Equity Market Strategy
The latest revisions in economic data show an unbeliev-able 8.4% increase in first quarter productivity, indicative of the long-lasting effects of productivity-enhancing technology spending, much of it emplaced during the capital spending boom last decade. Simultaneously, unit labor costs have also declined signaling expanding profit margins and a better environment for corporate profits ahead. Improving profits will lead to increasing earnings which, for some companies, will begin with the second quarter’s earnings report and, for most, will start when the third quarter is reported. Thus, operating earnings for the S&P 500 this year have moved up to $49.00, and to $56.00 for 2003. On these numbers the S&P 500 is selling at 19 times 2002 estimated earnings and 17 times 2003’s estimate.
We have made the case many times that price/earnings multiples, while probably a little too high when they were at 21 - 24 times, were also not likely to move down to the 14 - 15 times earnings area, the low end of the historical multiple range, for any extended period. We opined that periods when the market sold at 14 times earnings coincided with times of economic downturn, high inflation or some other relative disadvantage for the U.S. stock market and that, once the technology bubble was unwound, the market actually consisted of solid corporations, many of which have competitive advantage, diverse and global markets, excellent financial controls and capable management. Further, interest rates are low and inflation is under control. Consequently, we concluded, markets could logically sell off to 17 or so times earnings but were unlikely, in such a benign economic and regulatory environment, to stay much lower. With the market at 17 times 2003’s estimates, aren’t we there? Is this not then the buying opportunity of the century?
Maybe. But the bear market mentality continues to pervade the trading day. And corporate confessions are probably not yet finished. As questionable accounting practices are disclosed the offending company’s stock undergoes a punishing retraction which frequently extends to the entire market. This process is creating huge market volatility and causing capitulation in some technology industries. WorldCom, which Oakwood did not own in client portfolios, had a recent trading day in which 2/3 of its market float changed hands. IBM traded five times its average daily volume after an April announcement. While selected buy opportunities may exist, this environment is hardly conducive to reversing the current bear trend and mounting a sustained bull phase.
If the market still carries an extra measure of risk how is Oakwood positioning equity portfolios so that they remain invested but are not subjected to untoward volatility? First of all, we are choosing to emphasize large capitalization, high quality issues, most of which have multinational customer bases which could benefit from the weaker dollar. Secondly, all things being equal, we are emphasizing dividends more than ever before. Third, where sensible, we are holding more names, thereby increasing diversification as a measure of risk control. Individual issue selections, always the most important part of the process, have generally been more tilted toward value than growth for several months. Finally, from time to time, we will hold a little more cash than usual.
Most bear markets discount economic and profit downturns which explains the bear phase from March 2000 through September 2001 and, for that matter, most previous post-war bear periods. Since year-end 2001, however, except for the continued unwinding of the technology debacle, economic and profits news has been expected to be better. Yet, the market has put on one of the more vicious declines in its history this past quarter, based primarily on emotion and fear. The only comparable period in recent history was probably the 1962 bear market precipitated by the Kennedy administration’s handling of the steel situation and the Cuban missile crisis. Other emotion-driven bear phases since World War II have been very short lived - Eisenhower’s heart attack, the 1987 downturn, the Kennedy assassination, the 1998 Asian tiger meltdown.
It’s tough to put a calculator to emotion and fear. This is why we continue to engage in more risk averse approaches to portfolio management despite the fact that history tells us that the market, at some point, will return to the discounting of economic events which would result in a rally. We prefer, however, to wait for actual signs that stock price declines are likely to be at an end before we become more opportunistic. As evidence that the bear phase has run its course we look for stocks to decline on decreasing volume, for stocks in formerly high flying industries to capitulate and for better earnings and an improving economy to begin to drive stock prices.
Positioning for this more sanguine environment we continue to overweight financial services and health care, recognizing the low multiples of earnings and cash relative to their earnings prospects at which the former are selling, and the superior growth characteristics, worldwide franchises and positive demographic profile occupied by the latter. The upcoming healthcare debate in Congress attendant to Medicare drug reimbursement, as well as the rhetoric surrounding the pending midterm elections, are likely to buffet the prices of healthcare issues going forward but we believe these issues continue to be good portfolio choices for the long haul.
With the S&P 500 down -13.1% for the year to date, we note that the average change in that index in the first twelve months of an economic recovery is +15.3%, counting the ten major recoveries since 1945. It would appear that the equity market has some catching up to do over the next year.
