Good Times Roll On
JANUARY 3, 2000
Barrons
By Lauren R. Rublin
All things must pass: years, decades, centuries, even millennia, although the last tend to take their sweet time saying good-bye. The bull market, on the other hand, has been granted an exemption, or so stocks' fevered rise in recent weeks suggests. Someday, we've a hunch, the long-running party in U.S. equities will wind to a melancholy close, but it won't be anytime soon, if Wall Street's seers have read the tea leaves correctly. In other words, it will take a lot more than a new moon or a fresh page on the calendar to drive this awesome beast into the ground.
Consider all that the current bull market, now 17 years young, has survived just in the past five years. A global financial crisis. Foreign currency meltdowns. Derivatives disasters. Political scandals. Earnings woes. Antitrust lawsuits. The ubiquity of words like "paradigm." To be sure, the market has stubbed its toe (or should we say hoof?) upon more than one frightful occasion. And some stocks, even whole sectors (think utilities), remain peculiarly immune to the great good fortune that has swept up so many issues and issuers, dot.com and otherwise.
But when all is said, done, tabulated and toasted in time-honored yearend fashion, there's much to celebrate. For openers, there's 1999. Buoyed by gains in technology and commodities stocks alike, the Dow Jones Industrial Average rang out the year with its fifth consecutive double-digit annual increase -- a 25.2% advance, to a record 11,497.12. The broader S&P 500 likewise made it five for five, rising 19.5% to 1469.25, also an all-time high. The Nasdaq Composite topped them all by a very wide mile, however, leaping 85.6% to 4069.30 on a blistering rally in technology shares.
In the past five years, the Dow has gained 197% and the S&P 219%. But the Nasdaq has shot up an astonishing 907%, testimony to the ascendancy of technology in our economy and our lives (and, more recently, to the boiling over of speculative juices among U.S. investors). The tech-laden Nasdaq 100, comprised of the Composites's 100 largest issues, has averaged a one percentage point gain per week since 1994, says Douglas Cliggott, market strategist at J.P. Morgan.
Behind all the exclamatory headlines, a darker truth prevailed in '99. As the tables nearby soberly attest, more stocks fell than rose last year, presumably signaling higher interest rates and a concomitant slowdown in the U.S. economy. Yet Wall Street's pros, for the most part, remain remarkably sanguine about the year ahead. Most believe stocks will rise at least another 10% this year, in line with expected growth in S&P 500 operating profits, even as the Federal Reserve lifts interest rates to keep the economy from overheating. But the rate hikes "won't matter," says PaineWebber's Edward Kerschner. "They only matter when the Fed tightens enough to throw the economy into recession, and it's hard to see a 2001 recession scenario out there."
Heck, why stop with 2001? Stuart Freeman of A.G. Edwards already sees the outlines of Dow 19,000-20,000 at the end of 2003. And Kerschner, a longtime bull whose record is among the best around, sees Dow 25,000 in 2010. "This is not Herculean growth, but 7% compounded annually," he says.
The rosy consensus for 2000, at any rate, derives from the widespread belief that prevailing conditions will remain in force: that the U.S. economy will continue to grow at a sustained and healthy pace, but that powerful global deflationary trends will keep wholesale and retail prices in check, thus curbing the need for dramatic rate increases. Just the same, few market watchers expect Treasury bond yields to drop back below 6%, which means corporate earnings will have to do the heavy lifting, as they did in 1999, if stocks are to advance.
Chart:
What The Experts See For 2000
But there's good news on that score as well, maintains Bear Stearns strategist Elizabeth Mackay. "In 2000 the global economic recovery becomes the synchronized global expansion, which argues for another year of strong earnings growth," she says.
Coming into '99, forecasters were split almost evenly between those who saw an earnings recession and those who anticipated low- to mid-single-digit profit growth. But earnings for many S&P companies began to pick up smartly in the spring, notes Thomas Galvin, Donaldson Lufkin & Jenrette's chief market minder. All told, operating profits likely rose 12%-13% for the full year, he says.
Galvin made a comparatively daring call at the end of 1998, predicting 12% profit growth and a yearend Dow of 11,000 in '99. Later he embellished this view, asserting the year would end with a "millennial melt-up" that would lift the key indexes to successive highs. This year he remains a committed bull, predicting the Dow will hit 12,000 by the end of March and 13,000 by December's close. Bond yields will end the year around 6%, he says, while earnings will rise by about 13% in both 2000 and 2001.
The third quarter of 1998 represented the bottom for most global economies, Galvin says. Now, by his reckoning, a multiyear cyclical profit recovery has begun. "In the past few years, U.S. corporate earnings derived from restructuring and reengineering endeavors," he explains. "In the next three years, profit gains will stem from unit growth, which in turn will be a function of global economic health. A third of S&P profits come from non-U.S. sources, which were dormant and now are recovering."
At the same time, Galvin sees little reason for the Fed to raise rates substantially. Oil and wholesale prices peaked in '99's fourth quarter, and a third of the components of the consumer price index are deflating, he says. The ride up from here might get a little bumpy at times, "but I'd have to be wrong about oil, inflation and ongoing gains in productivity to see a market decline of 20% or more, given that many stocks already are in a bear market," he says.
Like most strategists, Goldman Sachs' U.S. equity strategist, Abby Joseph Cohen, came up notably short in her initial Dow forecast (9850) for 1999. Her team was too timid, as well, in eyeballing 5%-7% S&P profit growth, while the firm's economics department was far off the mark in predicting bond yields would end the year around 5%. Instead they finished Friday at 6.48%. But Cohen correctly foresaw that interest rates wouldn't play much of a role in setting the market's overall course, which would enable price/earnings multiples to remain relatively unchanged. In fact, the S&P bowed out the year with a lofty P/E of 33.4 times reported earnings for the past 12 months, just a bit above last year's P/E of 32.3.
More important, Cohen once again earned accolades by urging clients to stay the course even through last fall's darkest hours. And in August she revised her previous targets, saying the Dow would reach 11,500 by yearend. This year she thinks the market is starting at fair value. "Consequently, we think it is an up year, but we don't think it's a fabulous year," she says.
Absent a valuation "tailwind," stocks probably can rise to an extent commensurate with earnings growth of about 8%. Cohen's Dow forecast of 12,300 is, as always, "an achievable target," not an absolute marker. "It's our way of saying we're using sensible assumptions," she says.
To be fair, not everyone has hopped aboard the bullish bandwagon for 2000, much less the years beyond. Doug Cliggott of J.P. Morgan sees the Dow falling to 10,200 and the S&P sliding to 1300 by December's end, as rising rates and a tech-sector shakeout clip the averages' ascent. This year, he says, the market will correct the excesses of 1999.
Byron Wien, Morgan Stanley's U.S. strategist, predicts a "serious disturbance" and a year of "exceptional" volatility, albeit one that will deposit the Dow comfortably above 12,000 by December's final bell. Yet neither man sees a bear market in the offing, thanks to the Fed's continued restraint and solid earnings growth.
Bear in mind that Wall Street's fabled pundits have a dubious track record, although it's largely pleasantly so. Even the most bullish repeatedly have underestimated investors' tenacity, and the strength of the averages, in the years since 1994. Is a faulty telescope to blame, or is it lack of nerve?
Last year most market watchers, including most economists, completely missed the economy's fantastic strength, in large part because they missed the magnitude of the market's advance. Accordingly, they expected low interest rates to provide further fuel for the rally, even if earnings didn't perk up much after a flat showing in '98. Instead, yields climbed 25% from trough to peak, as an anxious Fed, in a preemptive strike at inflation, reversed the three rate cuts of the previous year. That corporate earnings rebounded with gusto is just part of the playbook, however. Who, in truth, could have foretold the year's grand finale: an explosive run-up in both popular and obscure technology stocks? In December alone, the techfest drove the Nasdaq up 22%, while adding billions upon billions of dollars to the market values of Cisco, Lucent, Yahoo and scores of other concerns.
As Byron Wien sees it, "The biggest idea of the year is that macro didn't matter. If I had told you at the beginning of 1999 that the long bond would end the year at 6.4%, that inflation would sort of be coming back, and that the price of oil would be $25 a barrel [more than double its earlier lows], you would have assumed it would be a tough year for equities."
And you would have been dead right -- and wrong. If you got the earnings picture right, chances are you would have avoided minefields like Maytag, Bank One and Xerox. But if you got the tech story right and joined the crowd piling into steaming Internet issues, you would have made a ton of money, at least on paper.
Greater in number, and gargantuan in size, tech stocks today also called the tune in the S&P 500, accounting for an unprecedented 25%-30% of the value of this capitalization-weighted index. Such is their outsized influence that without its tech components, the S&P would have ended the year with a loss of 1%.
What set off this tidal wave of buying? J.P. Morgan's Cliggott fingers "two dynamics that have been working independently, but that really came together at the end of the year." The first, he says, is a dramatic shift in "risk preference," which led investors to forsake conservative holdings for far more speculative stuff.
One way to measure the change in sentiment is through net changes in mutual-fund cash flows. In prior years, notes Cliggott, net inflows into growth funds and income funds were running just about even. But in '99 income funds garnered virtually no net new cash. Among growth funds, meanwhile, net inflows into techsector funds essentially had been rounding errors for the past four years. Then, last year, the blossoming of the Internet and a red-hot IPO market suddenly made these funds a magnet for cash. By the fourth quarter, Cliggott says, net inflows into tech funds were running at double the rate of flows into large-cap index funds.
The second factor in the so-called melt-up, he believes, was rapid growth in the nation's money supply. Even though the Fed had begun to lean against the wind in June, when it first raised short-term rates, by November even narrow measures of money were growing at an annualized rate of 11.5%. "It's just an assertion," Cliggott says, "but since so much of the world now runs on dollars, the Fed has been feeding the global financial system very aggressively." Concerns about Y2K-related disruptions have also prompted the central bank to increase liquidity.
What happens next is anyone's guess, but much depends on how the Fed decides to play its hand. "When has the monetary base grown faster than 10%?" Cliggott asks rhetorically. "There was late '86-early '87, and 1993-94. In both instances, as soon as the Fed started tightening -- in April '87 and in February '94 -- growth in the money supply slowed significantly. Nineteen-eighty-seven and 1994 were two of the roughest years for stocks."
Even if the Fed stands pat in February, it's unlikely that the Christmas rally will continue well into the new year, at least at its current breakneck pace. For one thing, as Abby Cohen and others have pointed out, some of the extraordinary performance disparity between tech and nontech issues is, well, technical -- relating both to year-end window dressing and sundry tax concerns. So what else is new? Professional and individual investors alike historically have let their winners run while dumping their losers at the end of each calendar year. "It's one reason we think you'll start to see some lesser-performing sectors do better at the start of 2000," Cohen says. "At the top of our list are banks and insurance stocks."
Yet there's far more to the tech-versus-nontech split than simple timing and tax planning. What can it mean when the market's most prominent sector boasts nirvana-like multiples, not just of earnings but sales, while much else trades at recession-level P/Es? The divergence lies at the heart of the old economy/new economy debate, which has consumed much of Wall Street -- and increasingly Main Street -- for the past few years. And if, perchance, the new high-growth/low-inflation tech-based economy is the real one, and not just something we've thrown on until the old one comes back from the cleaners, how do we analyze it?
Richard Bernstein, chief of quantitative research at Merrill Lynch, admits that 1999 left him sorely perplexed. "The big shock for me was that the market ignored fundamentals in favor of speculation," he says. But which fundamentals? And when it comes to Internet issues, is there any difference?
Qualcomm, a provider of digital wireless communications products and services, provides a telling example. Wednesday the stock rocketed 153 points, to $656 a share, after a brokerage analyst set a 12-month price target of $1,000 on the shares. That target, he noted, represented 175 times his profit estimate, and 55 times his sales estimate, for 2001. Currently 18% of all digital phones use Qualcomm's technology. That proportion will climb to 85% by the end of the decade, the analyst said. Fundamentals? Speculation? Lunacy?
The Internet frenzy, the nosebleed valuations, the seeming contempt for traditional measures of value clearly unnerved some of Wall Street's best and brightest. "All the traditional value tools didn't work," says Wien. "It was better to study sociology than statistics. Portfolio managers kept buying what was working regardless of price."
Todd Petzel, chief investment officer of the Common Fund, which invests endowment monies for scores of universities and other educational institutions, ruefully concurs. "Those of us who continue to have long-term investment horizons are being measured by the shortest of standards," he says.
Then there's Greg Smith, Prudential Securities' equity strategist, who moans that "no one seems to care" about earnings and balance sheets anymore. "I can tell you there is a major soul-searching going on in the investment industry," he says.
Smith believes he fell for the precept that investors grow more defensive with age. "Boy, did I get that wrong!" he exclaims. "A 64-year-old man now has a life expectancy of 15-17 years. He's no longer a defensive investor because he's not going to die in five years. He's got as much of a reason to be optimistic as a guy who's 45." Conclusion: Demographics matter, so long as you study the right ones.
To understand today's market, he now believes, it is just as important to recognize the powerful role of the individual investor. "The individual is the new gorilla in the market, but he plays by different rules," Smith says. "Individuals today are concept investors. They identify trends and products and they buy the stocks."
Frankly, that sounds a lot like Peter Lynch, fabled skipper of the Fidelity Magellan fund in the 1980s. And it goes a long way toward explaining, if not excusing, why investors in the late 'Nineties routinely pay sky-high prices for stocks such as Nokia, America Online and Home Depot.
A year ago, as 1998 was laid fitfully to rest, tout Wall Street was abuzz with talk of two bizarre occurrences: the seemingly imminent demise of the scandal-wracked Clinton Presidency, and the recent debut of a handful of supersonic IPOs with funny names ending in "dot.com." Lesson: Never underestimate the power of time to transform the extraordinary into the more extraordinary. Bill Clinton's still busy in the Oval Office (presumably alone); his wife has become a New Yorker (with Jewish roots, no less!), and Monica Lewinsky, the young woman once at the scandal's center, has become a promoter for the La Jolla, California, diet concern Jenny Craig, a P/E-challenged new-economy stock if ever there was one. Last week it soared 125%, to the precincts of $4.50. Just like that.
Meanwhile, higher up the California coast, a fresh crop of dot.coms is lining up to tap the public till in the first months of the new year. Will the stock market still be hospitable to such innocent babes, or for that matter, their grizzled elders? No, and yes, advise some seasoned observers.
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Tables: Who Rules the S&P | Five Fabulous Years
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"There isn't much history to go on about the end of a millennium," Greg Smith wryly observes. "Calendars weren't unified a thousand years ago, and some people didn't get the news that the new millennium had started until 50 or 60 years later."
Let the record show, however, that the 19th century was ushered out with a burst of optimism. And history likely will repeat. "Expect an undercurrent of relief that we survived a Y2K computer catastrophe," says Smith. "Companies probably will proclaim it in their ad budgets, and consumers might feel a little giddy. Investors who put away extra cash in anticipation of problems will have fat wallets, which could unleash a great impulse buying boom."
On Wall Street, of course, the boom is well under way. Cash measures no longer show big sidelined reserves, says Bear Stearns' Liz Mackay. Yet a rude awakening could await investors as the next planned get-together of the Fed's policymakers nears. Mackay's betting that Alan Greenspan & Co. will tighten credit in February, and that financial markets will recoil. "Last year's rate hikes merely took back three easings in the wake of the financial crisis of '98," she states. "I wonder if this time it won't be four steps and a stumble."
Jeffrey Applegate, Lehman Brothers' chief strategist, seconds the nasty notion. He's looking for a half-percentage-point tightening in the first half of the year, which might prompt a 10% stock-market correction. Assuming economic growth slows to under 4%, investors then will begin to refocus on the strength of corporate earnings, which in his view ought to help drive the Dow up to 12,750 by December's end.
In '98 and again in '99, the S&P 500's tech-stock components collectively returned more than 70%, trouncing the index's 10 other sectors by a Godzilla-sized margin. Will the techs reign supreme again in 2000? Absolutely, most strategists say, given the huge growth potential of many software and Internet concerns. What's more, demand for U.S. technology is likely to rise significantly in both Europe and Japan. "Japanese spending on information technology has been a very small percentage of that nation's GDP, so they're in a catch-up phase," says Sheila Coco, chairwoman of the global investment committee of New York's Fiduciary Trust. "The same is true in Europe. The 'Net is really taking off there now."
Just don't expect this year and last to be parallel adventures. In 2000, most market mavens wager, investors will begin to discriminate more aggressively between technology's winners and losers. An "outbreak of Darwinism," in Tom Galvin's words, is apt to change the dot.com landscape quickly, as some e-tailers find themselves shelved after a disappointing Christmas season. But investors' high hopes for business-to-business e-commerce, or "B2B" in current parlance, are likely to be rewarded.
Though skeptical about the consumer e-commerce bubble -- yes, they even call it a bubble -- many market watchers remain big fans of Internet "backbone" plays: companies such as Cisco, Lucent, Motorola and JDS Uniphase, whose products support the 'Net's infrastructure and broadband requirements. But at least one observer, J.P. Morgan's Doug Cliggott, strikes a note of caution about "old stalwarts" such as Microsoft, Intel and Dell.
Right or wrong, Cliggott has hit on some interesting issues. Corporate Y2K-preparedness, he notes, has led to hyper growth in the desktop computer business. Consequently, desktop spending presumably will be lower down on the list when companies set their tech priorities for 2000. "Instead, we'll see dramatic growth in networking, optical networking and bandwidth investments," he says.
Down the road, though, Cliggott sees a more fundamental conflict between "the new technology and the old thing." Supercharged PCs, he says, are all about "intelligence residing on the desktop." The Internet, in contrast, is about pulling intelligence back onto the network. "Three years from now, I don't think we'll have both," he muses.
Second only to questions about the proximate course of tech stocks is mass confusion about the fate of the rest of the market. The majority of stocks, as noted, spent much of '99 in the time-out chair. Only two other S&P sectors managed to match or beat the performance of the index: basic materials and capital goods. The S&P Transports and Utilities each toppled 13%; bank stocks were down an average 10%-15%; food stocks were off about 30% and shares of homebuilders retreated almost 40%. True enough, the small-cap Russell 2000 ended the year up 19.6%, outperforming the S&P by a whisker, but many smaller issues remain in the market's cellar. Some bull market.
And now? Folks like Marshall Acuff of Salomon Smith Barney believe the stock market's split personality will follow it into the new year. "The fundamental reason for the market's narrow success is that most of the great productivity gains have come in the General Electrics of the world, not in smaller companies," he says. "What broadens the market is inflation. If the typical company had a New Year's wish it would wish for more pricing flexibility. But that won't happen, because of the deflationary effects of the Internet, and the vigilance of the Fed and bond market."
Not so fast, counter other observers, who see rekindled hope for many of last year's rejects. Abby Cohen praises the prospects for selected paper and chemicals stocks, beneficiaries both of accelerated global economic growth. Liz Mackay also is bullish on cyclicals, which enjoyed a heady rally last spring. Alcoa, she notes, has been popping up on the new-highs list lately, and Bear Stearns' metals analyst recently raised his estimates for aluminum prices.
What, if anything, could derail the bull market for more than a quarter or two? Natural disasters, of course, and catastrophic events, including a Y2K calamity, although you can probably toss the last from the list if you're reading these words in the glow of an electric bulb. Runaway inflation and interest rates quickly would do the dirty deed, but as they say someplace or other, you can't get there from here. Few investors, at this early date, think the November elections will sound the bell for stocks, although a one-party sweep of the White House and Congress likely won't make Wall Street happy. The citizenry has gotten quite comfortable with divided government, says Liz Mackay. "It's a great insurance policy against sweeping change."
Now, if Mr. Greenspan were to take early retirement ... Oh, perish the thought!
And one more thing: Happy new year.
Fast Forward
Today it's dot.com this, Internet that. What in the world will investors -- and market seers -- be talking about a year from now? We put the question to a handful of market pros, and got an earful (excerpts below). What's your bet? Kindly e-mail us at Editors@barrons.com. (Please include your hometown and state.)
Ed Kerschner (PaineWebber):
"People will be talking about how overdue we are for a recession. We will have passed what previously was the longest stretch in U.S. history without one. Have we really muted the business cycle? We've been arguing for a half-dozen years that that's the case."
Jeff Applegate (Lehman Brothers):
"We'll be talking about what changes, if any, are likely to occur in fiscal policy after the November elections. Will the government be using the surpluses diverted from paying down the debt to pay for tax cuts under President Bush or spending increases under President Bradley? Also, there will be near-astonishment that we will be coming up on the tenth year of an economic expansion with no sign that we're late in the cycle."
Todd Petzel (The Common Fund):
"People will be talking about the makeup of the Congress, and how that will effect the economy in 2001. The market will be spooked if the same party wins the White House and majorities in the House and Senate. Investors have learned that they tend to lose when the politicians are all of the same party."
Liz Mackay (Bear Stearns):
"There will be a lot more excitement about economic growth in Europe. Many service companies stand to benefit from earnings growth generated in Europe, and U.S. advertising agencies are among the best positioned in that regard."
Tom Galvin (Donaldson Lufkin & Jenrette):
"A global synchronized recovery makes people paranoid. They'll worry that the days of high growth and low inflation are over."
Doug Cliggott (J.P. Morgan):
"We'll be talking about 7% Treasury yields."
Byron Wien (Morgan Stanley Dean Witter):
"At the end of the year people probably will be talking about how much more difficult this business has gotten. In 1999 it was easy to be in the wrong place, but it was easy to figure out where the right place was. By the end of 2000, even the right place will be pretty dangerous." |
