Amid Shadows, One Acquires a Feel for Substance
What are intelligent investors to think as the economy keeps showing strength while the stock market gyrates from doubt to confidence and back again? Simple: Always choose substance over shadow, the economy over the psychological basket case called “the market.” Sooner or later, reality wins.
The economy’s strength showed again Friday morning when the Labor Department reported that 217,000 jobs were created last month and unemployment fell. But the bond market’s reaction to that great news was an offense to common sense: Interest rates on long-term bonds rose on fears that more Americans working would lead to inflation and another hike in short-term interest rates by the Federal Reserve Board. Stocks did better, reckoning rightly that if U.S business is hiring more workers, it must also be making a profit.
But smart investors should ignore the whole shadow play. “Don’t be spooked by the market, think for yourself,” says stockbroker Esther Berger, who specializes in advising women clients at Paine Webber’s office in Beverly Hills.
Look at the realities behind the fears of inflation, at long-term interest rates that have gone up too fast and thus may well come back down.
Look at stocks of individual companies, especially those that have been rising through the past uncertain month.
And think ahead to what the future holds for companies and industries that may be out of favor in the market.
Interest rates are behaving strangely. In an unforeseen reaction to the Fed’s quarter-point boost in short-term rates, to 3.25%, long-term rates have surged. The U.S. Treasury’s 30-year bond, which influences mortgages and most business and consumer borrowing, has risen to 6.83% from 6.3%. That’s a very major increase, “one of the fastest in 40 years,” says John Isaacson, research director of Payden & Rygel, a Los Angeles investment firm.
Some instability in global bond markets is behind the oddity, plus the fears of professional bond investors that economic expansion will mean inflation and higher interest rates.
But inflation fears are misplaced, and long-term interest rates at or near 7% are not really sustainable. Business borrowing isn’t there, to begin with, because U.S. companies after years of trimming fat to increase efficiency are generating ample amounts of their own cash. McDonald’s, Toys R Us and Coca-Cola are buying back huge amounts of their stock, over and above what they invest in new projects, because they have so much spare cash.
This economy is efficient, spare and strong, not bloated. Price increases in service industries, which are 75% of the economy, were 2% last year. Productivity is rising, meaning U.S. business is getting more bang for the buck from every resource.
Now, with all that in mind, investors should make a list of stocks that are doing well even as the market drifts--either for purchase or to see if their mutual fund is holding them. Leading that list would be companies that provide machinery or services to industry, especially overseas, where competitive U.S. business is busy building the industrial infrastructure of the developing world.
Two Illinois companies--Caterpillar Inc., the Peoria construction equipment maker, and Deere & Co., the Moline-based farm machinery producer--will top such a list. Two engineering and construction companies now enjoying worldwide demand for their services, Foster Wheeler Corp. and Fluor Corp., will be on the list.
And there will be many others. But the point for investors is not to follow any specific list, but to jog their thinking about the real prospects for business.
Think, for example, about electric utilities, an industry that has been out of favor due to stock market fears of rising interest rates--which make utilities’ borrowing more expensive but their dividends less attractive.
As their stock prices have languished, many utility dividend yields have become rewarding--especially if you keep in mind that long-term interest rates are likely to settle back down. Financial consultant Laszlo Birinyi points to American Electric Power’s 7.2% dividend, at the current stock price, as attractive.
Utility analyst Edward Tirello of NatWest Securities recommends a variety of companies, including Central & South West, with a 6.3% dividend, and PacifiCorp at 6%.
At their current stock prices, most California utilities pay high dividends, including San Diego Gas & Electric at 6.5% and Pacific Gas & Electric at 6.1%.
And the utility industry is interesting for long-term reasons. The electric power business is about to be deregulated, meaning efficient utilities will be able to sell power at lower prices to business customers in the territories of other utilities. Ohio’s state government has already given approval for such competition, and other states will follow, says Tirello.
The prospect is for larger or smarter utilities to gain customers, but not merely that. Electric companies will gain efficiencies through alliances, or by swapping bits of territory with other companies. There will be mergers and spinoffs and all the other investment opportunities that come with regulatory change.
There is an added factor, touching on the telecommunications field. Electric companies will be upgrading their lines into the home in this decade, to accommodate the demands of modern appliances and systems. Yet in all the ballyhoo about information highways, there is scant mention of the electric companies’ potential to carry information or computer data over their power lines. But that potential is real and may well emerge competitively in the years ahead.
The electric utility industry, in short, will be an exciting business to study and invest in--for people who keep an eye on the substance of the U.S. economy rather than the shadows in its financial markets.
