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Even near 10% growth, will the market
still disappoint?
Heydon Traub, Boston Business
Journal, April 16, 2004
With just over a quarter of the year
complete, we have had a bumpy ride thus far in terms of stock market
returns.
Despite a strong start to the year, the market has mainly provided
volatility over the past two months. The market return for 2004 peaked on
Feb. 11 with a gain over 4 percent and since has fallen back about 1 percent
(specifically the S&P 500). Given the general feeling that seems to be out
there, you would think the market has disappointed investors so far this
year. But what's wrong with a 3 percent return?
In fact, investors should be quite pleased with an investment that is on
pace for about a 12 percent return for the year. This is especially true
when bonds have only delivered around 1.5 percent returns and cash returns
(money market funds) have been under one-quarter percent.
As always, readers are more interested in what the markets will do going
forward, so I will take out my crystal ball and give a best guess on this
front. Interestingly, I think we can expect pretty much what we have had
thus far, at least for the primary asset classes.
I will start with money market returns. The Fed Funds rate is currently 1
percent; some are projecting a Fed rate hike as early as this summer. I
would argue the Fed has been very clear it will lean toward boosting the
economy and risking some inflation. This would suggest it will not likely
raise rates until after the November election. If the timing is, say,
December, then you can expect a return of just 1 percent or less from
holding cash.
Given that the long-term real economic growth rate is likely to be close to
3 percent and long bonds typically yield levels similar to nominal GDP
growth, I would argue the equilibrium yield for long-term bonds would be
closer to 6 percent. This would mean the long bond yield is likely to go up
about 1 percent from here. This would lead to total returns for long bonds
that are negative if the yields were to rise the 1 percent noted by
year-end.
The damage for the broad bond market that includes short- and
intermediate-term bonds would be less severe. Funds that invest across a
broad spectrum of bonds will likely generate no return for the year in this
scenario.
Don't be confused into feeling safe owning bonds because the Fed will not
raise rates for a while. The bond market anticipates Fed moves about three
months in advance. And based on research by the Bank Credit Analyst, 40
percent of the bond price declines in a bond bear market occur before the
Fed hikes rates at all. Holding bonds is becoming increasingly risky.
Moving to the equity market, some say valuations are high, as
price-to-earning ratio based on reported earnings are about 21, high
relative to history. However, interest rates are historically low, and
earnings growth is expected to be higher than normal in the near-term.
Looking at valuations using expected 2004 earnings for the S&P 500, the p/e
ratio falls to 18. That number reflects expected earnings growth of 14
percent, and earnings are expected to grow 12 percent next year.
Despite the roughly 3 percent gain year-to-date, p/e ratios have been stable
this year thanks to growing earnings. I think we can expect some minor p/e
compression this year as the fuel from the big earnings rebounds begins to
slow down -- or even reverse in some cases.
The compression will likely bring it down to 17 times forward earnings,
reflecting expectations by year-end for slower economic and earnings growth.
The aforementioned fuel has been large tax cuts, incredibly low interest
rates and a falling dollar. At best, we can expect no tax cuts and may see
an increase by next year.
Lastly, the dollar's long decline seems to have stalled and we have seen a
bit of a rally recently. Again, it is likely that meaningful declines in the
dollar are behind us, and it is not unrealistic to see it rise, especially
once the Fed begins to raise rates.
However, for the most part, I would argue that the market has already priced
in most of these concerns. If it had not, then I would expect multiples to
be even higher, given such low interest rates and heady earnings growth. So
don't expect the market to fall when the Fed finally does raise rates.
In fact, the market tends to perform well by historical measure during the
initial phase of rate hikes, as a Fed move to raise rates typically means
the economy is growing strongly -- that is, until the third Fed rate hike,
at which point the market begins to flounder as the economy slows from the
series of rate hikes. But we are likely a long way away from the third rate
hike at this point.
To sum up the equity forecast, if the price-earnings multiple fell from 18
to 17 and earnings were flat, the market would fall just over 5 percent.
However, assuming earnings expectations for 2005 remain at 10 percent, then
the market would go up 5 percent over the next year (the 10 percent earnings
gain, less the 5 percent p/e ratio decline). Throw in a roughly 2 percent
dividend yield and we are at 7 percent -- not too exciting, but better than
returns of 1 percent or less for the other asset classes.
So buy stocks, but be prepared for "disappointing" high-single-digit returns
for the year.
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