By Joe Battipaglia, Chairman of Investment Policy 12/1/97
There are several reasons why we are in the midst of an explosive rally. First, we dismissed last week the notion that recession on a global basis is looming and felt that was a sturdy basis upon which to rally. The Japanese market is responding nicely to government efforts to allow free markets to take control and work through financial problems that the banks have labored with for the last decade. Between Friday and today, the Japanese market is up approximately 5%. Also, South Korea is close to a deal with the International Monetary Fund for a bailout package worth between $55-$60 billion. As for the U.S. economy, evidence continues to mount that companies are doing well and consumers are spending what they earn which is a sign of confidence. This suggests that outlook for profits in the U.S. are strong. With continued strength in the U.S., Europe in recovery mode, and China continuing to grow at 8% per annum, the rest of Southeast Asia should follow suit.
The financial blow-off of the last two months has actually done wonders to changing sentiment on a number of key fronts. First of all, the fear of inflation has all but disappeared and the wage pressure issue is no longer a major concern. The main concerns now are whether the dollar will be too strong, the fact that far eastern currencies need additional help, and if anything the expectation for inflation is lower not higher. On the rate front, the Fed has gone from being on the verge of raising rates to being in the position to sit tight at 5 1/2% on the discount rate with the long bond at 6%. The next move for the Fed in 1998 will be a cut in interest rates on the short end. It appears that they have now mastered the inflationary bugaboo. They have concerns about global stability of currencies. The dollar is ascending not descending and U.S. deficits have disappeared.
The next issue to address is expectations on profits. In October, some analysts basically cut their growth expectations for 1998 to zero and lowered their profit estimates by 50% in some cases. Now those analysts will be dealing with the fact that perhaps they were a bit too aggressive in cutting their expectations. When this kind of change in sentiment exists, it usually leads to stronger stock prices. Whether we get to new highs by year-end or some time in the first half of 1998 remains to be determined.
I think it will be a broad-based rally fairly quickly. The generals will lead the rally and it will work its way into the small cap arena, similar to the manner in which 1997 has played out. Strength lies across the board in technologies, financial services companies, pharmaceuticals, health care devices and also information technologies. Media stocks look extremely cheap at current levels after under-performing for quite some time. Also, REIT's for total return are appealing and closed-end funds would be an excellent place to play some of the emerging markets, which have been down significantly of late. In particular, the transports are very attractive. They should have a strong '98 with energy costs decreasing. Two of my top choices in the sector include Union Pacific (UNP-Strong Buy-$59 7/8) and Boeing (BA-Buy-$54). UNP has had troubles in the system and BA has had the pleasant problem of having to produce too many goods with limited capacity. These two stocks present a very good value in today's market. They are big cap names and have lagged the market of late.
I'd be aggressive and fully invested over the next 12 months. Look for interest rates to crack 6% on the long-end and for the Fed to cut rates in 1998. Our target for the Dow is 9000.
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