Equity Market - Strategy

In view of the fact that this is the nineteenth month of a punishing bear market and that stocks have repeatedly shown a high propensity to bottom in October, it may be that an end to the bear market is close in time. In terms of how much further it has to fall, it is important to note that bear markets have often bottomed out at roughly 15 times trailing 12 month earnings. With operating earnings at $50 and the S&P 500 at 1050 or so the market is trading at 21 times trailing earnings, implying that it could have further to fall.

We do not expect that the market will revisit old P/E multiple lows, however. First of all, those lows were achieved during times when interest rates were higher, when the country was running massive trade and fiscal deficits, when inflation was a worry and when U.S. corporations suffered from various disadvantages relative to producers in other parts of the world. These factors, all of which argued for lower P/E ratios, are virtually absent today.

Essentially, the multiple attainable by the market is a function of inflation and the equity risk premium. Inflation is currently very low arguing for a higher multiple while the equity risk premium has probably increased with recent events, which calls for a lower multiple. (The market multiple ranges between 17 and 28 times during periods when inflation is below 2%.) If we presume that recent equity risk premia have been lower than average and that the terrorist tragedies have moved the risk premium upward, the market multiple on trailing 12 month earnings should be around 19 times at current inflation levels. This implies that the downside risk in the market, assuming no further exogenous shock, is probably 9% or so. This would put the S&P 500 at approximately 950, a number already reached in the downturn immediately following September 11th.

The third quarter earnings reporting season is likely to provide investors with plenty of worrisome news. Earnings expectations for nearly every industry sector are being revised downward in the wake of the terrorist attacks and an impending recession. Negative pre-announcements are underway now and, as expected, many of them paint a picture of an exceedingly tough third quarter. The operating earnings estimate for the S&P 500 for 2001 is currently $44.00 but the number continues to be revised downward. Once 2001 is fully reported we expect that S&P 500 operating earnings will have declined approximately 25% year over year, the worst year for annual earnings on record. For 2002, we expect a sharp rebound back to $49.00 per share, a double digit increase, but still below 1999’s record levels.

As we have outlined in “A Word From the Advisor,” on the cover of this issue, there are abundant positive catalysts for stock prices. Massive fiscal and monetary stimulus, a consumer less vulnerable to layoffs, a banking system that is in good shape, plenty of cash waiting, presumably, to be invested into stocks, low inflation, reasonable valuations, corporate stock buybacks and merger activity all argue for better stock prices in the period ahead.

Despite this extensive list of positives for the stock market, investor psychology has clearly changed from bullishness to a bear market mentality over the past months. In other words, the mantra of “buy the dips” has been supplanted by “watch out for the dips.” For this reason, we are pleased that your equity portfolio, within its acceptable risk range, is positioned more defensively now. Not only are you holding over 10% cash but we have also systematically lowered the portfolio’s technology weighting in past months, reducing your exposure to this volatile segment of the market at a time when earnings expectations have turned negative. On the other hand, stocks added to portfolios in recent months have by and large been less risky issues, an enviable position since the market continues to punish investors who undertake excessive risk.

Industries which figure prominently in the portfolios are the financials, which continue to be priced at reasonable levels. Health care stocks, also very substantially represented, contribute excellent defensive characteristics. While staple goods such as food stocks have performed well in recent weeks we remain underweighted as we believe that such names will lag once the market turns generally upward. We also remain underweighted in deeply cyclical industries such as raw materials, consumer cyclicals and the aforementioned technology group, all of which continue to be exposed to the economic downturn.

In order to induce us to become more confident in investing your cash reserve we would want to see (1) indications of an impending end to Fed ease, (2) an improvement in the expectations component of consumer sentiment, (3) less volatility in measures of industrial activity and (4) signs of recovery in corporate profits. Until that time, we will hold modest cash positions, remain fully diversified and stay at the lower end of the targeted risk range.

The long run rate of growth in corporate earnings has been 9.4% and we have every reason to expect that U.S. corporations will match or exceed that number in the coming years. The pace of innovation in health care and biotechnology is nothing short of astounding and technology and telecommunications companies can readily resume a pace of growth well in excess of the average company. In addition, consumer electronics, prior to the market downturn, was poised for a massive upgrade cycle which, although stalled at the moment, will see virtually every household completely turn over its home electronics equipment within the next five years. Wireless devices, the poignant communications vehicles of the recent tragedy, will become absolute necessities and improvements in infrastructure will be installed. An upgrade cycle is pending in security devices and the promise of the Internet has only begun to be realized, with profitable applications at hand for nearly every industry. There’s a reason this country exports technology and education – both are in huge demand everywhere and both have created the very innovative era we’ve recently enjoyed. There’s no reason to think it can’t be continued.