Market Overview by Abby Joseph Cohen, CFA :READ LAST PARAGRAPH..
The following report was published on April 6, 1998. Please note that the views of
Goldman Sachs' economists and strategists are subject to change based on new data and
relevant events as they occur. These are not necessarily the views of Goldman Sachs
Asset Management or any of its affiliates.
Rites of Spring
- Springtime events include (1) earnings revisions, (2) seasonal mutual fund inflows, and
(3) renewed investor interest in economy-sensitive stocks.
- The outlook remains favorable for equities. No end in sight for the already long-lasting
profit expansion.
- Inflation has moved lower and real interest rates have moved passively higher without
Federal Reserve intervention.
- Supertanker America fosters a strong dollar. This may serve as a mild impediment to
economic growth, but keeps inflation in check and reflects the end of foreign investors'
negative attitude toward U.S. securities.
Summary
U.S. equity prices have moved higher in response to a confluence of favorable factors.
Domestic economic growth is solid, yet inflation remains mild-mannered. Commentary
about "disappointing profits" has proven to be premature, at best. Early indications for the
first quarter suggest that the U.S economy generated solid gains in GDP, job creation,
and profits.
Our newly introduced views on 1999 profits show ongoing gains in S&P 500 earnings. A
deceleration in profit growth occurred about two years ago, but the trend of 8%-10%
annual growth appears intact. The bull market in share prices has been linked to the
longevity of profit growth, rather than to the degree of its vigor. Our expectation that
profits will continue to expand throughout the forecast horizon encouraged us to raise
price targets for the key stock market indices late last month.
Rite of Spring: EPS Outlook Extended
Each March we review our estimates for S&P earnings per share, the timing based in
large part on the availability of final data for the preceding year. We also introduce our
earnings forecast for the subsequent year. As a result of this annual practice, we
recently made minor adjustments to our forecast for 1998 and, owing to a positive
outlook for 1999, raised our yearend 1998 and 12-month views on stock price targets.
For the S&P 500, these now stand at 1150 and 1200, respectively. As always, our price
targets are expected to be easily achieved and are intended to provide guidance as to the
direction of price change; precision is not intended. We project S&P 500 operating
earnings per share of .50 and .00 in 1998 and 1999, respectively.
Profit Perspectives
We believe that profit "disappointments" at the end of 1997 and early 1998 were largely
driven by two factors. First, most investors had previously failed to consider the effects
of FAS 128, the new accounting standard that moves the earnings of many companies to
a more fully diluted (i.e., lower) level. Second, corporate managers were accentuating
the potential negatives, perhaps trying to build in some margin for error in future reports,
especially from Asia. We believe that current profit expectations, for low single-digit
growth in early 1998, will be easy to achieve and may indeed be exceeded in many
sectors.
Few of our U.S.-based research analysts expect profit margins to come under
downward pressure in the first half of 1998. The principal exceptions are commodity
producers for whom global supply/demand imbalances mean continued price weakness.
But economy-sensitive industries with a domestic orientation (airlines, retailers, etc.) are
likely to show strong profit gains. Airlines, for example, benefit from strong demand,
lower fuel prices, and improved pricing flexibility. Many retailers are experiencing good
customer demand and lower input prices as a result of Asian difficulties. Unit labor costs
are still declining in the manufacturing sector overall, as productivity gains continue to
outstrip compensation increases.
The strength of the dollar may have a mild moderating effect on trade and profit growth.
It can be argued that in some cases a strong dollar intensifies the competition faced by
U.S. companies, reducing their slice of the trade pie. However, an important (and
offsetting) factor may be the expected reinvigoration of several trade partners, which
would make the trade pie grow larger. Thus far, the impact of the currency per se has
been seen mainly in the translation effects on the reported earnings of multinational
corporations. Even so, the impact seems to have been muted by corporate hedging
activities.
Rite of Spring: Flow of Funds
The seasonal pattern of mutual fund inflows has again been demonstrated thus far in
1998. These flows were quite vigorous through March, propelled by bonus and variable
compensation payments, and funding of individual retirement programs. In previous
years, the pace of inflows has abated somewhat after the April 15th tax-filing deadline.
The multi-year rise in U.S. equity prices has long been a domestic event. Foreign
participation has been anemic, with investors based in several countries having been net
sellers during much of the period. This changed in 1997, coincident with growing
concerns about Asia and other regions. Further, investors in other countries adopted
friendlier views toward equity ownership in general. This is expected to continue. Even
so, foreign involvement in U.S. stocks remains low, with non-domestic investors owning
about 7% of all U.S. equities.
Rite of Spring: Increased Attention Paid to Small and Cyclical Stocks
Relative valuation opportunities within the equity market seem concentrated in two
categories. First, small and mid-cap securities still seem to offer attractive risk-adjusted
expected returns, despite some recent improvement in their relative performance.
Relative value is a precondition to good share price performance. A catalyst must be
investor confidence in the durability of the overall economic and profit expansion, and
this has recently increased. In 1997, smaller stocks underperformed the larger-cap
indices except during the May through July time frame.
Second, deep cyclical issues (mainly those linked to global conditions) sport seemingly
attractive relative P/E ratios based on poor share price performance over the past
several quarters. There has been some investor enthusiasm generated in these sectors
recently, but the sustainability of the relative performance will ultimately depend on
earnings trends that have not yet improved The typical lead between share price and
earnings improvements is six to nine months. For some industries, in which global
demand is weak and productive capacity continues to expand, the recent moves may
prove to be premature, and mainly reflective of seasonal trading opportunities.
Valuation
There remains a notable disparity in the readings of different valuation approaches.
Those models linked to dividend yield continue to suggest that U.S. equities are
overvalued, as they have done since 1992. Models linked to nominal interest rates also
suggest overvaluation, as they have done for much of the last three years. Nonetheless,
the approaches that we believe have been the most statistically robust during this cycle,
such as discounted earnings models linked to inflation and Economic Value Added
(EVA") models, continue to suggest that the S&P 500 is now roughly at fair value, or
modestly undervalued. The undervaluation is more pronounced when 1999 profit
expectations are incorporated. |
