1987 Market Has a Tough Act to Follow : Dow Hit 30 Record Highs; Winners Led Losers 2 to 1 on NYSE

By BILL SING

Jan. 2, 1987 12 AM PT

Times Staff Writer

Like an aging rock superstar returning again for an encore concert, Wall Street turned in another stellar performance in 1986, prolonging the bull market’s life for a fourth straight year. But experts say it may be harder for stocks to retain their thunder this year.

Spurred by lower interest rates and low inflation, Wall Street rose far higher than most analysts had expected as stocks generally outshone bonds, precious metals, housing and many other investments. The Dow Jones average of 30 industrial stocks closed Wednesday at 1,895.95, a 22.58% gain during 1986, following 1985’s gain of 27.66%. Thirty record highs were set, including the current record of 1,955.57 reached on Dec. 2.

Impressive Gain

The broader Standard & Poor’s 500-stock index gained a more modest--yet still impressive--14.62%, its fifth consecutive annual increase. Gaining stocks led losers on the New York Stock Exchange by more than a 2-to-1 margin.

Such a strong showing came despite the sluggish economy, lagging corporate profits and worries about the Ivan F. Boesky insider trading scandal. Nor was the market hurt significantly by selloffs of stocks from investors seeking to take long-term capital gains before year-end to beat the rise in the top capital gains tax rate to 28% from 20%.

The year was marked by new single-day records in trading volume, including December 19, when 244.68 million shares changed hands. Volume for the full year on the NYSE hit 35.68 billion shares, 29.7% higher than in 1985.

The year also saw wild swings in the Dow average--including a record 86.61-point decline on Sept. 11--spurred by so-called program trading, in which major institutions trade large blocks of stock to profit from price differences between stocks, stock index futures and options.

Credit for much of Wall Street’s health goes to lower interest rates, which made Treasury securities, certificates of deposit, corporate bonds and other investments less attractive. Foreign investors and institutions were awash with cash and invested in stocks, despite lackluster corporate profits.

“If you don’t have more attractive alternatives, then it doesn’t take a robust economy to sustain a strong stock market,” said Robert Arnott, president and chief investment officer of TSA Capital Management, an investment management firm in Los Angeles.

But many analysts and investment managers, believing that much if not all of the fall in interest rates and inflation is over, are decidedly cautious about whether the market can shine as well this year as it did in 1986 and 1985.

Indeed, analysts note, the market was lackluster in the second half of the year, with only some stocks continuing to do well in the second half. All of 1986’s full-year gain was posted by July 1, when the Dow first closed above 1,900. That period, not coincidentally, corresponded to the bulk of the year’s decline in interest rates. And although the Dow index hit its all-time high in early December, many stocks peaked in late spring or early summer, analysts say.

Many see stocks continuing to remain attractive, with the Dow topping the magical 2,000 level, possibly before or after minor corrections that could drive the index back below 1,800.

But for Wall Street to show gains similar to last year or the year before--or reach even 2,500 or possibly 3,000, as some optimistic forecasters predict--investors will need more than just a continuance of low interest rates and low inflation, these experts say. They also will need a vigorous boost in corporate profits.

Profits Have Lagged

So far, earnings have not kept up their end of the bargain. Stock prices have far outpaced gains in corporate profits and stock dividends over the last few years, as shown by rising price-earnings ratios and falling dividend yields. Price-earnings ratios measure how much stocks are selling above their earnings per share.

The median price-earnings ratio of about 15.4 for stocks on the S&P; 500 and about 16 for the entire NYSE causes many analysts to worry that stocks may have gotten about as high as they can get without similar gains in earnings. The 15.4 ratio--although still far lower than the 18 and 20 ratios of the go-go 1960s--is much higher than the 12.5 in early 1986 and the 10 that was typical in 1983, noted David Blitzer, chief economist for Standard & Poor’s.

Disappointing profits, as well as sharply higher inflation or interest rates, or a recession, could spell the end of the bull market.

“Unless there is a rise in corporate earnings, the market will have problems,” said Michael Metz, market strategist at Oppenheimer & Co. in New York. He predicted that the Dow will tumble to about 1,500 this year, thanks in part to what he expects will be disappointing earnings.

Some Key Factors

However, many analysts say, a number of key economic and market conditions still favor stocks, albeit not necessarily pointing to torrid market gains. Among these key factors:

- Low interest rates. Although rates have trended slightly upward in recent weeks, economists predict that rates will remain low in 1987, perhaps dropping in the early part of the year and rising later. Many economists expect three-month Treasury bills to trade between 5% and 6% this year and 30-year Treasury bonds to trade between 7% and 8%. If that is the case, then stocks should remain attractive.

- Low inflation. This has continued to make stocks attractive against such inflation hedges as real estate and precious metals. Economists generally expect some gain in inflation this year--to between 3% and 4% from last year’s 1.3%. But that’s not enough, they say, to severely reduce the lure of stocks versus other hard assets.

- A sluggish but still growing economy. The fact that the economy is not growing by leaps and bounds is seen as positive for stocks, because an economy with plenty of excess manufacturing capacity and unemployment is not likely to trigger significant increases in inflation or interest rates. Also, some bullish analysts hope, a sluggish economy leaves room for more vigorous growth.

“The surprise next year (1987) will be in how vigorous the economy is,” said Werner E. Keller, director of research at the brokerage of Bateman Eichler, Hill Richards in Los Angeles. He is among several local analysts predicting a 2,500 Dow during 1987.

The consensus of nearly 50 economists polled by Blue Chip Economic Indicators, a Sedona, Ariz., newsletter, shows an expected 2.5% growth in the gross national product this year, somewhat less than the 2.5% to 3% growth expected for 1986. (Final figures for the year are not yet available.)

- Fast monetary growth. Robust growth in the money supply, thanks to liberal credit policies at the Federal Reserve, bodes well for continued low interest rates and for liquidity in the financial system. Such conditions rarely foster bear markets, analysts say.

- Tax reform. While the loss of the investment tax credit and other business tax breaks could hurt profits of some manufacturing companies, lower individual tax rates and other provisions increase the lure of financial assets. And the loss of the investment tax credit is not all bad: It is one reason companies are using excess cash to buy back shares instead of spending on new factories. That boosts stock market prices.

Tax reform also hurts tax shelters. “A lot of money in real estate tax shelters is likely to find its way into the stock market,” Blitzer of Standard & Poor’s suggested.

- Booming foreign investment in U.S. stocks. While stocks look expensive to some U.S. investors, they look cheap to foreigners as measured by price-earnings ratios. Japanese stock price-earnings ratios, for example, are around 50, more than triple those here.

In the first nine months of 1986, foreign investors bought and sold $203.6 billion worth of U.S. equities, 28% higher than the record $159 billion set for all of 1985, according to the Securities Industry Assn. That buying spree is expected to continue, particularly from Japanese investors, who are seen as increasingly buying--and paying premiums for--entire American companies in such industries as oil and financial services.

- Cash held by institutions. Equity mutual funds have a record amount of cash on hand, about $20 billion, equal to 10% of their assets, estimated Norman G. Fosback, president of the Institute for Econometric Research, a publisher of several investment newsletters. “Money is flowing in faster than the funds can invest it,” he said.

Pension funds also held a lot of cash, equal to about 8.4% of their portfolios at the end of the third quarter, up from 5.9% at the end of the first quarter and the highest in more than a year, according to SEI, a major pension fund consulting firm. “This indicates that money managers are becoming more conservative,” Jim Minnick, executive vice president of SEI, said.

The fact that money managers are somewhat bearish--and have more cash--is actually a bullish indicator, some analysts say. “When most money managers are pessimistic, it’s a good time to buy,” Fosback said.

- Low level of speculative activity. The bull market during the past two years has been centered in blue chip issues reflected in the Dow index of industrial stocks, which are less volatile and favored by pension funds and other institutions. More speculative stocks of smaller firms on the American Stock Exchange or in the over-the-counter markets did less well: The Amex market-value index rose only 6.96% in 1986; the NASDAQ composite index of OTC issues rose only 7.35%.

The absence of widespread speculative trading in the more volatile “secondary” stocks of smaller, faster-growing companies is bullish, as past runs of speculative fever have signaled that the market was topping out.

- Heavy insider buying. Purchases of their own stocks by company executives, directors and other insiders in the fourth quarter have been the heaviest since the third quarter of 1985 and the summer of 1982, Fosback said. That is very bullish, he said, noting that similar levels of insider buying in 1985 and 1982 preceded gains of several hundred points on the Dow.

- Lower dollar. Despite 1986’s expected record trade deficit, the dollar’s fall has lowered prices of American goods in foreign markets and boosted prices of foreign products here. That will finally begin to help exports of U.S. firms and hurt imports, experts say. This should help U.S. corporate profits.

And while economists predict that the dollar could fall more, they say that most of the decline has already occurred. That also is a good sign, because any stabilization of the dollar should encourage foreigners to continue investing in U.S. stocks, as they will be less inclined to fear losses from unfavorable currency translations.

- Corporate cost-cutting and restructuring. Years of belt-tightening should finally begin to boost corporate profits this year, economists say.

Overall, the consensus of economists polled by Blue Chip Economic Indicators is that pretax corporate profits will rise 8.3% this year, although some forecasters expect earnings gains as high as 29.3%. Blitzer at Standard & Poor’s expects a 20% rise in earnings per share for stocks in the S&P; 500 this year, compared to an 11% gain last year.

Profits are not the only story, however. Some analysts argue that cash flow is a better measure of stocks’ attractiveness. Cash flow is the combination of net earnings, depreciation and other non-cash charges from which a company pays dividends.

And, thanks to lower inflation, generous depreciation allowances and other factors, “corporations are bursting at the seams with cash flow,” although their stated profits are not that impressive, said John D. Connolly, chairman of the investment policy committee at Dean Witter Reynolds. Corporate cash flow has increased fivefold in the past decade while stock prices have only doubled, Connolly contends.

Negative Views

But not all forecasters are optimistic. Some say a slowdown in consumer spending and capital spending could trigger continued economic sluggishness or a recession, which could hurt earnings.

Experts also see other negatives that could hurt stocks. One is an expected decline in takeovers, leveraged buyouts and stock buybacks. The merger and leveraged buyout boom of the past two years has reduced the supply of stocks and driven up stock prices. But the boom is expected to slow this year, partly because of the side effects of the Boesky controversy and because the new tax law reduces the attractiveness of acquisitions.

Also, fewer companies are seen as attractive takeover candidates. For example, only about one-fifth of NYSE stocks and slightly more than a third of Amex issues are selling below book value, according to Fosback. Book value, by measuring the value of a company’s assets minus liabilities and other claims, indicates the ultimate value of a company’s stock in a liquidation.

With a more cautious outlook, analysts say investors may have to be more selective in picking winning stocks this year. Many of last year’s top performers may be hard pressed to turn in an encore, they say.

According to Standard & Poor’s, the five best industry groups for 1986, through Dec. 24, were tobacco (up 57.2%), pollution control (up 55.8%), metal and glass containers (up 50.1%), apparel manufacturers (up 44.7%) and paper containers (up 43.7%).

Five Worst Groups

But many of the stock groups expected to do well this year are among last year’s worst performers. S&P; lists the five worst groups as offshore drilling (down 56.9%), steel (off 20.3%), hospital management (off 18.3%), trucks and parts (down 13%) and semiconductors and components (off 10.5%).

Indeed, many of the individual stocks that did the worst in 1986 were from one of these groups. Seven of the 10 worst performers on the Big Board last year were in either the energy, steel or technology sectors. These sectors also accounted for many of the top losers on the Amex and OTC markets.

But many analysts say that energy stocks--and oil-service companies in particular--will return to grace this year, thanks to rising oil prices and the fact that energy stocks are cheap. “Oil stocks have definitely bottomed,” said Gregory H. Kieselmann, director of research for the securities firm of Morgan, Olmstead, Kennedy & Gardner in Los Angeles.

Many analysts also like stocks of computer and other technology companies for the same reasons. They, too, have been out of favor for the past two or three years, thanks to slumping computer sales and earnings.

But some groups held in favor for this year--including stocks in such cyclical industries as paper and chemicals--did well last year. They stand to benefit from the lower dollar and rising inflation. Paper and chemicals rose 28.2% and 32.7% last year, respectively. Interest-sensitive stocks, such as savings and loans, also could benefit from continued low interest rates. S&Ls; rose 28.1% in 1986.

Analysts also like stocks with international operations, such as drugs, that stand to gain from the falling dollar. And stocks with high dividends, such as utilities, also are expected to do well, as lower individual tax rates under tax revision favors stocks with high yields.

“Income is king,” Kieselmann of Morgan, Olmstead said.

Highlights for the Dow During 1986 Dow closes above 1,600 for first time (at 1,600.69, on Feb. 6). Dow closes above 1,700 for first time (at 1,713.99, on Feb. 27). Dow closes above 1,800 for first time (at 1,804.24, on March 20). Dow closes above 1,900 for first time (at 1,903.43, on July 1). Dow drops 86.61, its heaviest one-day loss ever (Sept. 11). Dow climbs 43.03 to record closing high of 1,955.57 (Dec. 2). The intra-day high reached 1,971.74. 1986 Top 20 NYSE Winners

Closing Price on Percent Stock Dec. 31, 1986 Change* Service Resources 15 1/2 +235.1 Banco Central 34 +226.2 Patten 16 +220.0 Reebok International 23 3/8 +152.7 Nord Resources 21 +150.0 First Capital Holdings 14 7/8 +147.9 Circuit City Stores 30 5/8 +147.5 Roper 18 3/8 +133.3 Gap Inc. 35 3/4 +130.6 L.E. Myers Co. Group 5 3/8 +126.3 Emerson Radio 9 1/2 +123.5 Ponderosa 28 3/4 +121.2 Rollins Environmental Services 25 7/8 +117.9 Fox Photo 30 1/8 +117.1 Countrywide Credit Industries 12 3/8 +115.2 Puerto Rican Cement 17 3/8 +113.8 Consumers Power 5 5/8 +108.3 Allied Stores 68 3/4 +106.0 Public Service Co. of Indiana 14 3/4 +103.4 Wayne-Gossard 24 +102.1

Stock Line of Business Service Resources office support services Banco Central Spain’s largest bank Patten sells undeveloped rural land Reebok International athletic footwear Nord Resources mining and mineral exploration First Capital Holdings venture capital Circuit City Stores consumer electronics, appliances Roper appliances, consumer products Gap Inc. specialty apparel retailing L.E. Myers Co. Group construction services Emerson Radio consumer and medical electronics Ponderosa restaurants Rollins Environmental Services chemical waste treatment Fox Photo photo equipment and film processing Countrywide Credit Industries mortgage banking Puerto Rican Cement cement, paper bags Consumers Power utility Allied Stores department stores Public Service Co. of Indiana electric utility Wayne-Gossard clothing