A Hangover from Dow 13,000?

Money manager Michael Farr says the sectors that have propelled the market are past their prime, and new groups will have to emerge to fuel the rally

The Dow 13,000 milestone was cause for celebration among some investors, but it left many pros scratching their heads. "Good news is being embraced and bad news is being brushed aside, and that's what makes a bull market," money manager Michael Farr quipped as he watched the Dow Jones industrial average claw above 13,100 for the first time on Apr. 25.

The 46-year-old founder and president of Washington (D.C.) investment firm Farr, Miller & Washington points out that there are three stages to any bull or bear market: denial, acceptance, and then exuberance or fear. "I don't think this is exuberance yet. I think it feels good, and it has a good buzz," he says. "But I'm feeling kind of old and stodgy because I'm thinking the hangover is really going to be ugly when it comes."

That's because the narrow rally in cyclical basic materials and energy stocks that has driven the Dow to new highs looks past its prime, Farr says. The more significant milestone will be when the Standard & Poor's 500-stock index, the broader benchmark used by many money managers, surpasses its March, 2000, closing peak of 1,527, he says (see BusinessWeek.com, 4/25/07, "The Next Market Milestone to Watch"). But that can't happen until other sectors like technology, health care, and consumer stocks take the lead. And that might be difficult given some of the pressures in the economy, particularly with consumers feeling the pinch from high energy prices and a slowing housing market.

BusinessWeek.com's Karyn McCormack spoke with Farr during the last hour of trading on Apr. 25, when the Dow hit the new milestone. Edited excerpts of their conversation follow.

What do you think of the Dow hitting 13,000?

This is better than a sharp stick in the eye. The composite of 30 industrial stocks making new highs is a good thing; it's just not remarkably significant. The more important number is the S&P 500. We're at 1,495 today, so it's 3.6% off the all-time [intraday] high of 1,552 back in 2000. It will be a stronger, more meaningful sign for the markets when the broad S&P 500 representing 500 different companies reaches and exceeds its historical highs.

I think it's important that the leadership has been relatively narrow. Certainly we see strength in the industrials as evidenced by the Dow's new highs. Broad market strength over the past four years has been led by an unlikely group of deep cyclical sectors—energy, utilities, basic materials, and telecom have driven the market advance.

Can their leadership continue?

This basic material and energy rally is long in the tooth, according to all historical numbers. It can always go higher—markets always go to excess. We always find out how high is too high after we've been there.

Do you see a change coming?

I think we'll see a rotation in leadership, but I have no idea when. I may wear out my worry beads until we get there. But we're certainly due. Large-cap growth is now in its seventh year of underperformance on the style charts.

What will it take?

It could take the Dow going through 13,000 and people saying they want to buy again. I think more sophisticated investors are seeing China hitting some speed bumps, some of which are pretty significant. Growth, even fantastic growth, has certain limits.

What about valuations?

The large-cap blue chip stocks, which have seen earnings double over the past five years and growing at a compounded rate of 13.5% per year, have not enjoyed commensurate price increases. Rather, they have seen their price-to-earnings multiples (the price that investors will pay for $1 in earnings) fall from 26 times to 16 times.

If Peter Lynch is right, blue chip stocks are very cheap. Peter Lynch's mantra was that the most significant indicator of stock price performance over time was earnings growth. So I'm not so much waiting for the market to crash, but waiting for leadership to shift back to the more traditional sectors and shares. By that, I mean technology, health care, and some of the consumer stocks.

Is the stock market disconnected from the economy?

I don't agree with that. I think that the stock market hears the noise of economic trouble like the drone of a distant dump truck and will recognize the impending problem when the dump truck is immediately in front of them and blocking their path.

There are real problems facing the economy that Alan Greenspan remarked about in late February, when he said there was a 30% chance of recession. Investors hear the noise but seem to be able to ignore it for now.

This all highlights an environment wherein it's crucial to understand the financial workings of your investments, the health and stability of balance sheets, and the aptitude of corporate management.

Are you buying any stocks these days?

I'm always in buying mode. I can't find all that I'm excited to buy. I like everything I own. I'm forced to exhibit the patience of Job with a portfolio of stocks that are seeing wonderful earnings increases, whose management is executing exceptionally well, and whose share price is crawling.

Can you talk about a few stocks you like?

I should disclose that I hold them and I may buy more or sell them tomorrow. These are not recommendations to buy or sell.

I continue to really like General Electric (GE). The stock is trading at 15.75 times earnings, which is below the average for the S&P. I believe they will continue to grow earnings in the 11% area, and they have a 3.3% dividend. Jeff Immelt has sold off the nonperforming divisions. He is an outstanding manager who is not getting anywhere near enough credit for what I think is real managerial excellence. And he's executing very well.

Johnson & Johnson (JNJ) is trading at 16 times earnings. It's growing earnings around 10% a year with a 2.5% dividend yield. They just bought a bunch of brand names from Pfizer like Visine, Listerine, Rolaids, and Sudafed. They have a medical-device business that's strong. They're a well-diversified, well-run company, doing a good job with their business plan, and their stock price really hasn't moved.

SRA International (SRX) is an IT contractor to the government. These guys aren't just geeks; they're geeks with top-level security clearance. That's a big deal because post-9/11 it takes a lot to get top security clearance. Homeland Security, the CIA, FBI, and NSA need systems for security. And the people with clearance to work on these systems [are] growing at a much slower rate than the need. So it's supply-demand, and prices are going up.

I think SRA is a very strong operator. The stock has come off its lows and looks cheap. It's around $24.68 today, down from $33 a year ago. With Congress imposing budget restraints on military activities, there is concern about government contractors getting paid in a timely manner. I think these concerns have created an opportunity.

What worries you the most?

I think the consumer will get stung by the real estate market as it continues to devolve. I think that the consumer is already getting stung by higher energy prices. The U.S. savings rate is negative.

With $1 trillion in ARMs [adjustable-rate mortgages] adjusting this year, and people spending more to heat and cool their homes and to drive and on groceries, these people are going to get pinched. The consumer is two-thirds of the economy, and it's tough to see the economy going ahead with two-thirds of it stalled. I think that the housing correction will extend and move lower than people think. This kind of trend always goes longer and deeper than anyone expects.

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