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Keep a weather eye on small-caps and high
yields
Heydon Traub, Boston Business
Journal, April 26, 2002
The first quarter of 2002 might best be described as the calm after the
storm.
After a tumultuous 2001 and the ups and mostly downs we experienced, the
most recent quarter showed remarkably flat returns for the two major indexes
of stocks and bonds. The S&P 500 stock index and Lehman Aggregate bond index
both returned zero percent from January through March.
And we are looking for similarly calm waters over the next year, too, as we
expect market performance to return to normalcy.
For the asset class of large U.S. stocks, we are expecting returns of about
9 percent for the next 12 months (all the forecasts here are based on
expectations for the next 12 months). This is down slightly from last
quarter because interest rates have moved upward, making them an improved
alternative for investors choosing between stocks and bonds.
However, this rise was not as damaging as it may appear from the 0.3 percent
rise in government bond yields. Despite the rise in government bond rates,
corporate bond rates were fairly steady. Thus, not only was the yield pickup
small across the broad bond market, but the cost of capital to corporations
as proxied by investment-grade debt remained unchanged.
International stocks show a similar story as we project returns there of 10
percent. Interest rates overseas are modestly lower than in the United
States, but offsetting most of this is the fact that price-earnings
multiples are also higher.
A key factor driving reasonably good returns for stocks globally is a strong
earnings rebound. For the United States, earnings are expected to grow about
13 percent. Earnings are expected to rebound even stronger for non-U.S.
markets, helping them to a slightly higher expected return.
Emerging markets were the star in the fourth quarter, and continued to be
the best place to invest in the first quarter as well. Despite the flat
returns for large U.S. and international stocks, emerging markets soared 11
percent.
Should you expect a continuation of the big returns? We don't think so.
Valuations have moved up closer to fair value. Also, some of the gains that
came from the recognition that the large discount applied to emerging market
companies due to accounting risk is no longer appropriate, given the
scandals at Enron and others.
We think this particular benefit to emerging markets has already played
itself out. We look for returns of 9 percent.
To relieve the boredom of such "normal" forecasts for the equity markets, we
last look at small-company investments. Small-cap stocks continue to shine,
as they rose 4 percent last quarter after rising even during last year's
debacle. Amazingly, over the past three years, small-caps have outperformed
their large-cap counterparts by 12 percent per year.
Although this would normally scare us off from an asset class, we do expect
small-caps to continue to shine. We project a return of 16 percent, and
here's why we still like this group of stocks. First, that big differential
over the last three years still hasn't quite made up the huge outperformance
of large versus small in the two years before that. More importantly,
corporate earnings are expected to more than double over the next two years
as small-caps benefit most from an economic recovery.
Moving back to some less-exciting forecasts, we are looking at returns for
investment-grade bonds of just over 4 percent. This is below the current
yield to maturity of around 6 percent, indicating that we expect a bit more
increase in yields over the next year, leading to some price depreciation.
Although 4 percent is pretty bad, that's still better than cash. With
short-term rates still very low and our belief that the Federal Reserve will
not raise rates as fast as the futures markets suggest, cash will only get
you about 2.5 percent.
If you want some excitement in bond-land, try high-yield bonds. After
providing essentially no return over the past few years, they outdistanced
both the broad equity and bond indexes, with a return of almost 2 percent in
the first quarter.
We expect the good times to continue there as well, as there is a lot of
catching up to do. Spreads over treasuries are still wide and these bonds
should benefit greatly from the expected economic recovery. We are looking
for about 9 percent returns.
Taken together, the theme to carry away from this is diversification.
Normally, the main reason to diversify is to reduce risk. However, if our
views come to pass, with small-caps the best equity investment and
high-yields the best bond investment, then diversifying into these areas
will give you what everyone wants: higher returns with less risk.
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