from Barrons Boxing a Bear
All-out collapse looks unlikely, but so does a rousing rally
By Jacqueline Doherty
So, after the Dow Jones Industrial Average blasted through the 9000 mark
you never thought it would see 7000 again. But here we are bouncing around
7600, wondering whether the market is one big buying opportunity or if it's
headed even lower. Obviously, reasons for concern abound.
Currency-related crises have spread from Asia to Russia to Venezuela and
Mexico. President Clinton is plagued by Monica allegations and his tendency
to fib. Terrorists have targeted the U.S. And many corporations are warning
of slower earnings ahead.
Yet the domestic economy does have
some sweet spots. Consumers remain
confident and keep shopping till they
drop. Inflation is under control, and
the yields on long-term Treasury
bonds have fallen to the lowest levels
in a generation. Such cross-currents
have analysts split: Bulls believe lower
interest rates will save the day. Bears predict that creeping global deflation will
overwhelm any benefits of those lower rates.
"If the meltdown occurs it's going to be because of deflation," opines Greg
Jensen, a research associate at Bridgewater Associates. "The power of the
deflationary force in the world right now is stronger than anything we've seen
since the Great Depression."
The excess industrial capacity around the world and the plunge in commodity
prices have surprised most market watchers. Right now, in the U.S. there is a
delicate balance between the negative impact of deflation and the positive
impact of low interest rates on corporate profits.
But if deflationary pressures eventually overpower the influence of lower
interest rates, the market could face more trouble, explains Jensen. One key
indication that deflation may be winning the day is the breakdown in the
correlation between stock prices and bond yields.
Normally, when bond yields fall, stock prices rise. It's easy to see why.
Lower interest rates raise price/earnings multiples while also reducing
financing costs for companies, and therefore boost corporate earnings.
However, since late March, the yield on the 30-year Treasury has fallen by
10.4%, but, instead of rising, the Standard & Poor's 500 Index has fallen
9.59%.
Some analysts also point out
that although yields on
long-term Treasury bonds have
fallen, short-term interest rates,
when adjusted for inflation,
have actually risen. You see,
while the fed funds rate has
remained steady at 5.5%,
inflation has fallen from about
3% to under 2%. As a result,
inflation-adjusted short-term
interest rates have risen from
2.5% to about 3.5%. "The Fed
has actually been tightening in a
passive way," Jensen contends.
Also, one might argue that
corporate financing costs
haven't decreased along with
the decline of long-term
Treasury yields. That's because
spreads on corporate bonds, or the difference between the yield on a
Treasury bond and the yield on a corporate bond, have increased
dramatically. This reflects investors' increased concern about the risks of
owning corporate bonds, and in the current global environment, it's
understandable. The worry is that an economic slowdown raises the risk that
some corporations will default on their bond payments, so investors are
naturally demanding more yield on corporate bonds to compensate for the
added risk.
Looking ahead, it's also tough to see how the market can rise dramatically
now that corporate earnings are deteriorating. The S&P 500 trades at 19.6
times expected earnings from continuing operations for the coming 12 months,
according to Charles Hill, director of research at First Call. In past bull
markets, optimism had boosted this "forward" P/E to a peak of only 18.
"Despite this recent correction, we're still trading at very high
price-to-earnings ratios. And that's in the face of an earnings outlook that
continues to deteriorate," Hill states. "You can't put record multiples on
earnings that are this far along in the earnings cycle."
Analysts now expect third-quarter earnings to rise 2.1% from a year earlier,
down from the 10% gain they had been expecting as of July 1. "It's clear that
the impact from Asia has been longer and deeper than most people thought,"
Hill notes.
So far, analysts haven't adjusted their earnings expectations dramatically
downward for either the fourth quarter of this year or for 1999, even though
the international crises don't appear to be going away any time soon. At the
beginning of 1998, analysts expected fourth-quarter earnings to be up 19.1%
from a year earlier. That expected gain shrank to 16% by July 1 and now
stands at 11.9%. But that's still quite a ways from the low-single-digit results
that some expect.
As for 1999 earnings estimates, they've barely budged, continuing to
anticipate a lofty 17%-18% gain. Hill expects earnings to be flat in the third
quarter, up 3% in the fourth quarter and in the single digits next year.
"The new-paradigm thesis is looking more and more suspect," says Hill,
referring to the notion that stocks, in the vibrant economy of the 1990s, were
no longer constrained by traditional valuation measures.
If corporate profits face pressure, you can be sure companies will spend less
on expansion, and that means fewer jobs will be created, says Lisa Cullen, a
Merrill Lynch investment strategist. "We don't see any reason to be bullish
about the market as a whole or about large capitalization stocks," she adds.
Those who believe the bull can persevere have put their faith in today's low
interest rates. "Bull markets don't die of old age, they're usually shocked into
bear markets," explains James Bianco, president of Bianco Research. "And
usually, those shocks include higher interest rates."
The correlation has proved true throughout history, says Bianco. Even in
Japan, when the stock market peaked in 1990, interest rates were headed
higher. The yield on the 10-year Japanese government bond rose from 5.01%
to 8.26% between August 1989 and August 1990. And in the U.S., when the
Dow peaked at 2999.75 in July 1990, it occurred as the yield on the 30-year
Treasury rose from 8.05% in the beginning of 1990 to 9.17% in September
of that year. The Dow proceeded to fall 21.6% from its high.
The same pattern can even be identified in the Crash of 1929, when
three-month T-bill yields rose by one percentage point, Bianco points out.
The good news: It's tough to see anything that would force interest rates
dramatically higher. With the U.S. economy slowing and the U.S. bond
market serving as a safe haven, both the fundamentals and the technical
readings favor interest rates remaining near current levels or heading lower.
And if the Dow can avoid crossing over the 20% barrier that separates a
bull-market correction from a bear market, we will by some measures set a
record for the longest bull market in history. The Dow is now 18% off of its
high. The current bull run began in October 1990, and if it can hold on until
November 10, the market will have maintained its upward trend for 422
weeks, according to the folks at ING Barings. That ties the previous record,
set back in the 1920s, when the market rallied from August 1921 to
September 1929.
Right now November seems very, very far away. And mimicking the market
of the 1920s is no comforting thought. All told, there appears to be a lot more
downside risk than upside potential.
|
