30 members replaced. That has made it more representative of
American business, ensuring its status as the world's most famous equity
barometer. Without any changes, the Dow Jones Industrial Average
wouldn't be anywhere near 8000 today.
In fact, the Dow's pacesetters have been relative newcomers like
Coca-Cola and Philip Morris. Coke arrived in 1987; Philip Morris, in
1985.
Coke's gain of 28.5% a year is staggering because it was already in a
mature business in 1982. But with Chief Executive Roberto Goizueta
marketing its soda globally with missionary zeal (and keeping a keen eye
on his company's stock price), the company has shown itself to be
anything but a has-been. Coke's shares, now around 65, stood at a
split-adjusted 1 1/2 in '82. Don't you wish you'd loaded up on a few
truckloads back then?
The stocks of two former Dow members, Bethlehem Steel and International
Harvester (now Navistar) distinguished themselves in a way their
shareholders certainly didn't enjoy. They actually have declined over
the past decade and a half, illustrating the danger of betting on
turnaround plays. Navistar has been a winner this year, doubling in
price, but that hasn't made up for its terrible showing in the previous
14 years. Its stronger competitor, Caterpillar, has done far better.
The ranking of the leading world markets since the bull showed up on
Wall Street holds some surprises. Few American investors would guess
that the Netherlands has the best returns among 14 major markets
(according to Global Financial Data of Alhambra, Calif.), and that
France is second The Dutch market has been aided by the strong
performance of such large multinationals as Royal Dutch Petroleum and
Unilever. The U.S. ranks fifth, with a 19.7% annual gain in the S&P 500.
Laggards include Italy, Australia, Canada and Japan. (All returns given
here are in dollars.) Italy's musical-chairs political scene hasn't
helped its market. And heavy concentration in natural-resource companies
has weighed on Canada and Australia. Japanese returns have been held
down by the halving of the Nikkei index since 1989. And Japan's woes go
on. This year, the Nikkei has barely budged, while the S&P is up 30%,
and major European markets have soared as much as 50%.
It's noteworthy that in local currency, Japan fares worst by a wide
margin among the leading 14 markets, up just 8% annually since 1982.
Only the doubling in the yen's value against the dollar has given
Japanese equities a respectable return. In market value, Japan is now
No. 2 behind the U.S. at $3 trillion, up from $400 billion 15 years ago.
(That's quite a comedown from the heady days of the "bubble economy" of
the late 'Eighties, when Japan's stock-market capitalization briefly
held the top spot globally.) And Britain has remained in third place, as
its stocks have increased tenfold in value to around $2 trillion.
Among a broader group of 45 countries, the best price gains in the past
15 years primarily have occurred in Latin America. On the other hand --
and perhaps surprisingly to anyone who's heard the praises of the
supposedly unstoppable Asian tigers sung again and again in the business
press -- Indonesia and Singapore are near the bottom. In fact, the only
Asian bourses to outpace the Morgan Stanley World index in the past 15
years are Hong Kong and Taiwan. Not surprisingly, given precious metals'
sorry showing in recent years, South African gold shares rank last,
having fallen below their 1982 levels.
In 1982, Latin America was in disarray economically. Indeed, its equity
markets didn't begin to appreciate until 1990, when inflation began to
abate and the Brady plan eased debt burdens. Since then, the gains have
been fantastico.
"A contrarian approach can pay off," observes Bryan Taylor, president of
Global Financial Data. "In the 1980s, Latin America had a debt crisis
and was the last place anyone wanted to invest. East Asia was viewed as
the place to be. But look what happened." Now, Latin America is in vogue
while the Asian Tigers have fallen from favor. Maybe it's time now for
investors to switch.
Here in the U.S., profits are critical to the market outlook. Investors
and analysts anxiously await each quarter's report for confirmation that
earnings gains will keep rolling on. Yet the profit emphasis is largely
a 1990s phenomenon. As the table on page 36 shows, S&P profits weren't
too much higher in 1990 than they were in 1981. Higher stock prices in
the 1980s resulted from higher P/E multiples as interest rates fell and
as takeovers unlocked the asset value in many companies.
The S&P 500 now trades at 21 times projected 1997 profits of $45.70 a
share, a near-record multiple for a period in which corporate earnings
aren't depressed by an economic downturn. That multiple seems high to
many, but Jeff Applegate, a strategist at Lehman Brothers, makes an
intriguing -- and bullish -- argument.
America is in a golden age of corporate profitability, he maintains.
Since 1926, the average annual gain in S&P 500 profits has been 6.9%, a
figure often cited by market historians as probably the best possible
over a long stretch. However, Applegate says, current equity valuations
are reasonable because he believes 10% profit growth is sustainable for
the foreseeable future. He points out that the 6.9% figure includes the
Great Depression, when profits plunged.
"Monetary policy is about as well-run as one could hope for, and fiscal
policy is sane for the first time in decades," Applegate contends,
noting that the U.S. budget is moving toward surplus, assuming current
economic projections hold true. These factors mean that the risk premium
attached to stocks is apt to remain low, supporting valuations. Bonds,
he maintains, are unlikely to be very competitive with stocks. Simply
put, bonds yielding 6%-7% can't provide equity-like returns.
There's plenty of talk about Baby Boomers and the retirement-related
demand for stocks. But few have looked at the subject globally. That's
why a recent report from Goldman Sachs, "The Global Pension Time Bomb
and Its Capital Market Impact," makes fascinating reading.
Goldman asserts that pension funds around the world face a demographic
crisis. To meet the needs of retirees in the 21st century, their
appetites for stocks will turn ravenous.
How much equity do these pension funds need? Goldman puts the number at
a staggering $1.8 trillion in the five years from 1996 through 2000.
During this stretch, the U.S market alone will benefit from $750 billion
of purchases from domestic and international pension funds, according to
Mark Griffin, the Goldman insurance and pension expert who penned the
report.
Japanese pension funds, he asserts, will be major buyers of U.S. stocks.
Why? Because they can't generate a 5 1/2 % required rate of return with
their longtime investment choice: Japanese government bonds, now
yielding just 2%. Griffin says it's no surprise that the big stocks in
the S&P 500 have been so strong in the past 18 months; international
pension funds want these large, liquid issues. These funds benchmark
their U.S. performance to the S&P 500, and thus have little need for
companies outside the index.
Bears point to the doubling of American corporate profits since 1991 and
argue that a slowdown is inevitable, regardless of what bulls like
Lehman Brothers' Applegate contend, especially with companies having
limited pricing power in a low-inflation environment.
Two traditional -- and largely discredited -- measures also suggest that
stocks are very pricey. The S&P trades at a record 4.8 times book value,
and its dividend yield is 1.6%, the lowest ever. Most equity mutual
funds have trivial yields, and some of those focused on growth stocks
pay no dividends. Old-timers point out that, historically, dividends
have provided nearly 40% of the total return on stocks.
Then there's the anecdotal evidence. Ray DeVoe says he frequently talks
to people in New Jersey supermarkets who are paying for groceries with
credit cards so they can make maximum contributions to retirement plans.
Jim Stack, the bearish publisher of the Montana-based InvesTech Research
newsletter, wrote recently about the boom in investment clubs. Some
18,000 have formed since 1995, more than the 12,905 that existed prior
to 1995.
And people are clamoring to become financial analysts. About 40,000
candidates have registered to take exams to become a chartered financial
analyst this year -- nearly double the 20,931 CFAs who existed at the
start of 1997.
Indeed, there may be plenty of reason for optimism over the next 15
years, when some Baby Boomers start living off their retirement nest
eggs. But it'll be very tough for returns to match the past 15 years.
Just do the math.
Say the Dow gains 14% annually, rather than the 16% over the past 15
years. At a 14% compound rate, the Dow would be around 58,000 in 2012,
over seven times its current level. And the value of all stocks would
hit an astronomical $72 trillion. (The Dow nearly doubles every five
years at a 14% growth rate.) Use a more conservative appreciation figure
-- say, 10% -- and the DJIA still is at a mere 34,000 or so in 2012.
Okay, so even Dow 34,000 may seem outlandish. But wouldn't it have been
laughable to talk about Dow 8000 in 1982? Yes, the stock market's
awesome power has surprised and delighted even the most passionate
bulls. But, given the trends still underlying the market's strength,
even after this long, great run, and the increased volatility evident
lately, there's a chance that they'll continue to be surprised -- and
laughing -- as the years roll on.
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Copyright c 1997 Dow Jones & Company, Inc. All Rights Reserved.
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