Revenge Of The Small Fry
Chalk one up for the little guy. While scores of Wall Street strategists were talking down the Dow, the small investor was jumping in with both feet. In just two months, December and January, investors poured an estimated $41.5 billion into stock mutual funds. That's on top of the $112 billion they plowed into the market in the first 11 months of 1995. And after racking up a 37% gain in 1995, the Dow has barreled ahead an additional 463 points in 1996, or about 9%. It's hard to find a market strategist whose yearend stock-market forecast wasn't blown out of the water in just the first six weeks of 1996.
Indeed, as the small investor was throwing money into stock mutual funds, many fund managers were retreating into cash. Case in point: Jeffrey Vinik's $56.7 billion Fidelity Magellan Fund. As of Dec. 31, 1995, the fund had 32.1% of its assets in cash and bonds, mainly in Treasury securities--vs. 4.3% at the end of October. As Vinik was accumulating some $14 billion in cash between October and December of 1995, the Standard & Poor's 500-stock index rose 13.5%. Little wonder that so far this year, Magellan is up 3.3%, compared with about 7% for the S&P 500.
DRIVING FORCE. Will small investors enjoy a year of solid returns in 1996? Or will that old saw about the small investor moving into a bull market late in the game prevail? As the Dow scales new heights, strategists are becoming more jittery, warning investors to keep to the sidelines. To be sure, markets don't move in a straight upward line. They do correct. But the forces propelling this market to record highs are still in place--and some are gaining momentum. Much of the power behind this market comes from low interest rates that are expected to go lower, inflation that is almost nonexistent, and earnings growth--in real terms--that is robust. "The fact that stocks are up so sharply does not mean that the market is wrong," says Alfred Goldman, an analyst at A.G. Edwards & Sons Inc. "It means that we analysts underestimated the power of its underlying momentum."
A new element has been added to the momentum of this market: As companies shift away from definedbenefit pension plans and put employees into self-directed 401(k) plans, individuals are being forced to take more responsibility for the investment decisions in their retirement plans--and are increasingly choosing stocks and stock funds. Indeed, more and more of them are going into stock-index funds, which, unlike Vinik's Magellan Fund, stay fully invested in the market.
To David Shulman of Salomon Brothers Inc., winning the war on inflation means that the old ways of judging whether a stock, or the overall stock market, is fairly valued have to be tossed out the window. "Instead of valuing stocks at multiples ranging between 12 to 16 times trend earnings [normalized historical earnings going back to 1960], a multiple of 16 to 20 times trend earnings might be more appropriate, which is where stocks traded in the 1960s," argues Shulman. Right now, the market is selling at a 17.7 price-to-earnings multiple, and with many companies reporting higher-than-expected earnings, it could actually be undervalued rather than overvalued.
Don R. Hays of Wheat First Butcher Singer in Richmond, Va., agrees that the stock market is undervalued and thinks that its stellar performance--outperforming every major world stock market (table)--will continue. "Investors are now going to benefit from corporate downsizing, government cutbacks, and the discipline of eliminating the threat of inflation from the economy," he says. Hays envisions an era where a Dow at 5600 is "the beginning of the stock market's best 15 years for the small investor."
Even some of the old ways of valuing stocks suggest that the bull has room to run. Looking at data from 1978 to 1993, Stanley Levine, director of quantitative research for First Call Corp., uses the relationship between the price-earnings multiple of the S&P 500 and the yield on the 10-year U.S. Treasury bond to calculate a fair value for the stock market. For example, when the 10-year Treasury yields 7%, a fair value for the p-e multiple on the S&P 500 would tend to be around 14. When the bond yields 6%, the p-e multiple would be around a 161/2 target. Right now, with the 10-year bond at 5.6%, and factoring in the 12-month forward earnings forecasts for the S&P 500, the historical relationship suggests a value of 767 for the S&P 500, a 16% jump from its current level of 660.
Falling interest rates are a tonic for the market for another reason: Liquid assets, such as certificates of deposit and money-market funds, become less attractive relative to stocks. "Short rates are coming down and there is no prospect of their improvement, so money has to go into stocks to get a decent return," says John H. Shaughnessy, a strategist for Hartford's Advest Group. Edward G. Riley, chief investment officer of the Private Bank at Bank of Boston, says there is a pot of about $300 billion in small CDs and money-market funds that may find its way into stocks if short-term rates go lower.
As in any bull market worth its salt, there are loads of concerns about too much speculation. First Albany Corp. market strategist Hugh A. Johnson is concerned that margin debt had risen to 1.3% of the value of shares listed on the New York Stock Exchange as of the end of December. Typically, margin debt makes up less than 1% of the value, he says.
Elaine M. Garzarelli of Garzarelli Capital, who is forecasting a 6500 Dow by yearend, is more concerned about the rising level of bullish sentiment, which historically has signaled a market top. The sentiment indicator in her model, however, is still neutral. The same situation prevails at Investors Intelligence newsletter. The advisers polled by the newsletter are at their most bullish since January, 1992--with 53.8% bulls and 29.4% bears. Nevertheless, Investors' technical model remains bullish on the market.
DECENT GROWTH. One of the biggest worries among strategists is that the economy will respond too quickly to easing monetary policy. "If economic activity moved from its current 2% up to 3% or 3.5% in the second half of the year, then the Fed would stop easing, long rates would firm, and that could stanch the flow of money into mutual funds," says Shaughnessy. But market watchers say that's a long shot, pointing to the sluggishness in retail sales and wage growth. First Call's Levine notes that Wall Street's big guns, the investment strategists, are forecasting just 5% growth in operating earnings in 1996. The broader universe of stock analysts, however, while cutting their estimates in recent weeks, are still looking for decent growth of 12% in operating earnings.
If there is a major correction looming, strategists have a hard time envisioning what could spark it. "Unless the market moves substantially above 6000, the risk is not substantial," says Dean Witter Reynolds Inc. strategist William Dodge. "This market now has the wind at its back like it wants to get overvalued, so that may be in store, but it's too early." Bank of Boston's Riley notes that since World War II major corrections have typically been associated with a major rise in interest rates of 125 basis points or so--a scenario that seems highly unlikely today.
With many strategists still fighting the tape, 1996 may be the second year in a row when small investors look a lot more savvy than the professional market mavens. A.G. Edward's bullish analyst, Alfred Goldman, offers this advice to his fellow strategists: "Traders should be ready to quickly buy pullbacks. Bears should reorder their ulcer medication."