From Prudential
Why I Think The U.S. Equity Market Offers Compelling Values Edward Keon, Jr.
Like this wandering quantitative analyst, returning from a marketing trip to Japan last week,
this article will run far afield of my usual topics. If it's too peripatetic, please excuse it as a
consequence of jet lag, compounded by a 3% drop in the U.S. market during my flight back
from Tokyo.
The Newspapers Seemed Particularly Full Of Nonsense This Weekend… An excellent reporter
for The New York Times ended her piece this weekend with the comment, “He [Fed Chairman
Alan Greenspan] wants to protect the nation from the ravages of inflation, but also wants
investors to party on. Trouble is, even the mighty Mr. Greenspan can't have it both ways.” Are we
geeky quants the only ones who look at data? Low inflation and a strong stock market, far from
being inherently incompatible, are almost always found together. Ibbotson and Brinson looked at
data going back to 1790 to show that the best equity returns came during periods of low
inflation/deflation and the worst returns came during periods of high inflation. No reading of the
historical data could possibly support the notion that a strong stock market causes inflation.
…Especially On The Alleged Tradeoff Between Growth And Inflation. Similarly, many
commentators seem to accept the notion that strong economic growth must inevitably cause
higher inflation. In my 1999 report Long-Term Equity Returns (LTER), I outlined a much more
plausible reading of the historical record.*
Stable Prices Lead To Higher Economic Growth… The sign and the causality of
conventional wisdom are wrong, in my view. Strong economic growth does not cause inflation;
rather stable prices create a business environment favorable to growth. Stable prices lead to
better decision-making, more confident investment, and less time wasted on manipulating
inventories and cash flows to create paper profits.
…Unless There Are Clear Economic Policy Errors… The only time in post-WWII U.S.
economic history that high growth appeared to lead to inflation was in the later 1960s. But it
seems to me that this was clearly due to President Johnson's desire to expand the Vietnam War
without raising taxes to pay for it. As a result, the U.S. had highly stimulative fiscal policy at a
time of genuine capacity constraints.
…But Economic Policies Of Today Seem Quite Sound… But today we have high surpluses
and restrictive fiscal policy, combined with high real interest rates, plus the world has changed
much, with tighter inventory controls and a global economy to supply scarce goods. (Wasn't it
just about a year ago that the worry du jour was global deflation caused by excess production
capacity?) In the U.S., we have had higher growth than conventional forecasters thought
possible for several years, especially the last two. The notion that there is a maximum rate at
which the economy can grow without igniting inflation is just a theory, not an established fact.
And conventional thinkers a few years ago held the opinion that unemployment could not go
below 6% without igniting high inflation. Unemployment is now close to 4%, and little
inflation is in sight.
…Led By Chairman Greenspan. As chairman of the Federal Reserve, Alan Greenspan has
shown that he is not a conventional thinker. He let the economy run in the 1990s when some
urged him to slow it down. He has beautifully fulfilled the statutory mission of the Fed—to
promote price stability and growth. I find it hard to believe that the chairman's remarks last
week could be interpreted by some as meaning that he “will raise rates until the stock market
goes down.” The Fed funds rate may rise 50-100 basis points; we'll see. But the objective will
not, in my view, be to wreck the stock market or the economy, but to extend this terrific
expansion. I continue to believe that the economy is clever enough to continue this expansion
with low inflation and solid profit growth, despite low unemployment.
In my view, sharply higher rates are unnecessary. If not having enough workers is the biggest
economic problem facing the U.S., wouldn't it make more sense to increase immigration than
to throw existing U.S. workers off their jobs to control inflation? Why not preserve the great
growth that is making Americans richer and provide supply of goods by importing workers to
make them? But the Fed Chairman has earned the trust of people worldwide; who am I to
argue?
I Strongly Believe That Inflation Will Remain Tame… It still looks to me as if powerful, long-lasting
forces besides interest rates are keeping inflation in check: technology-enabled
productivity growth, the price decrease and quality increase of technology stuff, price discovery
via the Internet, cost savings via the Internet, and global competition. Add to that a stronger
dollar, tight fiscal and monetary policies, and my guess that oil prices may be near a peak, and
it looks to me as though Greg Smith has it right: that as 2000 unfolds, the surprise may be that
inflation is significantly lower than expected. And if inflation turns out to be low as we expect,
that will almost undoubtedly be excellent news for the equity market.
…And The Equity Market Remains The Place To Look For Long-Term Gains. I've compiled data
supporting my contention that this market offers compelling values. I created a large-cap
universe consisting of all stocks in the S&P 500, the Russell 1000, and stocks with a market
cap over $1.6 billion (as I recently wrote, I think the market-cap cutoff for the Russell 1000's
rebalancing this June will be about $1.6 billion. I eliminated stocks without a FY1 forecast
from I/B/E/S International, ADRs, and a few others to arrive at a list of 1,095 names.
I suggest that this list offers a delightful smorgasbord to investors, with a range of industries,
valuations, and growth prospects to satisfy any craving.
n Except for REITs (with 21 names), all of the macroeconomic sectors offer at least 37 names,
so there are plenty of opportunities for sectoral diversification.
n One hundred and twenty-six stocks have either a negative P/E or a forward-12-months
expected P/E of over 100. Nearly all of these stocks are in the wireless, biotechnology, or
Internet industries. Surely these stocks are full of risk, but just as surely they are deeply
involved in some of the most exciting and fastest-growing areas of the U.S. and world
economies.
n But half the list, 547 names, consists of stocks with a forward P/E below 15x. Of these, 320
have a P/E below 10x. Looking for value? Half the stocks in this large-cap universe have a P/E
near or below the long-term stock market average valuation of about 15 times trailing earnings.
A glance at the lowest valuations shows that the Fed has clearly had an impact: Absent the
tobacco companies, the low-P/E stocks are heavy with interest-rate and economic-cycle-sensitive
stocks in home building, auto parts, airlines, retailing, and REITs.
n Technology dominates the overall list, as 250 names are classified as belonging in the PSI
technology sector, constituting 35.3% of this universe's market cap. Yet this actually
understates the case, since biotech is generally classified under health care and many wireless
firms are considered utilities or business services. I guess that the total tech influence is about
300 firms, roughly 40% of the market cap.
n The median forward P/E is 44.4x for technology and 12.1 times for the rest of the market.
n A third of the stocks, 372, started trading in the 1990s. Those newcomers have a P/E of
49.8 times expected 2000 earnings compared with 24 times for the rest of the list.
The New Guys And Gals In Town Have Clearly Made A Big Impression. The S&P 500 sells for
about 23 times 12-month forward earnings. My erstwhile colleagues at I/B/E/S provided the
following estimates: The U.K. market sells for 18.1x, the French for 26.1x, the German for
30.6x, and the Japanese for 43.8x. Valuations are not directly comparable across countries
because of accounting-standard differences, with the U.K. considered the most liberal and
Japan much more conservative. But also remember that these markets are not nearly as tech-heavy
as the U.S. and do not have nearly the exposure to global tech growth. My guess is thatU.S. nontech stocks are generally much cheaper than their global equivalents, and U.S. tech
stocks have much better growth prospects than non-U.S. tech stocks.
Home Is Where The Portfolio Is… Maybe it's just the home cooking, but it looks to me as if
the U.S. equity market offers compelling values. The market offers growth stocks with
incredibly bright prospects and value stocks that are selling at prices far below comparable
quality companies worldwide. Many stocks are so cheap, they could go private and easily
service the debt incurred in buying out the public shareholders. We may see more such deals,
or more cross-border acquisitions, or more examples of expensive stocks using their currency to
buy compatible cheap stocks (a la AOL-TWX).
…And A Strong 2000 Portfolio May Blend Mega Growth And Purer Value. For portfolio
managers, it looks to me as though a strategy of blending the cheapest of the cheap with the
fastest growers may be a winning game plan. I'll offer some specific portfolio construction ideas
along these lines over the next few weeks.
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