The Money Analyst - April 2002 Tracy Herrick
Jefferies' Chief Economist
* see link for important charts
--------------------------------------------------------------------------------
To receive a printed copy, contact Glenn Ostergaard: phone (310) 914-1093 or email gosterga@jefco.com.
jefco.com
CONCLUSIONS Stock prices will likely remain weak during 2002. The Dow Jones Industrial Average could end the year near 9500. That would represent close to a 10-percent decline from levels in mid-March.
The Nasdaq composite could also decline, possibly to 1600 by year-end 2002.
This performance of stocks would reflect, initially, a neutral, then a tightening monetary policy by the Federal Reserve as the year progressed.
Money supply will likely be the spearhead for these developments.
The rate for federal funds could rise four times during the remainder of the year, with a one-quarter-of-one-percent increase on each occasion.
The tightening would reflect an upturn in consumer inflation in the second half of the year, a weaker bond market, and concerns at the Federal Reserve over reinflating a stock market bubble.
Most of the weakness in stock prices would be focused on technology and growth sectors. These groups continue to show extended valuations.
In contrast, stock prices of value groups will likely hold. Dividend stocks with comparatively high yields could also hold, or show gains.
Military and defense stock groups could show further appreciation.
In 2003, the outlook for stock prices will likely brighten. The Dow Jones Industrial Average could gain 20 percent in that year.
Strength in stock prices in 2003 would reflect stronger earnings and renewed Federal Reserve monetary stimulus.
The easing by the Federal Reserve later in 2002 or 2003 could be prompted by banking problems at the time.
Currently, there is not a difficult banking situation. But, one could develop by year-end 2002.
Treasury bond yields have likely reached a major low.
Thirty-year Treasury bond yields could move up to 6.2 percent by year-end 2002 from 5.7 percent in mid-March. They could reach 6.7 percent in the first half of 2003. Medium- to high-quality corporate yields would likely follow a similar pattern.
A stronger economy in the spring of 2002 and an upturn in consumer inflation in the second half of 2002 would underlie the rise in bond yields.
High-yield bonds will likely rally through the autumn of 2002. A stronger economy would reduce the risk of these bonds, making them more valuable to investors.
A FED TURNING POINT The Federal Reserve shifted monetary policy from an easing to a neutral stance three months ago, in mid-December 2001. That marked a new direction.
The change was indicated by a leveling in the three-month bill rate from early December 2001 to mid-March. Rates remained close to 1 3/4 percent in the period. Earlier, during 2001, the bill rate had dropped sharply.
The shift was also indicated by a flattening in the growth rate of money supply, as measured by MZM, money zero maturity, to 2 percent from mid-December 2001 through February 2002. From early October through mid-December, this measure of money supply had been rising at a 23-percent rate.
SIGNAL OF TIGHTENING During his testimony to the Senate Banking Committee on March 7, Alan Greenspan signaled that he might tighten as 2002 progressed.
A sign of future tightening could be a further flattening or a fall in money supply, as measured by MZM, from recent levels near $5,730 billion. Another could be a one-quarter-of-one-percent rise or more in the three-month Treasury bill rate from recent levels near 1 3/4 percent.
The outward signal of a shift from a neutral to a tightening policy would be a publicly announced rate increase. That would occur following the earlier signals.
REASONS FOR SHIFT A shift to tightness would indicate that the central bank would not want a rebounding economy in 2002 and early 2003. Economic strength that soon would limit the potential to accelerate the economy during the year of the next presidential election, which will begin twenty-one months from now.
Nevertheless, there will still likely be a strong rise in economic output as 2002 unfolds.
REBOUND IN PROFITS The strength in the economy would be the basis for an upturn in corporate profits. From a 44-percent drop in annual rate in the fourth quarter of 2001, reported earnings of the Standard and Poor's index of 500 stocks will likely rise to a 5-percent gain by the fourth quarter of 2002, on a year-over-year basis.
The increase in profits would be in line with a rebound in gross domestic product of 5 percent to 6 percent in the fourth quarter of 2002.
That upturn is indicated by the sharply positive slope of the yield curve that developed early this year and continues in mid-March. The yield curve used here is measured by the three-month Treasury bill rate to the 30-year bond yield.
All of this would give the Federal Reserve reasons to turn restrictive by mid-year.
BANKING CHALLENGE Later in 2002, this outlook could be interrupted by a bank problem.
Difficulty with a major bank has been a recurring development during late recessions. This pattern suggests that a bank problem could occur by late 2002 or early 2003.
During those times, the difficulty has been due to unexpected loan losses.
In the past, the troubled bank has resolved the problems with assistance from bank regulators. In addition, the Federal Reserve has flooded financial markets with new funds. That has kept the problems of the afflicted bank localized and the banking system intact.
One consequence of new liquidity from a banking situation has been a bull market for stocks for a period of at least several months.
Two stress points for banking follow.
FIRST STRESS POINT First, the derivatives market could weigh on banks that had lent heavily to this market.
The key to measuring this risk would be the credit exposure of derivative-linked credit compared with bank equity capital. Most of this exposure is concentrated in a handful of the largest U.S. banks. In the case of three of these banks, this credit exposure recently exceeded bank capital. In one instance, it exceeded that capital more than sevenfold.
In mid-March, there were no indications of loan difficulty. But, from a cyclical point of view, it is still early.
SECOND STRESS POINT Second, U.S. banks face possible unexpected complications from the little-discussed economic slowdown in China or the effects of the soon-to-be-ended deposit guarantees of Japanese banks for accounts of over ten million yen, or about $75,000.
These developments are currently expected to be controllable by company and bank managements.
But again, it is early to dismiss the issue.
Separately, one index of overall bank stress developed by the Bank Credit Analyst has risen in early 2002, after having fallen in 2001. The extent of this stress recently approached levels that often have been associated with earlier bank crises.
NEW STEEL TARIFFS On March 5, President George W. Bush announced tariffs on a wide range of steel imports which would take effect on March 20. The tariffs range from 8 percent to 30 percent. They would decline over the coming three years.
The administration is well aware that new tariffs are economic depressants, and their negative effect on the economy would be worse than tax increases.
The decision appears to have been made for political reasons. A half-dozen House races in West Virginia and Pennsylvania this year could be decided by this issue. That could determine the leadership of the House in the next Congress.
Protectionism could spread. Other industries will probably line up for higher tariffs, to receive what they believe to be their fair share. It would not be difficult to politically justify more tariffs.
RETALIATION Retaliation by other countries could raise the stakes.
The European Union claims that tariffs on steel could cost it $2 billion per year in lost trade. The cost to Russia could amount to $500 million a year.
The net impact of U.S. tariffs would be to make bank loans of U.S. banks more risky. Reciprocal tariff increases were the principal reason for U.S. bank failures in the early 1930s.
Further, U.S. tariffs could also weaken the dollar. With a likely $360 billion current account deficit in 2002, tariffs would reduce the income available from trading countries for remittance as capital to the U.S.
The Federal Reserve is well aware of this. Alan Greenspan noted new steel tariffs as an unfortunate development during his Senate comments. It was his first criticism of the administration.
The Federal Reserve can act on the matter. It could inflate the economy to offset the negative effects of tariffs, if they were to spread. Or, if it would vigorously oppose the administration because of the issue, it could arrange for a recession in the year of election, which would remove the administration from office. The latter outlook is probably not likely.
At this time, the future direction of the tariff issue lies in the hands of European and other countries. They will probably escalate the issue, but not likely to the point that it would become destructive to the dollar or to the stock market.
IMPLICATIONS FOR STOCK INVESTORS Four implications follow.
In 2002, price-earnings multiples of the broad stock market will likely be compressed.
The price-earnings multiple for the Standard and Poor's index of 500 stocks was 30X in mid-March, based on four-quarters earnings, excluding extraordinary charges, as reported by Barron's.
COMPRESSION OF MULTIPLES Multiples of this average could decline to the low twenties by year-end 2002, as earnings will likely rise and stock prices would weaken.
In contrast, multiples could rise in 2003 as stock prices will likely rise more rapidly than earnings. The rise in multiples for that year could be small.
LONG-TERM CYCLES OF MULTIPLES The direction of price-earnings multiples in the coming two years will probably reflect the influence of a long-term cycle of multiples that typically lasts from 25 to 28 years. The current period appears to be in an overall downward phase of this long-term cycle.
Looking farther ahead, three to five years from now multiples could drop to the upper teens. The average multiple over the past 75 years has been 14X. That level could be reached five to seven years from now.
Thus, the oncoming period of a compression of multiples points to a headwind for stock prices.
STRENGTH OF LOW MULTIPLE STOCKS Some stocks could face this challenge successfully.
One group would be those with unexpectedly strong earnings growth. These would include stocks that have been considered value stocks, yet would outperform in earnings results.
In addition, stocks with low multiples and steady earnings could also show better performance than the averages.
A large number of stocks are in this group. Stocks in the nontechnology, nongrowth sectors of the Standard and Poor's index of 500 stocks often show a multiples in the upper teens, or lower. These stocks could be the core of a successful portfolio over the coming year.
STRENGTH OF DIVIDEND STOCKS Stocks with a comparatively high dividend yield could also outperform the Standard and Poor's index of 500 stocks. These would be stocks with yields of two percent or higher. In mid-March, the dividend yield of this average was 1.40 percent.
New interest in yields would be one consequence of disillusionment with the recent view that company managements are better investors than investors themselves.
In meetings with investors in Europe over the past month, many now believe that they can make better investment decisions than managements. Recent examples of unwise use of company funds raised the issue. A major point was that investors have unbiased incentives in the use of surplus company funds.
Moreover, dividends have become a hard measure of financial performance.
The view of these investors was also that many of the definitions of earnings, especially those carrying a high risk of restatement, were particularly less useful as a performance measure. Net earnings will likely emerge, once again, as the preferred measure for earnings.
WAR KEEPS EXPANDING The war in Afghanistan keeps unfolding into deeper conflict. Early March showed a step-up in the conflict.
The cost of the war continues to be swept under the rug and not publicly discussed. One estimate suggests it would amount to $250 billion in 2002. That would be in addition to regular costs of maintaining military forces.
The cost of the war would reflect direct expenses of combat, replacement of deployed weapons, expenses of pacifying and rebuilding afflicted countries, the cost of loans, grants and trade benefits to helpful countries, and CIA expenses related to the war. In reference, the Gulf War, one decade ago, cost $90 billion, lasted much less than a year, and used less costly equipment.
This estimate would not include a military invasion of Iraq, Iran, North Korea, or other countries.
The replacement of the three target governments that the U.S. considers unfriendly will probably occur within the coming two years. The administration has not wavered on the issue. The cost of these replacements would be an additional expense.
STRONG GROUPS As a consequence of this future spending, stock prices of the military, oil, and oil service groups will likely be strong. The aerospace and military groups have shown strength in the past two years. They could continue to benefit from the war.
Charts courtesy of The New Yorker Collection 1988, Peter Steiner, from cartoonbank.com, Federal Reserve Bank of Cleveland, Federal Reserve Bank of Philadelphia, Federal Reserve Bank of St. Louis, Federal Reserve Bank of Chicago, Federal Reserve Bank of New York, Federal Reserve Bank of San Francisco, and Board of Governors of the Federal Reserve System.
This report includes information available through March 19, 2002. |
