Visions Of A Soft Landing Have Wall Street's Heart RacingJeffrey M. Laderman
It's Thanksgiving, 1994. The stock market has been knocked around for the better part of a year. The Dow Jones industrial average is at 3675--below where it started the year. Then, over the next three months, the market is hit with the Orange County derivatives mess, the surprise devaluation of the Mexican peso, a devastating earthquake in Japan, the collapse of one of the world's most venerable investment banks, and the U.S. Senate's failure to pass the balanced-budget amendment. Top it all off with a run on the U.S. dollar that sends the greenback plunging to record lows.
What do you get? A Dow that's at 4040 and poised to go higher. "The market has sloughed off every adversity," says Byron R. Wien, U.S. investment strategist for Morgan Stanley & Co. Why is the market pushing higher and confounding the pros? The unusual combination of falling interest rates and high profitability.
So far this year, the yield of the 30-year U.S. Treasury bond has dropped about one-half a percentage point, to 7.36%. Measured from the November high in interest rates, the yield is down four-fifths of a percentage point. Even more amazing perhaps is that the yield on the 10-year bond, at 7.09%, has dropped nearly three-quarters of a percentage point so far this year and nearly a whole percentage point from its high. Lower interest rates raise valuations for stocks across the board.
PLAY OR PAY. The more-than-10% decline in interest rates this year has helped push the Dow up 5.3%. The broader Standard & Poor's 500-stock index, at 492, has climbed 7.1%. Market analyst Laszlo Birinyi of Birinyi Associates thinks there's more buying ahead from institutional investors and mutual-fund managers, who will try to make up for their poor returns of the past year. "Many underperformed last year and explained it away as a lousy market," he says. "But this year, we have a strong market, and not to participate in it is unpalatable."
But perhaps the more important message from the bond market is that the economy is slowing and coming in for a soft landing, while inflation--a major worry of markets last year--is not perceived to be a threat. In that light, "what's going on in the stock and bond market makes perfect sense," says Abby Joseph Cohen, investment strategist for Goldman, Sachs & Co. "The Fed has accomplished what it set out to do." The soft landing, notes Thomas M. Keresey, chairman of Palm Beach Investment Advisers Inc., "extends the economic cycle and the bull market. In two years, we'll be talking about Dow 5000."
Dow 5000? Soft landing? Those ideas still raise eyebrows on Wall Street. "The only problem with the market getting excited over a soft landing is that the Fed has never been able to engineer one," says Christopher R. Castroviejo, who runs Parallax Partners LP, a hedge fund. "Every business cycle goes through a soft quarter that people mistake for a soft landing." Castroviejo's fund was 100% long from December through February, but now he's thinking about some short sales.
DAZZLING POTENTIAL. And though a soft landing beats a recession or inflation any day, it can have a downside as well--slower earnings growth. "It's impossible to slow GDP and get higher earnings," warns investment strategist Jeffrey M. Applegate of CS First Boston. Lower interest rates offset some of the slowdown in earnings growth, but Applegate thinks there's little margin for error.
The bulls' case does not rest on sharply higher earnings. But earnings have the potential to dazzle investors. Corporate profitability, as measured by return on equity, is the highest it has been in years. Corporations continue to downsize and shed unprofitable businesses, a process that is keeping a damper on labor costs as well. That means more incremental revenue is falling to the shareholders' bottom line.
But even without big earnings gains, an environment of stable or declining interest rates and low inflation can be sweet for stocks. Goldman's Cohen says the S&P historically trades at a price-to-earnings ratio of 16.5 when inflation is 3% or less, yet the current price of the S&P is only 13.7 times expected 1995 earnings. If the stocks rose to make up only half that gap, the S&P would climb to 543 and the Dow well over 4400.
The bulls are going after high-quality large-capitalization growth, shying away from more speculative plays. "Where investors see steady and predictable growth, they'll pay up for it," says mutual-fund manager Elizabeth Bramwell of Bramwell Capital Management. That's why stocks such as Abbott Laboratories, Johnson & Johnson, Microsoft, McDonald's, and Procter & Gamble are on many buy lists.
Such big companies are also alluring because they have significant business abroad, where they may be helped by the weak dollar. That could be another reason why small-company stocks have been left behind in the rally, says Thomas A. Frank, lead portfolio manager of the Dreyfus New Leaders Fund. Still, he adds, "there are many small companies which are global leaders in their businesses." Some of those companies have large holdings in
his fund: Bush Boake Allen, A. Schulman, and Ferro, which are in various specialty chemical businesses; and R.P. Scherer, which makes capsules for drug companies.
Even the folks who are generally upbeat about stocks say there are still some barriers to a big move. Strategist Edward M. Kerschner of PaineWebber Inc. notes that while long-term rates are down substantially, short-term rates are not. "You can get 6.7% risk-free in a two-year note, and that's still a pretty good deal," says Kerschner.
An avowed bull, Palm Beach's Keresey admits the stock market has come along a little too fast and a little too easily for his comfort. "If first-quarter GDP comes in a little higher than expected, interest rates might back up a little bit, and stocks will have a short correction," he says. "If so, I'd view it as a buying opportunity." After all, Keresey is looking toward Dow 5000.