Economics Group
Research
G. David Orr
Chief Capital Markets Economist
The Generals Finally Follow The Troops
Yesterday's dive of 300 points on the Dow Jones Average and 40 points on the S&P 500 finally began to bring the popular averages more back in line with the average stock performance during the past several months. The Russell 2000 had declined by 6% from its April high by July 17, when the Dow was making a new high at 9338 -up 18% YTD. The Russell Index is now down 18% from its high, whereas the Dow and S&P have finally pulled back 9%. Prior to this slide, just five stocks had accounted for 25% of the gain in the S&P 500 during 1998.
We are not the people to get your stock market advice from. Don Hays is the chief market strategist for Wheat First Union and has been right on recently, raising both the caution flag and his recommended cash position while many market gurus were going in the opposite direction.
What we can add to the mix is the view that this decline is primarily a stock market event, not an economic event. Yes, there are earnings uncertainties due to Asia and to the wage/price squeeze on profits. Since last fall, we have steadfastly forecast 5.5% earnings growth in 1998 - in marked contrast to the double digit gains of the past several years and the double digit expectations of many market analysts.
One of the forces now at work is an adjustment by the popular averages to the reality of lower earnings expectations. In that sense, this correction is a healthy phenomenon. It's not that something is wrong with the stock market now - what was wrong was the prior explosion in the prices of the popular high capitalization stocks, which ignored the stresses developing in profit growth. The quicker those high cap "darlings" get their P/E ratios back into some semblance of alignment with their sales and earnings growth, the better for all concerned. Warren Buffet should be a happy camper - his annual report revealed that he prefers it when stock prices decline to valuation levels that make him want to buy.
When we say the market decline is not an economic event, what we mean is that protracted bear markets are driven by interest rates as well as by earnings (and expectations). The interest rate level and trend is an important component of the P/E ratio. Since the Federal Reserve is not likely to raise interest rates this year, the deterioration in P/E's should be limited to the degree of "expectations overvaluation". We don't expect the Fed to lower interest rates either, however, and since bond market yields have not declined since June, interest rates have become a "neutral" factor - in contrast to the steady decline from 8%+ bond yields in late 1994.
Also, protracted bear markets have been associated primarily with 15%-20% declines in corporate profits, whereas corrections (no matter how nasty) are more associated with shortfalls in earnings growth relative to expectations. There are clearly sectors of the stock market that are in the process of experiencing 15%-20% (or more) earnings declines, and their stocks should reflect that. But the broad cross-section of companies in retail, construction, services, finance, communications, etc., still have decent, if no longer spectacular, earnings increases.
What we would emphasize is that expectations about what kind of returns the stock market could consistently deliver had outrun the ability of the economy to deliver. Since the start of 1995, the Dow had risen 144%, or a 28% annual compound rate, by the time of its recent high in July. Over the long term, profits cannot rise too much more than nominal GDP. So if nominal GDP increases 5% per year, improved productivity and foreign sales could put profits up 7%-8%. Then add 2%-3% for dividends and you get the approximately 10% long term return that most sober veterans know is the bogey for annual stock gains.
The sooner expectations revert to that 10% long term annual increase rather than the 20%-30% mania that has prevailed since 1995, the more solid the footing of the stock market will become. Meanwhile, there are now hundreds of very solid small to mid-size companies whose stocks are selling at very reasonable valuations, and worthy of investment consideration.
As we mentioned, we will leave the market timing calls to Don Hays, who is still very cautious. So now is probably not the time to jump back in with both feet. Do remember, however, that in Alan Greenspan's answer to a follow-up question about what would happen if the stock market experienced a severe decline, he said that in recent years, those who had used the periodic corrections as buying opportunities had been rewarded. He is not bearish on the economy.
August 5, 1998
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