From Business Week. "The Right Stocks For A Slowing Economy." A more optimistic outlook. Jeff
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Source: Business Week
Date: 06/26/2000
BusinessWeek Investor: MIDYEAR INVESTMENT GUIDE: The Stock Market
Author(s): MARCIA VICKERS
Document Type: Articles & General info
The Right Stocks for a Slowing Economy
Look for companies with the promise of strong future growth
With the stock market struggling to put forth positive gains so far this year, investors are likely thinking the only way to approach doubling their money by the end of 2000 is to fold it over and put it in their pocket.
It makes sense that expectations have been humbled. The Nasdaq, down 24% from its high of 5049 on Mar. 10, now posts a negative 5.4% year to date. The Dow Jones industrial average is down 7.6%, and the Standard & Poor's 500-stock index has managed to eke out a measly 0.012% so far this year. Volatility is high, and many stocks that investors thought were immune to rising interest rates--blue-chip techs in particular--have been hit hard.
To make matters worse, many bearish soothsayers predict that in a slowing economy stocks will be hurt. They argue that it will eat into corporate profits, make it more difficult for both private and public companies to get funding, and maybe even dampen productivity.
STRONG FOOTING. But don't fire your broker or cancel that E*Trade account just yet. Although it's likely that 2000 won't end up the most stellar year in the market, some bullish signs will continue to play out during the second part of this year. First, market valuations have improved, especially in growth stocks, with price-earnings ratios looking much more favorable. That's because, despite stock prices having come down, corporate profits continue to come in exceedingly strong. History is also on the side of the bulls: Since 1832, preelection and election years have produced an average aggregate two-year gain in the Dow Jones industrial average (or its pre-1896 equivalent) of 17.3%, vs. only 6% during the first two years of an administration, according to the Stock Trader's Almanac.
Technically, the market is on strong footing, with breadth improving dramatically. Since Mar. 10, when the Nasdaq hit its all-time high, 35 groups out of 107 in the S&P 500, including unlikely suspects such as footwear, food, and alcoholic beverages (are suddenly poorer Internet millionaires drowning their sorrows at all-night dance parties?) are up 20% or more. Compare that with the period from last July to the end of February, when more than half of the S&P groups were down more than 20%. ``It's the most amazing breadth statistic I've ever seen,'' says Peter Canelo, strategist at Morgan Stanley Dean Witter Co. So far this year, the S&P mid-cap 400 index is up 10.7% and the S&P small-cap 600 some 5.3%, trouncing the negligible S&P 500 gain.
A slowdown can actually be good for the stock market. For one thing, it means the Federal Reserve is less likely to keep raising interest rates. Second, although a slowing economy may dampen profits, it also takes the edge off wages. So with interest rates and wages stabilizing, corporate profits will likely stay on the fast track.
Indeed, corporate earnings are poised to grow by double digits in the last three quarters of this year. ``Any slowing in the economy won't show up in corporate profits until 2001, if then,'' says Chuck Hill, director of research at First Call, the earnings research firm. Second- and third-quarter earnings are estimated to be up 23% and 19%, respectively, over last year, according to First Call. ``It's clearly going to end up a very strong year,'' says Hill, who points out that this year's numbers are especially impressive because they even top last year's strong profits of 18%. The sectors with the strongest earnings estimates going forward: technology, energy, and basic materials.
With strong earnings and lower stock prices, price-earnings ratios have ratcheted downward. The forward p-e of the S&P 500 has fallen from 26 to 24, some 8%, since Mar. 10. And the Nasdaq composite index, trading at a forward p-e of 104, is almost 15% down from its March peak.
Still, p-e's don't tell the whole story, especially in this kind of slowing economic environment where strong future growth is a necessity. ``It's a loser's game to try to time this market. I would definitely shift to long-term thinking and buy the best growth at the best prices,'' says Mary C. Farrell, senior investment strategist at PaineWebber Group Inc.
Following this logic, a better way to look at the p-e's is to compare them with the expected growth of earnings, or what is usually referred to as PEG. Often, PEG is expressed as a ratio, where a p-e (based on estimated earnings for the current fiscal year) is divided by the estimated annual growth of earnings over the next five years. The idea is, the lower the PEG ratio, the less you are paying for future earnings. It's a good way for investors to make sure they're getting good, strong growth at a reasonable price.
LITMUS TEST. As a rule of thumb, indexes or companies with PEG ratios below 1.5 (the current PEG of the S&P 500) are considered relatively cheap, and those with PEGs above 2.25 are considered expensive. Looking at PEG, the stock market appears reasonably priced right now. The S&P 500's PEG ratio of 1.5 is its lowest level since late 1997 and 35% lower than its all-time high of 2.0 in January, 1999. That's because, although p-e's may have gone down, expected growth in many companies has accelerated. ``In a slowing economic environment there's more pressure on profits and very little pricing power, so you have to be much more selective and find companies that can deliver steady, impressive growth--that's the litmus test,'' says Farrell.
There's a caveat, however. Sometimes companies may have low PEG ratios because they're out of favor or are highly cyclical. That's why PEG is best used in conjunction with fundamental or technical analysis or to compare a company with others in its sector or even to compare a sector with the overall market. For instance, one area that looks good right now using PEG is technology and telecommunications. Although these companies traded at a 10% premium to the market during the March Nasdaq runup in terms of PEG, they are now almost on a par with the S&P 500. And the PEG of the tech and telecom segment of the S&P 500, around 1.5, is a far cry from its six-year high of 2.7 in April, 1998, according to a study by Salomon Smith Barney Inc. ``We believe this indicates that a lot of damage in tech stocks is coming to an end,'' says Jeffrey M. Warantz, an equity strategist at Salomon Smith Barney.
In fact, PEG shows that many New Economy companies, because of their strong growth forecasts, are better buys than Old Economy companies that may have lower p-e's but slower growth. An example: EMC Corp., the data-storage company, has a forward p-e of 41 vs. Coca-Cola Co.'s forward p-e of 33, but because EMC is expected to grow 31% annually over the next five years and Coke only 13%, EMC's PEG ratio is a mere 1.4 compared with Coke's 2.5.
``People are focusing more on PEG right now because they want to buy companies that have good quality earnings and sustainable growth,'' says Brian Rauscher, an investment strategist at Morgan Stanley Dean Witter.
Using PEG, Morgan Stanley Dean Witter's Canelo especially likes companies that are benefiting from a warming global economy. His picks include financials such as Citigroup, American Express, and AIG; health-care companies such as American Home Products and Pharmacia; and techs Intel and Applied Materials.
TWO BEARS? Canelo recently cut his recommended cash holding to zero from 10% and raised stocks to 80% from 75%. He maintains that we've not only seen a bottom in technology, but that we've already had two separate bear markets--first in Old Economy stocks and more recently in tech--and that the worst is behind us. He thinks the S&P will end the year around 1,650, or up some 13% from current levels, the Dow at around 11,500, or up 8%, and the Nasdaq around 4,400, up about 4%.
PaineWebber's Farrell also favors strong growth stocks, especially blue-chip techs that have been beaten down since late March. ``Information power has roughly doubled every 18 months for the last 30 years in the U.S., and the Internet could really accelerate a lot more tech growth, so in this market you still have to have some commitment to tech,'' she says.
Farrell likes Oracle, which is 6% off its 52-week high, and Cisco Systems, 19% off its high. Others picks: IBM, Hewlett-Packard, Motorola, and Gateway. She also likes some defensive plays--relatively safe stocks that are less likely to have earnings disappointments. Those include financials like AXA Financial and Bank of New York and health-care stocks such as Schering-Plough and Warner-Lambert, as well as biotech Amgen. ``It's going to be a brutally competitive economic environment, so it's a return to fundamentals,'' says Farrell. She thinks the Dow will end the year up at 12,500 and the S&P at 1,600.
So what's the best advice for the second half of 2000? Think long term, and buy the best growth at the best price possible. And if you choose wisely, you may end up with a little more money in your pocket--whether it's folded or not.
Using PEG to Pick Stocks
A good way to find companies with strong expected growth that are selling at reasonable prices is to use PEG, a comparison of a company's price-earnings ratio to its estimated annual growth rate over a five-year period. PEG is often expressed as a ratio, the p-e divided by the growth rate. The lower the ratio, the cheaper the stock relative to its growth prospects. The following stocks look good in terms of their PEG ratios.
COMPANY PEG
APACHE APA .47
APPLIED MATERIAL AMAT 1.29
BEST BUY BBY 1.26
CIGNA CI .98
CITIGROUP C 1.31
FEDERAL EXPRESS FDX 1.21
GTE GTE 1.43
TARGET GROUP TGT 1.21
TEXACO TX 1.37
UNITED HEALTH GROUP UNH 1.12
DATA: MORGAN STANLEY DEAN WITTER
FOR THE RECORD
Senior investment strategist Mary Farrell of PaineWebber is the author of the recent investing book Mary Farrells Beyond the Basics...
ON TECHNOLOGY STOCKS
The tech arena is definitely the one place to be. We're not going back to the Old Economy. But I think its crucially important to own tech stocks that have earnings. It may be a new economy, but we havent repealed the old laws of valuation.
ON THE ECONOMY
The economy will continue expanding. We now have more muted business cycles that get much more extended. Indeed, we've had only one recession since 1981, and it was very mild by post-WWII standards, so there's no reason to think that this expansion can't continue. Still, I do think it's a maturing expansion that's showing signs of slowing.
ON GROWTH VS. VALUE INVESTING
I would argue that the best value in the market remains growth. Yes, there are many cheap stocks, particularly Old Economy stocks. But I would rather pay a premium for growth than own a stock just because it's cheap.
ON INTEREST RATES
The chances of another interest-rate hike have been reduced significantly by the most recent economic reports, which really are confirming that this is a slowing economy.
Copyright ¸ 2000 by The McGraw-Hill Companies, Inc.
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