Closer Scrutiny of Earnings Could Hurt Stocks This Year
The Wall Street Jounal Online by Erin Schulte - February 23, 2002
Investors looking for a profit recovery to propel stocks in 2002 may findthemselves disappointed, just like those townspeople who strained to see the emperor's new clothes, Merrill Lynch's top strategist says.
Richard Bernstein, chief investment strategist for Merrill Lynch, has the lowest recommended stock allocation among Wall Street's leading strategists -- 50%. He thinks possible changes in accounting practices may create a tougher investment climate.
Bernstein believes companies have been artificially improving earnings figures with questionable accounting practices. Now, post-Enron, investors are demanding more straightforward financials, which could lead to weaker per-share earnings figures, and thus lower share prices.
Last week, we talked to market bull Ed Yardeni, who is leaving his post as chief investment strategist Deutsche Banc Alex. Brown to take the same job at Prudential Securities. Mr. Yardeni said he expects the market to gain momentum in the second half of the year and estimated that the Dow industrials could hit 11,500.
Mr. Bernstein's predictions for 2002 call for humbler gains, and he concedes that major indexes could see their third down year in a row -- something that hasn't happened in about six decades -- if the economic turnaround investors hope for doesn't match their dreams.
As we consider Mr. Bernstein's assertion that the recent accounting problems could be a big stumbling block for the market this year, readers should consider his recent calls.
As chief investment strategist for Merrill Lynch, Mr. Bernstein predicted the Dow industrials would hit 11,000 last year, making him one of the sharpshooters among Wall Street's soothsayers.
As a point of reference, Goldman Sachs' perennial bull Abby Joseph Cohen, was about twice as far off the mark with a target of 13,000.
The Dow Jones Industrial Average closed Dec. 31 at 10021.50.
WSJ.com: First of all, have you set 2002 targets for the S&P, the Dow and the Nasdaq?
Bernstein: Only for the S&P. It was 1200. At the beginning of the year, people said 'Where will it be at the end of the year?' and we haven't changed it. We may change it, but we haven't changed it yet.
WSJ.com: It seems like we got off to a rocky start this year. Why are you sticking with that number?
Bernstein: Well, it's really not a great return, actually. The S&P's only at about 1080. I still think there's quite a bit of downside risk, especially for the Nasdaq. However, when we wrote that, we thought the return for the year would be roughly about 5%. We also said there was a great possibility the S&P would have its third down year in a row. I still think that's a pretty sizable risk.
WSJ.com: So you're bearish this year, were you as bearish last year? How has your view of the investment landscape changed?
Bernstein: We've been more cautious than the rest of the Street for the past three years, during the technology bubble, coming out of the technology bubble. We were pretty conservative that whole time.
WSJ.com: And you've been pretty right.
Bernstein: Well, knock on wood -- it may just be that the broken clock is right twice a day. In terms of incremental bearishness, we're not as bearish as we were during the tech bubble. But we're certainly far from pound-the-table bulls.
WSJ.com: Some strategists I talk to expect decent earnings growth this year. Are they missing something?
Bernstein: What they're missing is that wages have continued to rise faster than pricing in the overall economy. That can be very good for consumers, and I think that's what people are looking at, assuming the consumer's going to be quite strong.
But our view is that it's going to be very difficult for profits to rebound until we start correcting that relationship.
In 1998, wages rose faster than pricing. But it wasn't a big deal for two reasons. One, the economy was strong, so you could still sell units even though margins might have been squeezed. Two, in the next year or so, profits were extremely strong.
Now you have wages rising faster than pricing again, almost at the same level as in 1998, but you're in a recession, you're not selling anything, and there's no profits. So where are you going to get a capital spending cycle?
That's what people are missing, is that what drove that capital spending cycle was very strong profitability.
WSJ.com: And of course, the problem hasn't been the consumer, right?
Bernstein: The problem has not been the consumer. In light of what I just said, with wages rising faster than pricing, with the inability to do capital spending and the inability to sell things, how do you correct that situation?
Well, you lay people off -- you make yourself productive the old-fashioned way.
Where I differ from most economists on the Street is that I think unemployment will rise to levels higher than they think and will rise for longer than they think.
WSJ.com: What level might it reach?
Bernstein: I don't know, but whoever [has the highest estimate], I think it's going to be higher. That's kind of the way I think of the world as opposed to trying to come up with one number. I just think, 'Are things going to be better or worse than people think?' and unemployment is the thorn in the side of the consumer story.
WSJ.com: Just how serious are the Enron-related accounting issues everyone's worried about right now?
Bernstein: It's part of a bigger picture. We wrote about this last fall and nobody seemed to care.
One of the factors that historically separated the United States stock market from many other markets around the world was the transparency of our fundamental data.
An argument that we made was that the move from GAAP to pro-forma earnings announcements had clouded that transparency. It was effectively gone, because pro forma numbers are unaudited.
People are kind of pointing at the auditors, but there's a difference between the accounting issue and the reporting issue. You can get a squeaky-clean opinion from your auditors and then report pro-forma numbers, which are unaudited. That's the bigger issue.
That argues for much, much lower valuations on stocks in the U.S. because you have to be compensated for the riskof not knowing what's going on inside the company.
Nobody cared about this -- the high p/e ratios and, at the end, the opaqueness of the fundamental data. Investors or analysts or the companies said these are the numbers that justify the capital appreciation. And we said, this is very highly speculative.
It's part of a bigger issue, that we think the market is very highly speculative.
WSJ.com: How's that going to shake out? Are companies going to move to using the GAAP numbers?
Bernstein: I think they'll be forced to. I'll bet the Securities and Exchange Commission in the next 12-18 months will probably come out with some announcement saying they can't announce pro forma. That's my guess, though I don't know that for a fact.
WSJ.com: How would that affect stock prices if it did indeed happen?
Bernstein: I think for a lot of companies, we're going to find out that the emperor has no clothes.
Basically, [they've been] putting anything out to maintain the capital appreciation, and that's very speculative.
The reason I sound so bearish is I'm applying conservative principles to what I'm seeing, the same conservative principles I've always used, but the speculation of the market has moved away from me, so I look incredibly bearish.
WSJ.com: Then why do you think everyone else is overlooking these things?
Bernstein: In general, to keep the capital appreciation going.
WSJ.com: Because no one wants to lose money?
Bernstein: Not because they don't want to lose money, but because they want to make more.
WSJ.com: Analysts keep mentioning a possible credit crunch. Do you think that's a threat?
Bernstein: We've written about that a lot as well. We started last year when the Fed was easing very aggressively. We thought it was odd that the Fed was being so aggressive but the financial sector wasn't a leadership sector in the stock market. It should have been among the better-performing sectors and they weren't.
The Fed's prime responsibility is to the banking system, and bank stocks were not performing well, brokerage stocks were not performing well. Something wasn't right -- we thought it might be credit risk.
One of the possible problems with the fed being preemptive is that it can lower interest rates at the worst part of the credit cycle.
If that happens, one of two things will occur: either you don't lend, which is showing up in some of the Fed's surveys with senior bank-lending officers. As you can see in the paper market, people are getting a little upset right now. Or, you underprice credit risk. The underpricing credit risk is called zero-percent financing. I don't know if there's going to be an all-out credit crunch, but I think we should expect the availability of credit will be curtailed moving forward.
WSJ.com: On to the economy. Recent reports show signs that it's picking up, but it doesn't seem to be as strong as some might have hoped. Now we hear occasional rumblings about a double-dip recession. Do you expect the economy to gain some steam as we move along in the year?
Bernstein: I do think that as the year progresses, the economy has a pretty good chance of rebounding. We're not Japan -- yet.
But there are still questions about what's going to go on with the consumer, and that will move the recovery.
For me, as an investor, what I care about is not necessarily what's going on in the economy, but what is the stock market's view of an economic recovery? The stock market had been pricing in a very fast, very strong profit recovery.
WSJ.com: And you think it'll be disappointed?
Bernstein: That's been our theme. Either what happens with the profit recovery is anemic relative to expectations, or what if it doesn't turn on schedule? There's plenty of room for disappointment.
WSJ.com: So you don't like the stock market much. Where should investors turn?
Bernstein: Well, where we think there is outrageous opportunity are in higher-quality assets.
WSJ.com: Can you explain what that means?
Bernstein: Companies that have more stable earnings, like consumer staples. But again, nobody cares. You have to look far and wide to find institutional investors overweighted in consumer staples.
Nobody wants to play higher-quality assets because they're so sure there's going to be a turn in the economy, they're so sure there's going to be a turn in profitability. There's a very unusual confidence built into the valuations of lower quality assets.
Within each sector, you will find that higher-quality, more stable stocks, are cheaper than lower-quality stocks in nearly every sector. If you think there's going to be a rebound in earnings, why would you play a safe-haven stock?
You can now buy the higher-quality assets at a discount. That's not the way it's supposed to be. You're supposed to pay a premium for safety and be compensated for risk. You have these opportunities for more stable growers in every sector. Its not often that you get these opportunities.
WSJ.com: Your asset-allocation model is 50% stocks, 30% bonds and 20% cash?
Bernstein: In 1982, when the secular bull market began, money-market rates were 12%-16%, and the S&P 500 p/e ratio was 7.
What happened was everybody looked backwards and said, gee, stocks performed so miserably during the '70s, and now I can get this sort of riskless return out of money-market funds. Why wouldn't I take a riskless 12%-16%. But obviously, over the next 20 years, it paid to be in the equity market, not money-market funds.
Today, money-market rates are 2% or 3% and that same multiple is now 41. Everybody says, 'Where else can you get equity-like returns -- there's no way you should be in cash or bonds, because equities will outperform.'
That was the correct cry 20 years ago. Today, I think we're entering a period which nobody ever believed was really happening, where equity returns are more along the lines of 5%-6% longer term. If that's true, bonds and cash become more competitive.
Updated February 23, 2002 11:56 a.m. EST
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