Stocks May Warm To The Fed's CooldownJeffrey M. Laderman
Even in bull markets, stock market investors have crises of confidence. They fret about the next turn in the economy, surges of inflation, unwelcome surprises in corporate profits--and exogenous factors, such as the threat from North Korea's nuclear plans. But from late 1990 until early this year, worried investors could take comfort that the Federal Reserve was solidly backing them with a monetary policy that was unambiguously bullish for stocks.
But now, when equity investors break out in a cold sweat, there's no warm, friendly Fed to reassure them. Since early February, the central bank has hiked short-term interest rates 1.25 percentage points in an attempt to cool down the economic expansion. That sent the Dow Jones industrial average plummeting from 3979 to 3593--nearly 10%--in just eight weeks. The Dow recovered to 3769 by June 6, but that hasn't quashed fears of yet another steep drop.
Now, equity investors' overriding concern is the Fed itself. The main debate on Wall Street these days is how effective the central bank will be in slowing the economy and heading off inflation before it becomes a problem.
RATE DEBATE. Has the Fed done enough tightening of monetary policy, or will it need to do more? Byron R. Wien, Morgan Stanley & Co.'s U.S. investment strategist thinks the stock--and bond--markets will have an upbeat second half, especially in the fourth quarter, because the Fed's braking action is working. "The economy is slowing," says Wien, "and interest rates will come down later this year." On the other hand, strategist David G. Shulman of Salomon Brothers Inc. and Jeffrey M. Applegate of CS First Boston contend that fed funds, at 4.25%, will have to go over 5% before the economy cools enough to satisfy the central bank. There could be trouble for stocks later in the year if the Fed boosts rates yet again.
The Fed debate may drag on for months. But it could be a huge mistake for investors to sit on the sidelines until it's resolved. Even Applegate, who expects more tightening, is counseling investors to buy. "Most of this year's declines came in six trading days," he says. "The rebound will happen the same way. If you stay too defensive now, you risk getting shut out later."
In fact, all the hand-wringing over the Fed's next move is obscuring the market's fundamental strengths and the reasons to stay with stocks:
-- Company profits are looking bright, and analysts are still raising their 1994 and 1995 forecasts, even in the face of higher interest rates. Zacks Investment Research says analysts are looking for a 16% gain in earnings for the Standard & Poor's 500-stock index this year and a 13% increase in 1995.
-- Corporations are generating plenty of cash. Kenneth S. Hackel of Systematic Financial Management, a Fort Lee (N.J.) money manager, says stocks are cheap when valued by free cash flow (net income plus depreciation, less preferred dividends and necessary expenditures). Hackel says the S&P stocks are selling for 23.5 times free cash flow, vs. the long-term average of 25. Companies use free cash flow to make acquisitions, buy back shares, and pay dividends.
-- Equity mutual funds are still getting huge inflows from individual investors. Inflows dropped in March, but April's $11.3 billion was nearly as high as in April, 1993. Fund watchers say May inflows ran at early 1994 levels.
-- Sentiment--when measured by polling newsletter writers, investment advisers, and stock-index futures traders--is decidedly bearish, which is a contrary indicator and bullish for stocks. The reason is that the market already has discounted the bad news, so any favorable developments trigger a lot of buying.
Perhaps the best case for stocks is the behavior of the market itself. Despite the spike in interest rates, the Dow and the S&P stand where they started in January. At worst, the stocks fell 10% from their highs, as compared with the 17% plunge in long-term bonds and 20%-plus spills in many emerging markets. Don R. Hays, investment strategist at Wheat First Butcher Singer, says the overdue correction--until this year, there hadn't been a 10% sell-off since 1990--is done and has cleared the deck for the next leg up. Says Hays: "For the first time in two or three years, I feel pretty good about the potential for the S&P 500."
In fact, some money managers are looking to big-cap stocks after several years of playing in cyclicals or small-cap to mid-caps. "Investors like the quality and the liquidity of the big-cap stocks," says market analyst Laszlo Birinyi of Birinyi Associates. He notes that money has gone into the big-cap stocks and shifted away from the OTC companies.
Actually, there's good reason for moving back to the big S&P stocks. First, the index is home to lots of big consumer stocks that have languished for the past few years. Such companies as Disney, Johnson & Johnson, Merck, and Wal-Mart Stores are frequently mentioned. Roger Engemann & Associates' private accounts and Pasadena mutual funds, together worth $4.7 billion, are chock-full of such big consumer stocks. Engemann argues that the market will embrace these companies because the cyclicals' growth rate will decline.
What's more, these stocks are cheap. The large-cap growth stocks as a whole trade at about the same price-to-earnings ratio as the S&P, which means the premium price often attached to these stocks has disappeared. Lehman Brothers analyst Elaine M. Garzarelli says many growth-stock sectors, such as drugs, health care, and food companies, are attractive. She recently upgraded the S&P soft-drink stocks--namely Coca-Cola Co. and PepsiCo Inc.--because they trade at a p-e ratio only 5% higher than that of the S&P 500. Typically, Coke and Pepsi sell at p-e's 30% to 45% greater than the S&P. By her estimation, the soda stocks should perform 37% better than the S&P over the next 12 months.
HERE'S THE BEEF. The shift to big consumer growth stocks also dovetails with an expected pickup in business overseas. "These companies' exposure to Europe is going to help," says George W. Jacobsen, chief investment officer of Trevor Stewart Burton & Jacobsen, a New York investment manager. Among his choices are Gillette, Hasbro, Kimberly-Clark, Mattel, and McDonald's. Jacobsen also is bullish on two advertising agencies, both with substantial non-U.S. revenues: Interpublic Group of Cos. and Omnicom Group Inc.
Of course, there are still some opportunities outside the large-cap growth stocks. Richard S. Huson of the Crabbe Huson Group, a pension and mutual fund manager, thinks IBP Inc., the giant beef processor, has little downside and potential for big gains. IBP has a large cost advantage over its competitors. Coupled with lower cattle prices, IBP has a recipe for plump profits. "It's not affected by the economic cycle," says Huson. "It's in a cycle all its own that is now favorable."
Even investors who believe the economy will slow may want to use energy stocks to hedge against higher oil prices. Among the favorites are Amerada Hess, Atlantic Richfield, Occidental Petroleum, and Sun. W. Anthony Hitschler, president of Brandywine Asset Management, says Amerada Hess is especially attractive because it's benefiting from a large capital-spending program. Analyst James F. Clark of CS First Boston estimates that each $1-per-barrel hike in oil brings about 53 cents to Amerada's bottom line.
For contrarian-minded investors, some of the best buys are big investment banks, such as Bear Stearns, Merrill Lynch, and Morgan Stanley. James H. Gipson, president of Pacific Financial Research, says these big brokers sell for a mere 30% to 40% premium over the value of their securities inventories, a bargain price. "The cheapest thing on Wall Street is Wall Street itself," says Gipson. For sure, if the crowd is so negative about Wall Street itself, better times and higher prices can't be far away.
TABLE: STOCKS THAT SHOULD THRIVE IN A JITTERY MARKET Stock price* P-E ratio** Dividend yield AMERADA HESS 49 43.0 1.2% Coming off a period of losses, the p-e is high. But this oil company is a smart investment for those who think oil prices are going up. AT&T 55 1/2 16.9 2.4 Flight to quality is spurring interest in the premier telecommunications company. Will be major player in global info network. CITICORP 40 7.6 1.5 Despite higher interest rates, bank stocks are strong. Citi should profit as foreign economies pick up. IBP 26 12.9 0.8 Giant beef processor has lowest overhead in industry. Larger herds should keep cattle prices down, profits up. Stock price* P-E ratio** Dividend yield JOHNSON & JOHNSON 42 3/4 14.1 2.7% Health-care stocks are starting to look better, and this giant is showing up on many buy lists. MORGAN STANLEY 60 1/4 7.5 2.0 Earnings may have peaked, but this blue-chip investment bank sells at not much more than the value of its securities inventory. OMNICOM 46 3/4 15.5 2.7 As they fight for sales, companies will step up advertising expenditures. That's bullish for advertising agencies such as this one. WAL-MART STORES 23 3/4 19.5 0.7 Onetime stock market darling sells near three-year low, yet new stores in Canada and Mexico should keep profits rolling in. *JUNE 6, 1994 ** BASED ON 1994 ESTIMATES DATA: BW INTERVIEWS WITH MONEY MANAGERS AND ANALYSTS, ZACKS INVESTMENT RESEARCH, BLOOMBERG FINANCIAL MARKETS GRAPHICS BY ALAN BASEDEN