GADR Update for 3/6/98.
More than a year ago, on 2/14/98, we wrote, in part:
"Even those friends of ours who don't know the difference between
debt and equity (and don't care), are aware that the DJIA closed
above 7,000 this past Thursday."
[The DJIA closed at 8569 today.]
".....[W]e are concerned about the possibility that we are at the
onset of, dare we say it, an "irrational exuberance" in the equity
Markets. Viewed statically, we find the Market correctly valued, as
discussed above. Our concern comes from the situation viewed
dynamically. In arriving at the current state of what we
believe is a correct valuation, the Dow has advanced at a 30%+ rate
annually in 1995 and 1996. And, the Dow has advanced more than 8%
in less than 2 months this year."
[As it turned out, the Dow returned about 25%, including dividends,
in 1997, while cash earnings (cash flow minus capital spending)
advanced only about 12%.]
"Perhaps, like last year, after dashing from the starting block, the
Market will spend much of the remainder of 1997 moving more or less
sideways, so that earnings yields and interests rates can remain in
sync."
[From 12/31/96 to the first week of August 1997, the Dow soared from
6448 to 8259, a price gain of 28%. Then, faced with a deteriorating
situation in East Asia, the Dow did retreat a bit, including a 1-1/2
day meltdown in October, winding up with a 23% price increase on the
year. And, the yield on a Treasury Bond with 4 years to maturity
fell about 6 "percent-of-a-percent" over the course of 1997. Thus,
the 12% advance in the Dow's cash earnings, along with the decrease
in bond yields, kept the yield on bonds and the cash earnings yield
on the Dow from getting too far out of sync.]
"But, what happens to all that 401(k) and IRA money going into
mutual funds? Will fund managers do the prudent thing and park some
of this money in Treasuries Bills or corporate bonds, while the band
plays on? ..... (None of them are unaware of what befell former
Magellan manager Jeff Vinik when he tried to back off the throttle.)
"Since we do not know the answer to this question, and do not know
anyone who does, we chose to remain fully invested in common stocks.
However, especially in times like these, we are making sure that the
forward cash earnings yield on our portfolio comfortably exceeds not
only the Market average, but the historical norm for interest on
Treasuries as well."
Returning to the present, we continue to stay the course in managing
our own investments -- making sure that projected cash earnings, as
a percentage of price, exceed those available on bonds of comparable
quality going out 3 to 5 years.
The problem, over the course of the coming year at least, is
that we have become increasingly skeptical about the earnings
projections themselves.
We have done some research upon the 25 DJIA stocks for which Value
Line presents both cash flow and capital spending, which excludes the
5 financial firms and retailers. In other words, we examined the
Dow's 25 industrial industrials.
Based upon this research (more of which appears at posting #1), we
find that the trailing price to cash earnings ratio on this
"DJ25" is a lofty 28.2, which implies a paltry 3.6% cash yield.
Since the (accrual basis) trailing p/e on the S&P 500 (as reported in
"Barron's") is 1.2 times greater than that of the DJIA, it may be
roughly estimated that the trailing price to cash earnings on the S&P
500 is over 33.
We are not saying that such valuations are unsustainable in a perfect
world. Instead, we are saying that it is not a perfect world.
Specifically, the situation in Asia will get worse before it gets
better. In particular, Japan, concerned about funding the retirement
of an ever growing population-cohort of retires, has been unwilling
to go deeper into national debt to restart their economy, which has
been torpid for a decade.
But, Japan must consume, rather than export, a greater proportion of
its output, if the rest of East Asia is ever to recover. Most
developing countries in Southeast Asia cannot afford to consume more
of their own output. As long as Japan is flooding export markets,
the former won't be able to export enough of their output either to
earn the currency to buy products from U.S. companies or to pay
dollar-denominated debts. Absent a surge of consumption by Japan,
these other countries will have no choice but to devalue their
currencies to increase their exports, thus aggravating their
dollar-denominated debt problems.
And, there is increasing risk that mainland China will again devalue,
which step, in 1994, led to the current crisis in much of the rest of
East Asia. China's 1994 devaluation, in turn, was in part do to its
inability to keep increasing export growth in the face of Japan's
sluggish demand for imports.
We don't agree with the doom and gloom crowd. But, we calculate the
median estimated forward 12 month growth in cash earnings on the
entire DJIA to be 14%. We just don't buy that. A mid-single-digit
earnings performance seems much more likely.
It happens that intermediate term Treasuries have dropped another 5
percent-of-a-percent since the beginning of the year, thereby
increasing the relative advantage of stocks by the same amount.
Amazingly, this puts the yield on T Bonds a few years out below that
of the overnight rate. In other words, these bond buyers are betting
that the Fed will lower the overnight rate. With unemployment at a
26 year low, that looks like a bad bet.
Even if interest rates remain this low, in combination with a 5%
increase in the Dow's earnings, it would imply only a 10% increase in
the DJIA -- if current earnings multiples are maintained. That is,
if earnings multiples that predict perfection hold up. But, 5%
annual profit growth is not perfection -- and the Dow is already up
over 8% after only 10 weeks in 1998.
Therefore, we feel it is more likely than not that this year's market
advance will be in the neighborhood of 10% -- but, that's the way we
have felt for the past three years <g>.
Today it was announced that job growth surged by 310,000 in
February, and the unemployment rate dropped to 4.6%. Intel issued an
earnings warning on Wednesday, Motorola did likewise on Thursday,
and Compaq followed suit today. It sounds to us like 1998 earnings
projections on the economy's most profitable sector might be
significantly exaggerated.
There was a time when this kind of news would have sent stock
prices down and interest rates up. Today the reverse occurred. It's
starting to feel irrationally exuberant.
Reynolds Russell
web.idirect.com
"There are no sure and easy paths to riches in Wall Street
or anywhere else." (Benjamin Graham) |
