Where's the Bottom?
When Will We See It and What Will Lead Us Off the Bottom?

The 27% decline in the S&P 500 from its high in the past 12 months has been clearly traced to declines in the technology and telecommunications sectors. Virtually every other major sector of the market has actually increased in price in the same period. Technology, however, declined 58.4% and communications was down 39.2% and together these two sectors comprise a quarter of the market. Thus, the story of the stock market in the past twelve months continues to be the story of the unwinding of the technology bubble, as we discussed last quarter.

The news for the market, however, is not all bad. The Fed has just lowered interest rates for the third time and, historically, during the twelve month period immediately following a third rate cut, the equity market has risen by at least double digit rates in every period except one in the last 75 years.

Plenty of money is sitting on the sidelines waiting to go into stocks. Over $175 billion has already been added to money market funds in the first quarter of 2001, more than the $160 billion that was added to those funds in all of 2000. The total of all dollars now sitting in money market funds exceeds $2 trillion and, traditionally, a large percentage of these balances is eventually invested in the stock market. Needless to say, the dedication of a significant portion of this money to stocks would have an immediate positive effect.

As important as the Fed and positive flows are to the stock market, we still believe that valuation (or the establishing of both absolute and relative values for stocks) is still the best way to predict a bottom in stock prices. Once values are established for a group of stocks they can be compared with previous periods in the market to determine whether or not their current values are similar to those that prevailed during past periods of market lows.

While the NASDAQ is a barometer for technology stocks, most investors in large capitalization U.S. stocks use the S&P 500 as the relevant benchmark. We believe that, in order to predict the bottom in the S&P 500, we must first select an appropriate method of valuation, determine reasonable bands for that method during normal market periods and then determine a likely floor by applying past values to current conditions. In establishing valuation, we use forward 12 months earnings estimates that have already been revised downward for recently announced disappointments.

At present, on forward 12 month earnings estimates, the S&P 500 is selling at a price/earnings multiple of 20 times, the lowest forward multiple at which it has sold this year and the lowest forward multiple at which it has sold since the Asian credit crisis of August 1998. Historically, the market has traded within forward multiple bands of 14 and 24 times, although it consistently sold at much higher multiples in the 1998 and 1999 period.

If 14 or 15 times is the bottom of the range, what would cause the market to trade that cheaply and when have such periods of low multiples occurred? Periods of low forward multiples for the S&P 500 in the past have occurred during times of increasing interest rates, periods of high inflation, times when recessions were anticipated, periods of mounting deficits, times when U.S. companies were not competitive with the rest of the world (through excessive debt, high relative labor costs, manufacturing inefficiency or negative currency effects) and war or other upheaval such as the mid-70’s oil crisis.

Are ANY of these factors, which could take the market to the low end of the historical multiple range, in effect right now? Well, we have decreasing interest rates and monetary ease, NOT monetary tightness. Worldwide excess capacity and continued strong imports, among other things, contribute to an environment with little inflation pressure at present. The fiscal situation is one of surplus, not deficit, and we expect a tax cut this year. U.S. companies are not only competitive with the rest of the world they are, in fact, the world’s low cost producers of many goods and own both the world’s leading technologies and many of its most recognizable brands. They are managed efficiently, with much vision and the clear recognition that most markets these days are global in scope. We are not currently at war and no upheaval is evident (though, admittedly, upheavals are never evident until they are upon you). We may or may not be in recession but, if we are, it’s too late to “anticipate” it and we are likely to be closer to a buy point than a sell point in the stock market. Hence, we conclude that the low end of the forward multiple range is not likely to be attained.

Where should the multiple be? We submit that the market should trade between 18 and 22 times forward earnings, and at a higher multiple when growth rates expand again and time horizons lengthen. This is well within the multiple range at which stocks trade when interest rates are low, inflation is low, companies are healthy and competitive and fiscal restraint and potential tax cuts are evident.

Why should the market trade at the high end of its forward multiple range? Why not lower, say, 16 or 17 times? Well, one-third of the companies in the S&P 500 have been replaced in the last six years due mostly to existing names being merged out of existence. The names that have been added have consistently been in higher growth, higher multiple companies. Thus, the S&P 500 has become a “growthy” index which argues for a structurally higher P/E multiple.

More importantly, as the pro-active Fed has become more and more successful at dampening the volatility of economic cycles, the equity risk premium has gradually declined which has the effect of cutting off the low end of the multiple range at which the market can sell.

We emerge from this brief analysis with the belief that the S&P 500 will not sell much below 18 times earnings, down 2 multiple points from here at most, which would mean potential additional downside of 10% to 15% in the S&P 500. However, it is possible that the multiple won’t go lower than where it is selling right now, which means we are at or near a bottom.

There are other early but unmistakable signs of market bottoms. New York Stock Exchange breadth (advances over declines) has been consistently on the plus side by a substantial margin. Downward earnings revisions have slowed. Prior to the absolute tantrum thrown by the market (March 22) in the wake of the Fed’s latest 50 basis point move (when the market clearly wanted to see 75) there had been signs that some technology stocks were beginning to establish a base. And, perversely, the extension of the decline in technology stocks to the blue chips last month, while scary, was, in our view, early evidence of capitulation, that is, a decline that becomes broad based when, seemingly, everyone throws in the towel. Many market participants believe that no sustainable upturn is likely until we experience large volume, combined with precipitous declines and near-panic selling, the classic definition of “capitulation.” Once this occurs, say believers, the market should reverse itself and mount a sustained move upward.

It looks as if everyone is selling. The New York Stock Exchange traded 1.7 billion shares on March 22, the third highest volume session ever, while over 2.5 billion shares were traded on the NASDAQ, its 14th busiest day ever. Earlier in March, the Dow Jones Industrial Average closed down over 430 points in a single session. It is estimated that $10 trillion of market value has been lost in stocks worldwide since March 2000, a number roughly equivalent to a third of world GDP. Could this be capitulation?

There are signs, however, of an emerging base forming in technology. Manufacturing capacity growth for semiconductors has now slowed for the first time in a year and a half. A peaking in capacity growth has been a good indicator of a bottom in relative performance for these stocks for the last few market cycles. The Producer Price Index appears to be rising and an increasing PPI (or, at least, one that is not declining) usually coincides with rallies in technology-related industries. A bottoming process in analysts’ downward estimate revisions appears to be occurring. Those companies for which expectations have not been high, such as semiconductor companies, are seeing the bottom in downward revisions and their stock prices are not finding new lows when the market sells off.

Perhaps the most important reason why we may be near the bottom for technology stocks is that, as previously noted, valuations are now much more reasonable. In fact, relative price to sales numbers are nearing past lows, a fact that could represent a buying opportunity.

It is probably not possible to live through the magnitude of this downturn without structural damage to the market. U.S. corporations incurred a lot of debt in the 100 plus months of the economic expansion. Individuals stopped saving as they saw the values of their investment portfolios rise. Both of these situations must now be unwound as corporations and individuals repair their damaged balance sheets. Such a process takes far longer than a couple of quarters. Thus, we believe the long road back to 5000 on the NASDAQ and to new highs on the S&P 500 will be slow and volatile. Stock selection, therefore, is critical.

During the first quarter Oakwood reduced client portfolio technology holdings and held cash. As the quarter drew toward a close, some of this cash has been redeployed into the market, especially into the domestic oil service area. At present, Oakwood portfolios remain no more than market weighted in technology and we await clear indications of improving earnings visibility before we would consider moving to an overweighted position.

We are overweighted in the oil service sector, believing that exploration and development activity will increase in the coming years. We also continue to overweight financials in the belief that the attractive characteristics of these stocks surpass any short term asset quality concerns. The industrial sector is also overweighted and includes specific global powerhouse stocks we continue to like.

Despite our over and underweighting in certain economic sectors, we remain convinced that broad diversification in quality companies is the most appropriate way to participate in any potential rally. Consequently, we continue to have representation throughout the economy, which we believe gives the portfolios maximum flexibility while retaining no small measure of risk control.