No Mistaking,Fundamentals Still Apply
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Evelina M. Tainer, Ph.D. provides this monthly column on investment advice. Ms. Tainer is Chief Economist at Econoday, Economic Consultant to the Federal Reserve Board, and author of Using Economic Indicators to Improve Investment Analysis, (John Wiley, 2nd Edition, 1998).
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Stock prices tumbled on that memorable day July 17. Did inflation reports point to price jumps? No. Did Federal Reserve Chairman Alan Greenspan sneeze? Probably not. It appears that Dell's quarterly earnings only came in on target. As a result, tech stocks were instantly dumped on fears that technologies had become overvalued. Blue chip stock prices, of course, fell in sympathy.
The market reaction because of Dell was a one-day event. The various stock market indices recovered over the next several days. Nonetheless this episode illustrates the irrational element in the stock market.
Investment theory suggests that the stream of earnings anticipated by a company determines stock prices. The earnings could be affected by a variety of factors such as strength of economic growth, the rate of inflation, interest rate levels and global economic conditions, to name a few. The rational investor will take all available information into account in making his or her investment decisions.
In this case, investors had a certain earnings expectation for Dell factored into its stock price. If earnings turned out higher than expected, then Dell's stock price would have increased; conversely, if earnings were less than expected, the earnings should have declined. It seems that Dell's earnings were on target, but investors in tech stocks were used to being surprised on the upside. The "expectation" was not fulfilled because the "upside surprise" didn't occur.
In a market where "irrational exuberance" becomes the norm, it may make sense to become irrationally fearful as well. If an investor knows that valuations are not determined by fundamental factors such as earnings, interest rates and inflation, then he is right to be fearful that the house of cards could fall at any minute.
Fundamentals Forgotten?
Does fundamental analysis matter any more? It depends on where you look. Stock prices may be more in line with underlying valuation in the blue chip area, but less so on technology stocks. According to Russell data, the 50 largest companies in terms of market capitalization returned 39.1 percent in 1998, but the 1001st through 3000th company in the Russell 3000 lost 2.6 percent during the year.
How have individual investors become so enamored with the stock market after years of neglect? Perhaps they have come to realize that the returns in the market are not likely to be matched in "safer" instruments such as Treasury securities. The chart below compares average stock market returns to the yield on the 10-year Treasury note. Interest rates have decreased steadily since the early 80s and yields have become quite meager in recent years compared with stock market returns.
The chart depicts the 10-year average change in the various stock measures. The 10-year Treasury note is simply the level in December of that particular year. Note that stock indices have not exactly performed the same in this 30-year period. For instance, the Wilshire 5000, which encompasses the entire market, outperformed the Dow and the S&P until 1989. Between 1989 and 1997, the Dow Industrials outperformed the wider measures.
What are the fundamentals that consumers see? Individual investors are bombarded by annual returns of stock market indices or mutual fund averages. In comparing these to interest earnings they could receive on their bank certificates of deposit, it's a no-brainer. Buy stocks.
Now is a low interest rate environment. Low rates spur economic activity. Consumers can borrow more money for bigger homes as well as for new cars, boats, and vacations. Businesses can finance more capital spending on plants and equipment. If consumers and businesses are spending more money on these large-ticket items, clearly the funds must be accumulating as profits to the corporation, as long as compensation and other business costs remain roughly unchanged.
In addition, the streams of future earnings are calculated to the present value using current interest rates. Lower interest rates yield a greater present value of future earnings.
So far, individual investors appear to follow fundamental analysis -- low interest rates are good for economic activity and profits.
Individual investors also know that inflation is bad. But the Federal Reserve, global competition and improved productivity gains have virtually wiped out inflation. Prices of consumer goods are barely higher than a year ago. Prices of consumer services are up only 2.4 percent from year ago levels -- and the trend in this series is heading lower rather than higher.
Investors have seen that the low inflation environment has not only given consumers more money in their pockets to spend on more goods and services, but has also reinforced the low interest rate environment. Again, individual investors are quite rational about looking at fundamentals here.
The final key determinant of stock prices is earnings. Profits are enhanced by a rapidly growing economy. Once again, investors appear to follow fundamentals as economic growth consistently exceeds expectations of professional market participants and economists. Real GDP expanded at a whopping 5.6 percent rate in the final three months of 1998 while the year as a whole grew 3.9 percent for the second straight year. This performance has been made more notable by the weakness of many of this nation's neighbors.
In addition to profit growth, financial analysts look at the price-earnings ratio as an indicator of stock valuation. At 25, the P/E (based on future earnings) is at a record high. Some equity analysts believe the P/E ratio should be at roughly half this level based on traditional measures. This indicator is probably the most bearish of the fundamental factors -- yet probably the one to which individual investors pay the least attention.
Missing Links? If individuals are (generally) looking at fundamentals, what is Alan Greenspan & Company so upset about? Two things. First, economic activity has been so strong and healthy that it is already employing much of the skilled labor force. In order to produce more goods and services, companies may need to bid up wages and in turn prices to get the additional skilled labor required. Despite its absence, wage-push inflation remains the primary fear that motivates the Federal Reserve these days. Higher wages mean higher compensation costs to corporations. This leaves less room for profits.
In the past couple of years, improved productivity gains have played a major role in holding down inflationary pressures. If workers can produce more goods and services with the same available capital, higher wages are not inflationary. Moreover, global competition has curtailed wage demands and forced companies to reduce production costs whenever possible. Addressing Congress for the semi-annual Humphrey-Hawkins testimony, Alan Greenspan suggested that the U.S. economy is now "less prone to inflation than in the past."
The other major factor that many analysts fear individual investors are ignoring is RISK. Individual investors new to the rough and tumble world of stocks have only seen bull markets and market crashes that have recuperated in less than six months.
Most of the investors now following the stock market did not participate in the bear market of the 1970s when prices languished for several years. The risk that economist, financial analysts and Alan Greenspan consistently mention is not in their realm of comprehension. How could it be if market crashes are seen as "windows of opportunity" to buy bargains?
Surveys undertaken by various mutual fund companies typically find the same result. Consumers are used to the large returns of the past few years. About 55 percent of those surveyed by IAI mutual fund group expect at least 15 percent returns in the long term. Professionals in the business may smirk (or tremble) at this unrealistic expectation, but it is worth noting that the average return over the past 10 years for the Dow Jones Industrial Average, the S&P 500, and the Wilshire 5000 is roughly 16 percent. Since most investors have been in the market only for the past 10 years, their point of reference is rosy to say the least.
This 16 percent rate is a far cry from the 11.2 percent average return since 1926 estimated by Ibbotson Associates. The United States has certainly experienced a variety of business cycles with robust growth, sluggish growth and everything in between during this 70-year period. Isn't it likely, then, that annual stock market gains will revert back to their long-term average? If so, we would need to see some low/no growth years in stock prices
The Bottom Line
The stock market is supposed to be a leading indicator of economic activity. Perhaps it is the leading aspect of this indicator that is changing. But, if interest rates begin to rise, stock prices are likely to dip as individual investors shift out of the equity market. If economic activity moderates and profit growth languishes, stock prices are likely to head south.
Anomalies have existed in the financial market for extended periods in the past. For instance, in the 1980s, inflation was moderating rapidly, but long-term rates remained at high levels yielding high real rates for several years. Given that many of these bond investors had been burned in the 1970s when inflation was on an accelerating kick, it made sense that bond market players wanted to make sure that inflation was dying before allowing rates to settle at lower levels.
In the same fashion, the stock market may appear overvalued in segments. We haven't experienced such a low inflation, low interest rate environment since the 1960s. The record P/E (price-earnings) ratios that appear unrealistic today may indeed be realistic in this kind of environment or in segments of the market. Take special note of small capitalization stocks -- they have not participated in the late 1998/early 1999 rally at all despite analysts' predictions of a recovery for two years running.
Perhaps the market segment doesn't matter after all. At February's Humphrey-Hawkins testimony, Alan Greenspan warned, "Equity prices are high enough to raise questions about whether shares are overvalued."
What's an individual investor to do? Remain cautious and diversified. Don't shrug off long-term averages that reveal potential stock price corrections. Greenspan promised to watch vigilantly for signs of economic slowdown and signs of inflation. Individual investors need to do the same.
By Evelina M. Tainer
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