|
|
Forecasts for the next year (or, buy even
though it hurts)
Heydon Traub, Boston Business
Journal, July 26, 2002
Just when it looked like the economy had turned the corner to steady growth,
accounting scandals sent the market reeling yet again. In what has become
the largest bankruptcy in history, WorldCom's $3.8 billion of hidden losses
is likely to bring down the company.
With investor confidence crumbling and terrorism here in the United States
still a serious threat, it seems a tempting time to get out of the stock
market. But as we have discussed before, the stock market generally moves in
the opposite direction that the majority of investors expect it to go. Thus,
with most investors bailing out of the market, we are expecting a sizable
rebound in the near-term.
Briefly looking at history as a guide, in the last 40 years, the market has
fallen by a double-digit percentage quarterly loss eight times. In every
case, the returns for the following quarter were at least 5 percent, and
often much more. You have to go back to the attack on Pearl Harbor in
December 1941 to find an occurrence of a quarterly loss following a
double-digit quarterly loss. And in that case, the market recovered all of
its losses in less than a year. However, if you go back to the depression
years of the 1930s, you can find several instances where buying after a
large quarterly loss was a bad idea. Thus far, with a sizable loss thus far
for the third quarter, buying was a bad idea. However, we think this
scenario is much more likely to play out with a big recovery than a
depression-era meltdown.
As is often the case, the key is what happens to earnings. Back in the
1930s, company profits were disappearing and stayed low for many years.
However, in the majority of cases when the market recovered, the market
losses were due to concerns unrelated to earnings problems for the overall
market: Sept. 11, the Enron scandal, the Long-Term Capital Management
crisis, the Gulf War, etc. Today, the earnings picture is reasonably good.
Earnings for 2002 are expected to grow 5 percent to 10 percent, adjusted for
changes in accounting for goodwill. For 2003, it is an even rosier 10
percent to 15 percent. With an improving earnings picture, we think the case
for a market rebound is quite strong.
As usual, a key factor we look at is valuation, and in particular, price
multiples in relation to interest rates. Given the big market decline, the
forward price-to-earnings ratio (using expected earnings over the next 12
months) is 16.2 (all prices are as of mid-July). This translates to an
earnings yield of 6.2 percent. Over the last 20 years, the earnings yield
and bond yield have generally been at similar levels. And when they move
apart, they have tended to gradually move back to similar levels. In order
for them to move to the same level, the market would need to rise by 31
percent (assuming rates stay the same). Due to some other factors, such as
the abnormally high level of corporate bond rates, we are actually looking
for a return of "just" 16 percent for large-cap U.S. stocks over the next
year.
Our favorite major asset class continues to be small-cap stocks due to its
strong earnings outlook. Consensus earnings growth is looking for earnings
to double over two years based on strong earnings growth this year and next.
Although we expect the actual growth will come in somewhat below this, we
are still looking for small-cap returns of 21 percent.
The best equity asset class last quarter was international stocks, as they
fell only 2 percent. The losses were mitigated by strong gains from foreign
currencies as the EAFE (Morgan Stanley's Europe, Australia, and the Far East
stock index) basket of currencies returned 11 percent.
In addition, the Far East markets were up 5 percent, in U.S. dollars. Thus,
after more than a decade of disappointing international returns, EAFE
actually has outperformed the U.S. market by over 2 percent annualized over
the last three years. We expect continued better results from international
as valuations are similar to the United States but rates as a whole are
lower, mainly due to Japan's 10-year bond yield of just 1.3 percent. Thus,
we are looking for returns in this asset class of 18 percent over the next
12 months.
Sticking with non-U.S. investments, we are looking for even a bit stronger
returns from emerging markets, with a forecast of 20 percent. Although
returns for emerging markets are actually positive over the last 12 months,
valuations in that region are still reasonable. In addition, these markets
tend to move more in both directions than the developed markets. So with our
expectation of a market rally, this asset class should respond strongly.
Lately, the best option has been bonds, which have returned about 8 percent
to 9 percent per year in recent years. However, we think the good gains in
bonds are behind us.
Despite the very low rates on cash, the returns still have looked good
relative to stocks even at just 2 percent. However, we expect this won't be
the case going forward, and with returns of just 2 percent for cash, this
will not be the place to be in the near-term.
Now is not the time to take your money and go home. Generally, the best
stock market gains are had at the point when investing is most
uncomfortable. If we are not there now, we are pretty close. And with both
stock multiples fairly low and interest rates very low, the odds haven't
been this good for stock market gains since the mid-'90s.
|
|
