from Abby Joseph Cohen this morning:
PART 2
World Investment Strategy Highlights Portfolio Strategy
United States: US stocks remain notably undervalued
.........Exhibit 25: Forecasts and performance
>>>>>>>>>>>>>>S&P 500<<<<<>>>>>CURRENCY RETURN, %<<<<<<<
>>>>>>>>>>>Level>>>% Chg>>>> $ >>>>>> ¥ >>>>Euro>>>>> £
In 12m>>>>>>1150>>>>29.6>>>>29.6>>>>19.4>>>>12.6>>>>26.9
Last 3m>>>>> 848>>>> 6.1>>>> 6.6>>>>14.8>>>>11.1>>>> 8.9
Last 12m>>>>1073>>>-16.2>>>-14.9>>>-12.4>>>-21.6>>>-20.7
We have slightly reduced our 12-month rolling price targets for the S&P 500 and Dow Jones Industrials Average, reflecting the high level of investor risk aversion. Even so, expected equity returns are likely to be substantial and in excess of returns from Treasury securities.
The current high level of investor risk aversion is expected to decline, but this will take time. Consequently, we have raised the required ERP in our dividend discount model to a significantly higher than normal level. If this is correct, equities are notably undervalued, although less than previously estimated. We have therefore reduced our 12-month S&P 500 target to 1150 from 1300 and our Dow Jones Industrials target to 10,800 from 11,300. Valuation models are not timing devices, but this DDM approach seems most useful in a 12- to 18-month time frame.
Three factors driving extreme risk aversion
The critical question for investors is whether risk aversion will remain at these extreme levels. To answer, we try to identify the key factors driving the risk intolerance and think about their likely development. These factors are, in our view: (1) economic uncertainty; (2) investors™ confusion and anger regarding accounting and other corporate issues; and (3) the geopolitical environment. To the extent that ugly scenarios in each category are already widely discussed by investors, the level of risk aversion may not rise, and could fall, from current levels. Even so, it has become even less likely that risk aversion will fall back to the historical midpoint within our normal forecast horizon of 12-18 months.
1. Economic uncertainty
Economic uncertainty has been an issue for almost three years. The pace of economic and profit growth peaked in late 1999, and has been under pressure ever since. But the three-quarter recession has ended and, although some deceleration may occur, our Economic Research group does not expect a "double dip" into negative territory. They have written extensively on many of the issues now worrying investors, and their conclusion is that moderate growth is the most likely outcome. Profits have been recovering since late 2001, based on both GDP-based data and accounting-scrubbed numbers for the S&P 500.
The question we need to ask with regard to investor aversion is whether economic worries will intensify from current levels. To the extent that unpleasant scenarios, including deflation, are already widely discussed, the current required ERP associated with this factor might be sufficient.
2. Accounting and corporate governance
Among the most vexing problems have been those encountered in accounting and corporate governance. Most US companies have moved towards improved self-compliance, under the rapt attention of regulators, shareholders and their boards. We
believe the worst is now in the past. Corporate profits have been rising since the beginning of the year, although the data have been difficult to parse due to mammoth accounting adjustments. These adjustments have exceeded $200 bn for the companies in the S&P 500. These are roughly 30% of reported income, and are similar to the adjustments made in the early 1990s. At that time, adjustments were linked to prior overstatements associated with inflation puffery and values assigned to tangible assets. More recently, large adjustments have been related to goodwill impairments often linked to intangible assets.
Again, from the perspective of investor risk aversion, we need to ask whether perceptions in this category will deteriorate from current levels. This is not likely, from an accounting standpoint, given the dramatic adjustments already made by the US™s largest companies. But more time will be needed before investor comfort in this area is restored. We believe that two particular areas of current investor concern, pension accounting and accounting for ESOs, will have mainly company-specific, rather than economy-wide, implications.
3. Geopolitical environment
Geopolitical concerns are obviously weighing on investor sentiment. One year ago, this meant a focus on the aftermath of the terrorist attacks of September 11. The recent bombing in Bali, and attacks in Yemen and other locations, indicate that global terrorism remains a factor. Furthermore, there is intense focus on Iraq and potential military engagement.
Again we ask whether investor risk aversion is already reflecting these worries. Although it is difficult to determine how much of the current required ERP is attributable to such developments, the commodity markets offer some guidance. Our Energy Research team believes that the current equilibrium price for crude oil should be well below $20/barrel, yet current prices are near $30/barrel, indicating that a notable war risk premium already exists in energy markets. It therefore seems quite likely that a notable risk premium is already priced into the equity markets. There is a striking contrast with 1990, when Iraq invaded Kuwait. In that instance, most investors were caught off-guard by developments. The rise in energy prices, and the sharp decline in equity prices, came after the hostilities began, not before. Indeed, the stage whispers coming from Washington since the spring on the possibility of military engagement with Iraq may have been intended in part to prepare the markets for such an outcome.
Risk aversion appears elsewhere
First, intense risk aversion is also impeding economic growth. Many business leaders, concerned about similar issues, are approaching decisions about expansion with trepidation. Furthermore, there may be some reluctance to undertake bold initiatives, given the increased scrutiny with which business strategies are currently viewed. Plans to hire new workers or invest in new facilities are now undertaken with the greatest of care.
Second, the wide spread in corporate bond yields over Treasury securities of comparable maturity suggests that the concerns afflicting equity prices are also impeding corporate bonds.
As noted above, we expect the current extreme level of risk aversion to abate. This would be to the benefit of economic growth and the performance of corporate securities, both equity and fixed income, which in our view are likely to outperform Treasury securities during the forecast horizon.
Near-term impediments to share price recovery
Powerful share price rallies since late September are supported by our valuation conclusions, and are fueled by notable cash positions in portfolios. Even so, we note that non-fundamental factors may dampen share price performance. For example, portfolio clean-up, mainly of poorly performing issues, is occurring. Mutual funds typically complete this process by the end of October, but most individual taxpayers will do so between now and late December. |
