The New Nifty Fifty Correction?
FOOL ON THE HILL
An Investment Opinion
by Louis Corrigan
Reasons abound as to why the market has swooned of late. Some of them are technical. Computer program selling sank stocks late yesterday after a change of heart by Prudential's formerly bullish director of technical research, Ralph Acampora. Once known as "Mr. Dow 10,000," Acampora said he now believes the Dow Jones Industrial Average (DJIA) could drop 15% to 20% from its July 17 high. That would sink it to somewhere between 7,470 and 7,937. (It closed Tuesday 9.1% off the 9,338 high.) This technical breakdown reflects certain legitimate fundamental problems: weak corporate profits, indications of a slowing economy, renewed signs of inept Japanese leadership perpetuating Asia's troubles, Kenneth Starr's reinvigorated crusade against President Clinton, and so on.
Yet for those of us who believe that prolonged bear markets don't begin with inflation and interest rates edging ever lower -- or with an entire generation pumping their retirement money into the stock market like never before -- all of these good reasons amount to little more than excuses for institutional money managers to lock in what should be some healthy 1998 profits.
Many investors, I believe, have actually greeted the stock market's recent losses with a sense of relief and wouldn't mind seeing a bona fide capitulation sell-off that drove the Dow down further. That's because keeping up with the large-cap averages has required that money managers buy those new Nifty Fifty stocks that already trade at ostensibly fat premiums to their long-term earnings prospects. Those are the big, safe, liquid stocks that have been moving the averages and so had become almost the only ones that kept going up. Of course, that rationale is as circular as it sounds. The resulting merry-go-round has left investors so dizzy that many are happy they can now leap to the comfort of bonds or cash without having to go further into the business of paying earnings multiples that discount, as the saying goes, not just the future but the hereafter.
Of course, it's not so much that Coca-Cola (NYSE:KO - news) , for example, is overvalued at the 54 times trailing earnings it traded for last week. (It may not be.) But there are simply very few multibillion-dollar companies that can even arguably justify such multiples. Yet, as the Wall Street Journal's Greg Ip and Aaron Lucchetti reported last week, just 78 stocks had accounted for all of the gains in the S&P 500 index this year up to last Tuesday. With the likes of Microsoft (Nasdaq:MSFT - news) and Pfizer (NYSE:PFE - news) sporting price-to-earnings (P/E) ratios above 60 and Cisco (Nasdaq:CSCO - news) and Lucent (NYSE:LU - news) carrying triple-digit
P/Es, it's clear that a very small group of stocks trading at many times their annual growth rates were responsible for the overall S&P 500 trading at 28.1 times trailing earnings. Meanwhile, the vast mid-to-small cap arena appears to offer bargains a dime a dozen.
Indeed, the Ip-Lucchetti article, "For Thousands of Stocks, Bear Market Is Here," clearly laid out the market's problematic undercurrents and suggested that if trouble wasn't brewing, it ought to be. The line charting the ratio of advancing stocks versus declining ones peaked on April 3, long before the major averages hit new highs. The line charting the ratio of new highs versus new lows has been declining since late May. These technical readings reflect a remarkable divergence between the major averages and the average stock. A week ago, the average New York Stock Exchange (NYSE) stock was 24.3% off its high whereas the average Nasdaq stock was 35% below its high. A drop of 20% or more is usually considered a bear market.
As the Journal reported, the smaller a company's market cap, the worst the average performance. NYSE companies valued at less than $250 million were, on average, 43.3% off their highs. Businesses in the $250 million to $2 billion range were off by 25.4%, with stocks in the $2 billion to $5 billion off 19.8%, and stocks in the $5 billion to $20 billion range off 16.3%. Even companies with market caps over $20 billion were down 11.7% on average. With the DJIA down just 9.1% from its high even after yesterday's bloodbath (and still up 7.3% for the year) and the S&P 500 just 9.7% off its high (and still up 10.5% for the year), it's pretty clear that the market averages have been led higher by almost literally a handful of behemoths. Meanwhile, the Russell 2000 index of small-cap stocks was, as of yesterday's close, down 18.3% from its high and actually down 8.1% for the year.
To be fair, not all of this divergence is irrational. Many of the largest multinational firms have the access to cheap debt and equity capital as well as the infrastructures and market positions to continue producing solid growth partly by buying up or licensing new products developed by others. Think of Microsoft's purchase of WebTV or the way the top pharmaceutical companies profit from deals with small biotechs. To a degree, these giants are simply in a position to get more out of a given set of resources than smaller companies can. Moreover, they have more moving parts than their small-cap cousins so they have more room to manage expenses to ensure steady profits when times get tough.
Also, the idea that these market leaders are overvalued simply because of high P/Es is silly. As Dale Wettlaufer has discussed, Jeremy Siegel's analysis of the original Nifty Fifty stocks shows that, as a group, these stocks really weren't overvalued when they peaked in December 1972 at a collective P/E of 41.9. Indeed, the best of the lot were still significantly undervalued based on the returns they would generate over the next 25 years. Coke topped out at 46.4 times earnings at the time but needed to trade at 92.2 times earnings to be fairly valued, in retrospect. Pfizer had a P/E of 28.4 but could have merited a multiple of 54.9. Arguably, today's multiples are even more benign given the current outlook for tame inflation and interest rates.
On the other hand, a dollar in quality earnings is the same no matter what company generates it. While one should be willing to pay more for companies perceived to have a comparatively safer stream of future earnings, one can't help but feel that the market has for a while now been misallocating capital by simply declaring thousands of American businesses unsuitable terrain for equity investing. So much money seems to be in the hands of paranoid institutional investors who want performance but only when safety and liquidity are also part of the equation. The feverish pursuit of these stocks presumed to be safe simply may have created the kind of excess that makes them unsafe, especially compared to other opportunities.
Therefore, a 10% or even greater drop in the major large-cap players would seem to be literally a correction, an instance of capitalism's market system readjusting investors' perspectives so they may deploy capital more sensibly going forward. Hopefully, the correction will turn more eyes toward the wallflower small- to mid-cap stocks that have been so long ignored by fund managers anxiously looking to put billions of new cash to work as quickly as possible in order to keep up with the market averages.
If that doesn't happen, it seems possible that the baby boomer money machine that's helped fuel the rising averages could create even more dire problems as managers of multibillion dollar funds chase fewer and fewer stocks. The reckoning then might be postponed until Asia hits the inevitable upswing, and international money that's been flowing into the dollar and U.S. multinationals starts heading back home. Personally, I think most long-term investors should be cheered by the recent market jitters and perhaps should even hope we see another leg down.
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