Equity Market - Strategy
Despite rallies mounted late in the year, market capitalization weighted global equity prices fell approximately 20% in 2001 on the heels of a similarly dismal 16% decline in 2000. U.S. equities fully participated in this first sequential market decline since 1973-1974 as the bellwether S&P 500 fell 12% after a 9% decline in 2000. The NASDAQ Composite declined another 21% in 2001 after having been down nearly 40% in 2000. Since the bottom was reached on September 21, however, both indices have acted substantially better.
Corporate earnings have fallen into a crater. Twelve months ago the 2001 consensus estimate for S&P 500 operating earnings was in the $63 range. Today, that number is around $44, a shortfall of nearly a third from expectations that existed as recently as a year ago and an estimated decline of 32% from the record earnings levels of 2000. This earnings decline will represent one of the largest single year earnings downturns in history.
In view of the improvement in the stock market in the final quarter of 2001 and the $44 operating earnings per share estimate for the year, the market is currently selling at a healthy 26 times trailing 12 month operating earnings. Since this is near the high end of the P/E range at which stocks have sold in the past, some market observers have been prompted to note that the market is still expensive and, hence, still vulnerable to a downturn.
In response to this view, we would first note that markets are forward looking. The recovery in 2002, while it probably won’t be a “V” shaped “snap-back,” will allow corporations to turn in a 12% or so level of earnings growth. Thus, the S&P 500 consensus earnings estimate for 2002 is $49.35 and, on that number, the market is selling at 23 times operating earnings, a level more consistent with average valuations in recent times.
Second, analysts and market strategists are, unfortunately, trend followers. This means that estimates tend to be too aggressive at peaks and too conservative at troughs. A larger-than-consensus operating earnings estimate for 2002 lowers the P/E ratio to a greater extent. A few market strategists are estimating that operating earnings can return to their old 2000 highs, that is, approximately $56, by 2003. While we believe it is too early for a precise estimate of 2003 earnings, the market would be selling at just 20 times that number.
Finally, historical P/E ranges and averages are inclusive of periods that encompass a much higher level of interest rates and inflation. By most of those metrics the market is somewhat undervalued at present. As we pointed out last quarter, the market multiple ranges between 17 and 28 times during periods when inflation is 2%.
Whatever its proper valuation level, a retrenchment in the stock market, after the fourth quarter run-up, would not be surprising. The weakness in fourth quarter earnings and, for that matter, the expected weakness in earnings for the first quarter of 2002 may not be fully reflected by the market, now that stock prices have appreciated off their September lows. In addition, the market appears to be anticipating rather quick economic growth off the recession floor and, if the profits environment remains as weak for as long as we suspect, capital spending will be lackluster and the “snap-back proponents” will be disappointed.
The potential to retrace some of the progress recently made by the market does not deter us from the longer term, generally positive stance on stocks we articulated last quarter. Monetary and fiscal stimulus is massive, the consumer is less vulnerable to layoffs than in previous recessions, the banking system is in good shape, plenty of cash is waiting on the sidelines to be invested into the market and the general environment is one of low inflation, low interest rates and reasonable, if not cheap, valuations. In addition, inventories have been further worked down, corporations are repurchasing their own stock and merger activity is plentiful. There appears to be little doubt, absent another shock, that the year ahead will be better than the year just completed.
Such a market scenario is tailor-made for our conservative equity strategy with its orientation toward risk control. We continue to diversify portfolios across all major economic and market sectors in the S&P 500, believing that broad diversification is an effective way to control the volatility of the portfolio. Additionally, as we mentioned last quarter and as you have probably noted, the stocks added to our portfolios in recent months have primarily been less risky issues since the market is not presently according a sufficient reward to investors for taking incremental risk. This has the effect of lowering the overall beta, or risk measure, of client equity portfolios. Finally, we continue to hold modest amounts of cash equivalents which we expect to deploy when market opportunities are presented. As always, we seek stocks which are selling at prices that represent attractive values relative to growth rates and which have identifiable and predictable streams of earnings.
We remain underweighted in technology and technology-based telecommunications. The capital spending driven, or corporate, portion of technology is still many months (if not a couple of years) away from another major up cycle and the consumer-driven portion may be vulnerable in the near term if layoffs proliferate. It is not lost on us that fully 75% of the decline in profits for 2001 comes from the technology industries. In view of the magnitude of the price move off September lows (which was driven by purely non-fundamental factors) and the tough quarters these companies are facing, we think that too much recovery is currently priced into the technology sector.
We also remain underweighted in consumer-based industries, reflecting the belief that, no matter how well the consumer sector has held up, consumer spending becomes more vulnerable if the recession deepens. Within the sector, we continue to emphasize stable growth characteristics, such as those offered by the health care, retailing and media industries.
We are overweighted in financials as we continue to believe that the stocks of these companies are very cheap relative to their growth rates. We are also overweighted in capital goods and industrial conglomerates reflecting our conviction that the best of these companies will see their stocks act as bellwethers of an improving economy. Most other major sectors continue to be roughly market weighted and are represented in portfolios by good stock choices.
Common stock investors have endured a great deal over the past two years. Because the economic recovery is likely to be muted, at least in the early quarters, and because the market price/earnings ratio is not as low as it has been at the bottom of past recessions, common stock returns in 2002 may be somewhat restrained, if still positive. But looking outside the confines of an artificial one-year time frame, it must be remembered that there is one risk the market has consistently paid investors to take - that of investing in stocks. We will continue to keep our clients prudently invested in that arena and expect to judiciously add value as opportunities are presented while controlling, to the extent possible, portfolio downside risk.
