Mike this is from Economist.
The bulls' last charge?
N E W Y O R K
The Dow keeps setting new highs. But the number of shares whose prices are still
going up is dwindling fast
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TRADERS cheered on the floor of the New York Stock Exchange as the Dow Jones
Industrial Average edged past the 10,000 mark for the first time on March 16th. By the time
the cameras ceased clicking, the Dow was back in four figures again. The bull market in
American shares is still under way—but the Dow's hesitant creep past its latest milestone
reflected growing unease. The stockmarket indices are increasingly dependent on only a
handful of shares to lift them higher, raising questions about whether this dwindling band
can take the strain.
Wall Street's best-known bulls are still rampant, however. Ralph Acampora, of Prudential
Securities, now has his sights on a Dow at 11,500 some time this year. Abby Joseph Cohen,
of Goldman Sachs, is more bullish than ever—even spotting signs of improvements in some
of the world's most troubled economies, which would bode well for American corporate
profits.
Many bearish commentators (a category that has included The Economist), are loth to cry
wolf again, having been embarrassed too often during the past few years. Why not 11,500,
they shrug? For that matter, why not 36,000, as suggested by James Glassman of the
American Enterprise Institute? After all, share prices now owe more to faith in the
miraculous power of Mammon than to any prudent analysis of economic fundamentals.
True, the profitability of American companies has increased impressively during the past
few years, partly justifying higher share prices. But Ned Riley, a strategist at Bank Boston,
calculates that only 20% of the rise in the broad S&P 500 index since 1990 was linked to
increased profits. Fully 80% stems from rises in the average p/e ratio—of share prices to
profits—which has now reached its highest ever. And there is no sure way of predicting
what will cause investors to lower their expectations. Disappointing profits have not yet
done so; according to First Call, a research firm, the earnings of the S&P 500 rose by only
3.7% in 1998 compared with 1997, far below expectations a year ago.
But recently the bears have found fresh justification for their gloom in signs that America's
new popular religion has become narrower. Belief in the virtues of shares in general is giving
way to faith in a few talismanic shares. Whereas on March 16th the Dow was 12% higher
than it was on June 1st 1998, and the S&P 500 20% higher, the Russell 2000 index, which
contains a much broader spectrum of shares, was down by 11% (see chart). The ten
best-performing Dow shares are up by 48% since last June. According to Philip Roth, an
analyst at Morgan Stanley, two-thirds of the shares in the Russell 2000 are now more than
20% below their 1998 highs.
Individual investors have not escaped this. Morningstar, a research firm, says that the
average stockmarket mutual-fund is up by only 0.5% so far this year, compared with more
than 5% for the S&P 500.
The growing gap between a few leading shares and the rest makes some sense. Last year,
most of the 50 biggest S&P 500 shares delivered higher profits, whereas the earnings of
nearly two-thirds of the remaining 450 fell. The average p/e of the 100 biggest S&P 500
companies—around 32 times forecast 1999 profits—is well above the 19 times for the
smallest 100. In other words, investors expect continued faster earnings-growth from giant
firms like Microsoft and General Electric.
Demanding times
If, as seems quite likely, these firms fail to maintain this expected breakneck growth,
disillusioned investors may punish them severely—as they recently did one wonder-share,
Dell, when its revenues (not even profits) disappointed them. In general, only a few Wall
Street analysts, led by Abby Joseph Cohen, are optimistic about profits this year. Most
macroeconomists predict another tough year. And there is concern about the quality of
company reporting. In his latest letter to shareholders, a much-followed investor, Warren
Buffett, observed that “a growing number of otherwise high-grade managers have come to
the view that it's okay to manipulate earnings to satisfy what they believe are Wall Street's
desires”.
Yet, for all this, it is possible that big shares will continue to rise. One reason is that
American baby-boomers are pumping money into retirement funds, and a growing share of
this money is going into funds that track big stockmarket indices. One recent study* tackles
economists' traditional argument that mismatches of supply and demand should not move
share prices because the market is “efficient”—meaning that prices reflect all available
information. It found evidence that surges of money into index mutual-funds led to
permanent increases in share prices, and may explain up to 30% of the recent increase in
the S&P 500.
Some 29% of money invested in American equity mutual-funds in 1998 went into index
funds—six times the proportion in 1994. Many big mutual funds that claim to be actively
managed also, in practice, track indices. Pension funds, too, are indexing more than ever.
Two other sources of demand also favour big stocks. Foreign investors are pouring money
into American shares—with net purchases of $64 billion in 1997, and $43 billion in
1998—and they typically choose well-known companies. Firms have also been buying their
own shares—last year alone they bought $263 billion more than they issued (presumably
not, perish the thought, because this keeps the prices of managers' share options up). Much
of this is done by bigger companies, which have spare cash or can borrow cheaply.
How long demand remains so strong will depend, in part, on America's macro-economic
policymakers. The Federal Reserve, which cut interest rates three times late last year, seems
unlikely to put them up again until there are clear signs of consumer-price inflation. Nobody
expects that soon. New data from the Fed shows that America's financial sector borrowed a
record $1.1 trillion last year (up from $653 billion in 1997). Much of this can be attributed
to Freddie Mac and Fannie Mae, two federal-government-sponsored mortgage agencies.
David Tice, of the Prudent Bear Fund, says that, for no obvious reason, they went on a
lending binge just as the rest of the market dried up in the panic of last autumn. Will the
authorities reduce this flow of money any time soon? Maybe. But next year both the
Clinton administration and Alan Greenspan, the Fed's chairman, come to the end of their
terms in office. Both may feel tempted to keep inflating the stockmarket bubble and leave
the aftermath to their successors.
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