The Daily Interview: Bull Vs. Bear Face-Off
By Diane Hess
Staff Reporter
3/2/01 2:35 PM ET
If you were looking to get two more different perspectives on the market, chances are you couldn't do much better than talking to Charlie Reinhard, the senior U.S. investment strategist for Lehman Brothers, and Doug Cliggott, the chief equity strategist for J.P. Morgan.
Whereas Reinhard sees the market rebounding in the second quarter due to rate cuts and opportunities in tech and financial stocks, Cliggott feels that slowing earnings will be a drag on the market for the foreseeable future and that tech and financials present the greatest risk to investors.
We spoke with both of them recently, posing the same questions about their outlook and views on the market to each. Here's what they said.
TSC: Make your best case for the bulls over the next six months.
Charlie Reinhard: As the market tries to stare you down and scare you down, don't let it wear you down. We think that there's light at the end of the tunnel very soon.
Historically, the S&P 500 bottoms about two and a half to three months after the Federal Reserve cuts interest rates, which [in this case] means March. Economic momentum usually troughs five months following the S&P's trough, and earnings momentum tends to come back eight months afterwards. So the normal course of events is for the market to turn up, even before we see an improvement in the economy or in earnings.
Analysts historically downgrade their earnings estimates even after the market rebounds, so people might not see the visible signs of a pickup in the economy or in earnings. But the things that will enable the market to move higher are the Fed ease and valuations.
When the Federal Reserve lowers interest rates, it lowers the cost of capital, which increases the present value of future earnings. We think the fed funds rate will be 5%, by the next Federal Open Market Committee meeting, and 4% by the end of the Jun. 27 meeting.
A year ago, we had an overvalued market. When 2000 began, the S&P 500 was about 20% overvalued. Our model suggests that we're now 17% undervalued. So, we think that the combination of attractive valuation and a Fed ease of interest rates will be what turns the market around and, incidentally, is what normally turns it around.
TSC: Make your best case for the bears over the next six months.
Doug Cliggott: What made us come into the year maintaining a very cautious viewpoint was a concern that earnings were going to come in pretty far below consensus expectations. If anything, in the first two months of the year, we're even more worried about the earnings trend in the U.S. than we were three or four months ago.
So far this year, we've lowered our guess at S&P earnings per share growth to minus 11%. We had predicted 0% EPS growth. Our thinking is that if we're wrong on minus 11%, we might be too optimistic. I think that's why we've still got a pretty cautious view toward the broader market. On the other side of things, when we've seen that we've had bad earnings but the market's done OK, the key then has usually been that we've had a strong bond rally.
But even the strength of the bond rally, should it continue to keep on running this year, and it could happen, is not something on which we would want to base an investment strategy. If we assume that bond yields finish the year around where they are now, it's tough for us to get excited about stocks yet.
TSC: What are your targets for the market?
Charlie Reinhard: We make a one-year forecast, which is for the S&P 500 to finish the year at 1600. We took our target down from 1675 to 1600 last week, which is not say that we aren't constructive on the market. We're so constructive on the market. We just think that 1675 is unrealistic right now.
Similarly, we took down our 2001 Dow Jones Industrial Average target at the same time last week from 13,000 to 12,500. We don't make forecasts for the Nasdaq Composite Index; it just has too many stocks.
We anticipate a normal rebound from a correction low. We're about 19% below the high close on the S&P 500. The typical soft-landing correction has been 18%. The mean correction during hard landings has been 24%. The mean one-year rebound from soft landings is 31%, which gets you to right around 1600 from today's levels. So, if we just see the average type of behavior, it's going to be a good year.
Doug Cliggott: We came into the year with an end of June 2001 target of 2000 for the Nasdaq and 1300 for S&P. We thought we would finish the year on a strong note, so we predicted year-end 2001 targets of 2500 for the Nasdaq and 1400 for the S&P.
We haven't formally revised those targets, but in our eyes the risk in those numbers is to the downside. Before we revise the numbers, however, we want to get a look at first-quarter earnings. But if I had to guess where might the Nasdaq bottom, I would be surprised if it bottomed above the 1500 or 1600 level.
TSC: What are the tools you use to forecast the market?
Charlie Reinhard: We have a fair-value model, which is sensitive to interest rates and to consensus earnings. We're really looking at after-tax, after-inflation cash flows. We take our earnings forecast for 2002, multiply that against where our model suggests that fair value for PE ratio should be at the end of the year, and come up with our price target.
Right now, our model suggests that the market should be trading at around 25 times forward earnings, but it's only trading around 21 times future earnings. We think valuation is attractive, but we also think fundamentals are improving. We believe the market has already priced in more than the consensus drop in earnings and we think that the further Fed ease will help improve the cost of capital and plant the seeds for profit growth.
Doug Cliggott: We use two variables to forecast earnings growth. The first is the year-over-year change in industrial commodity prices, which we use as a proxy for global demand. Right now, that measure is down 9% from its year-earlier level. Our guess is that it bottoms in the second and third quarter of this year at about minus 15%.
The reason I stated earlier that the risk to our current earnings growth prediction is to the downside is because given that commodity prices are already down 9% and the economy still appears to be decelerating, a minus-15% bottom might be too optimistic.
The other variable we use is the year-over-year change in business investment spending. We had assumed that it will bottom in the second or third quarter about minus 3% to minus 5%.
When we looked at the durable goods orders report a couple of days ago and saw that the orders for nondefense capital goods in January were exactly where they were in January a year ago and that shipments showed only 3% growth, we thought that maybe we were too optimistic on the capital spending trend as well.
TSC: How has visibility affected your projections?
Charlie Reinhard: As a result of it, we took our earnings per share growth forecast down from positive 4% to minus 4% for 2001. When the S&P 500 undercut its Dec. 20 low, we took that as a sign that earnings were going to be slower than what we had been forecasting.
Added to the anecdotal evidence from different firms and evidence from our economic team, we began to think that earnings were going to be lower than we had forecast. Initially, we had predicted the earnings trough to take place in the first half of the year, based upon the normal length of time between earnings peaks and earnings troughs -- which is normally around six quarters. But realizing that it was going to take a little bit longer, we pushed back the trough in our earnings forecast to the third quarter.
Doug Cliggott: Visibility is another thing that makes us think, oh my goodness, this might be worse than we thought. That's because we're not seeing analysts take down their numbers for the second half of the year. And so, companies are saying they don't know what it's going to look like, but it appears that earnings expectations are, at least on paper, being set for an environment where things really improve in a very significant way in the second half of the year.
TSC: How has confidence affected your forecasts?
Charlie Reinhard: It's one of the considerations that caused us to drop our earnings growth estimate and it also led us to estimate a larger amount of Fed ease. We were looking for the Fed to take rates down to 4.5%, but the drop in consumer sentiment was one of the factors that led our economic team to increase their rate-cut forecast. Instead of seeing a V-shaped recovery, we're looking for a "capital V" -- it will go a little bit deeper, but come back a little bit more.
Doug Cliggott: Confidence affects our thinking in the sense that American consumer spending is a huge part of global demand and it seems that confidence is a whole lot weaker than current spending. So, it could be a guide, an indication that growth in the coming months is going to be weaker. It's no guarantee, but it's part of the mosaic that makes us think that our current guess at earnings growth is probably too high, rather than too low.
TSC: How does the inventory overhang play into your thinking?
Charlie Reinhard: There is a bit of an inventory overhang in the economy right now. We think it will take a couple of quarters to work itself off. But inventories are lean by historical standards. The buildup that we see right now is nowhere near what one normally sees prior to a recession or protracted periods of subpar economic growth. So, we think it's a problem, but it's not as big a problem as it's been in the past.
Doug Cliggott: The real optimists think we're going to get a fast workout of the inventory situation. That could happen, but it's important to remember that the value of technology goods disappears. When an auto company builds inventory and finally sells it three or six months later, the price isn't usually dramatically different from what the firm expected to get. But given how rapid products change in the technology sector, it's not unthinkable that inventory value would go to zero -- that no one would ever want it. That makes me think that we don't really know the earnings base for a lot of these technology companies.
TSC: Which sectors are you optimistic about?
Charlie Reinhard: We're looking at groups that perform best on correction bottoms in a soft landing. Thus, we recommend an overweight position in the financial sector. Other reasons to be bullish on the group are that inflationary pressures are falling, the Fed is lowering interest rates and headline inflation should fall now that energy prices are no longer working against it in the same fashion.
Technology tends to be the very best rebound sector for the very first six months after making a market trough during periods of soft landing. When the market starts to rebound, confidence picks up. When confidence picks up, so will the economy. As the economy picks up, earnings will, too. As a result of that, capital spending will increase and the technology sector will be one of the best performing groups -- certainly an outperformer during that time period.
Right now, we like the valuation in technology. We look at forward PE ratios, meaning the price today divided by forward 12-month earnings expectations, and compare them to the long-term growth rate that analysts are expecting for different sectors over the next five years. That's called the PEG or price-to-earnings-to-growth ratio. Right now, we're showing that the technology sector has the third-lowest PEG ratio of all the sectors in the S&P 500.
Doug Cliggott: The three pieces of the market that we are suggesting an overweight position [in] are the areas where we see the least earnings risk: health care, consumer staples (food, beverages, household products, etc.) and energy.
In an environment where you're worried about earnings and economic growth, where you think people are going to behave in a very cautious way, you want stock in companies for your equity portfolio that make things that people need to buy. We need to buy food, beverages, toilet paper, toothpaste and paper towels. What we can postpone is buying a new computer, cell phone and car -- or borrowing money to pay for any of those things.
TSC: Which groups make you leery?
Charlie Reinhard: We're wary of health care, which we think is an expensive sector right now. In fact, we have it pegged as being the second most expensive sector on a PEG ratio basis. It's benefiting from the fact that its earnings predictability is very good at a time when we're experiencing an earnings trough. Other sectors that we're staying away from are the consumer sectors: staples and cyclicals. We think the economy is going to grow below its potential rate of growth, which we think is around 4% for some time. We anticipate we'll be pulling back from a soft landing, and that's a not a period where the two consumer groups typically outperform.
Doug Cliggott: We've got two sectors which we'd want you to be significantly underweight. One is technology and the other is the financial services group. That's where the risk to current earnings expectations is the greatest to the downside. I don't know how long it will take before I would recommend buying into technology again. I wish I could tell you.
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