Holding Tight or Headed for a Fall?
Having finally succeeded--if barely--in planting its flag above Dow 10,000, Wall Street turns its sights to the next peak on the horizon.
But whether the trail leads higher or lower from here is a matter of heated debate among market pros.
While it is seldom stated this way, a large camp on Wall Street holds a simple and ulcer-inducing view: U.S. stocks are overvalued relative to earnings and to yields you can earn on bonds, but you have to own stocks anyway.
“Sometimes I have to close my eyes tight and just buy,” said Hugh A. Johnson, chief strategist for First Albany Corp.
An overvalued market doesn’t necessarily have to tumble to the point where prices seem more historically in line with the fundamentals. A less traumatic alternative is for the market to simply mark time--while earnings catch up to share prices.
Many analysts seem to expect the latter course, judging by the most recent survey of Wall Street investment strategists conducted Friday by Bloomberg News.
The strategists’ average price target for the blue-chip Standard & Poor’s 500 index at year end is 1,335--a mere 1.9% above where it closed Monday.
In other words, most pros think blue chips will be nearly dead money for the rest of the year.
Some, however, think the market is dangerously tempting fate.
Differing Views of the Future
On the bearish side is Don Hays, veteran investment strategist for brokerage Wheat First Securities, who calculates that the S&P-500; stocks are about 34% overvalued.
He gets that number by comparing the “earnings yield” of stocks--their expected earnings per share over the next 12 months as a percentage of their price--with the yield on 10-year U.S. Treasury notes.
With blue chips trading at about 25 times estimated earnings, on average, their earnings yield is less than 4%, compared with 5.25% for 10-year T-notes, Hays said.
Either stocks must fall, or bond yields must fall, to correct that overvaluation, the argument goes.
Hays likes this method of valuing stocks because it is known to be favored by Federal Reserve Chairman Alan Greenspan.
With stock prices so far ahead of earnings, it would take a long time for earnings to catch up, given even moderate profit growth. Worse, Hays expects an “earnings recession” in the S&P; 500 stocks this year.
After the “March madness” surrounding the run-up to Dow 10,000, Hays foresees “a long period of doldrums” in the big-capitalization stocks--one that could shake investors’ confidence and help slow the economy, he said. That is why he recommends investors keep their portfolio mix at just 35% stocks, with 40% in bonds and 25% in cash.
Thomas M. Galvin, chief equity strategist at Donaldson, Lufkin & Jenrette, agrees that earnings need time to catch up. He just thinks it will take a lot less time than most people expect.
Galvin recently raised his portfolio allocation to 80% stocks, 15% bonds and 5% cash, tying for most bullish of the 16 strategists in the Bloomberg survey. His 12- to 18-month targets are 1,500 for the S&P; 500 and 11,000 for the Dow.
The continued market surge will be powered by earnings growth, Galvin believes. The Asian economic crisis has been the main dampening force on worldwide corporate profits for more than a year but a recovery may be in process, he argues.
First to feel the revival was the U.S. technology sector, which also was first to feel the ill effects of Asia in late 1997 and early 1998, according to Galvin.
Looking for Signs of Strength
As tech exports to Asia have improved, those stocks have surged, powering the Nasdaq composite index to an astounding 75% rise from Oct. 8 through Feb. 1. The Dow managed a 21% gain in that period--not bad, surely, but not in the same ballpark.
Many commentators have pointed out that if the Dow had more technology issues besides just IBM and Hewlett-Packard, it would have crossed 10,000 long ago.
Galvin turns that thought around, proposing that the Dow’s mainstay industrial concerns may turn out to be its strength in the months ahead.
One sign that the sector may be edging out of its slump was the report earlier this month by Union Carbide, a Dow stock, that its first-quarter profit would come in near the high end of the range of analysts’ estimates.
If other industrials start seeing a resurgence in exports, it would be good for the health of the whole market, which has been far too reliant on a handful of big-name stocks, Galvin said.
Yet John C. Bogle, founder and senior chairman of mutual fund giant Vanguard Group, argues that earnings prospects don’t hold the key to this bull market’s future.
While Bogle finds the significance of Dow 10,000 to be “basically nil,” the broader context is tremendously significant. The last five years of this bull market have taken us into terra incognita, he said.
Only about 10% of the market’s long climb can be explained by traditional factors such as a healthy economy and rising corporate earnings and dividends, he said.
The rest, according to Bogle, represents a revolution in people’s thinking about stocks as an investment. People today are willing to pay a far higher price for the same amount of earnings than at any previous time, Bogle said.
To bet that the market can repeat its performance of the last five years, he said, all you have to believe is that investors will continue their willingness to pay ever-higher prices for the same earnings--driving the price-to-earnings ratio for the typical blue chip to 50 or 60 or beyond.
Bogle doubts it will happen.
Authors James K. Glassman and Kevin A. Hassett, however, have no doubt.
Forget 20,000, say Glassman and Hassett, both affiliated with the American Enterprise Institute. The title of their forthcoming book is “Dow 36,000.”
Stocks remain profoundly undervalued even now, they argue, because investors continue to demand an inappropriate “risk premium” from stocks as compared with bonds.
Although stocks tend to be more volatile--hence risky--in the short-term, they have consistently generated far greater real returns than bonds over the long haul because their earnings and dividends have risen so dramatically.
What has been happening in the 1980s and ‘90s, Glassman said, is that investors at last have recognized the superior performance of stocks and have started paying up for it.
He wonders why some people insist on taking that belated recognition as a sign of irrationality.
Glassman and Hassett calculate that to equal the long-term return of bonds, stocks need only provide an earnings yield of about 1%.
That implies an average price-to-earnings ratio of 100. At that level of valuation, the Dow would be at 36,000, they say.
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Thomas S. Mulligan can be reached by e-mail at thomas.mulligan@latimes.com.
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The 10K Race: How the Dow Did It
The Dow Jones industrial average’s historic close above 10,000 on Monday marks another milestone on a spectacular journey that has lifted blue-chip stock values nearly twelvefold since August 1982. Expressed proportionally--that is, with each 100% Dow gain charted in equal space, as below--the index’s climb looks far steadier over the
last 17 years than its point gains in the 1990s would suggest.
Even so, the Dow’s gains have clearly accelerated since 1994.
*
1982: Start of bull market; Dow at 777 as interest rates plunge and recession ends.
1986: Oil prices collapse; Reagan tax reform.
1987: Market crashes as rates rise.
1988: Economy booms; stocks rebound.
1990: Iraq invades Kuwait.
Mid-1990 to early 1991: U.S. in recession; Fed cuts rates.
1992: U.S.S.R. dissolves.
1994: Fed rate hikes slow economy.
1996-1998: U.S. economy booms while inflation sinks.
Mid-1997: Asian economic crisis begins.
Aug. 1998: Russian debt default.
Monday: 10,006.78
Recipe for a Long Bull Market
Stocks’ dramatic gains since 1982 have been powered in part by plunging interest rates and, in the ‘90s, by a surge in corporate earnings. But ebullient investors also have simply become willing to pay more for stocks relative to earnings--excessively so, argue Wall Street’s bears.
Falling rates ...
30-year U.S. Treasury bond yield, annual closes and latest:
Monday: 5.64%
Sources: Times research, Bloomberg News
*
... and rising profits ...
Standard & Poor’s 500-stock index, operating earnings per share:
1990: $25.85
1995: $38.79
1999*: $49.00
* Estimate from Goldman, Sachs & Co.
*
... drive P/Es sky-high.
Price-to-earnings ratio of S&P; 500 index, end-of-year figures and 1999 estimate based on this year’s estimated operating earnings:
1999 estimate: 26.7
More Coverage
* The powerful U.S. economy and the stock market have reshaped each other. A1
* For more than a century, the Dow index has been synonymous with the stock market. C6
* How the Dow 30 stocks have performed since the average stood at 5,000. . . . A history of the Dow’s key dates and a look at its original components. . . . Calculating the index has gotten more complex. C6
