By Arnie Kaufman
The confidence on display not long ago has vanished. Current expectations of market returns are modest. Raves about the new economy have given way to suspicion, calling into question p-e ratios that are still high on a historical basis. This type of skepticism, however, is what you generally see at buying points.
While corporate news remains poor, we at S&P believe this is a time when it is justifiable for investors to act on the promise of improvement. That's because the Federal Reserve is cutting short-term interest rates in so determined a fashion. And, if not totally by design, tax relief will be arriving just when it is needed. It's a good bet that the combination of monetary and fiscal stimulus will pull earnings out of their slump.
Our analysts expect the low point in corporate profits for the current cycle to occur in the third quarter, which will be the fourth straight quarter of decline. The market typically anticipates a turnaround in earnings by several months, as it already has to some degree (the "500" is now 10% above the early-April low). But stocks also generally deliver solid gains immediately after the earnings trough, with more restrained progress thereafter.
S&P chief economist David Wyss has identified nine occasions since 1961 when profits on the S&P 500 declined for at least four straight quarters. Six of the nine were associated with recessions and three with economic soft landings (or as we used to call them, growth recessions). The S&P 500 index began recovering before eight of the nine profit troughs (the exception was 1987), with the average lead time a little more than two quarters. Over the first four quarters of the stock market rebound, the S&P 500 gained an average of nearly 27%.
It's our view that for the market to perform well in the next year or two, the above-trend growth rate in business productivity that began in the mid-1990s and was interrupted by a decline in the first quarter of this year must resume. We think it soon will. The productivity trend in the 1950s and 1960s was persistently high, but went negative during economic slowdowns. Productivity cycles are lengthy. The shortest period of strong productivity growth was 1920-1930.
High productivity enables the economy to grow fast without generating inflation or elevated interest rates, and it boosts corporate profit margins. It thus tends to lift p-e ratios.
S&P's forecast is that the S&P 500 index will reach 1365 at the end of 2001, for a gain of 12% from 1214 now, and hit 1455 by mid-2002, up 20% from the current level. We see Nasdaq rising to 2465 in six months and 2675 in 12 months, up 22% and 32%, respectively, from 2028 at present.
We now believe that equities should make up 70% of the average portfolio, up from 65% previously. Bonds should account for 25% and cash 5%.
Kaufman is editor of Standard & Poor's weekly investing newsletter, The Outlook