There's Only One Way To Ride An Aging Bull: Carefully
It has almost become a ritual. Each December, Wall Street forecasters predict that stocks will make only modest gains in the year to come. Then, as the year unfolds, stocks zoom as profits soar and interest rates sink. For the past three years, the Standard & Poor's 500-stock index has logged a 28% average annual gain.
This December is no exception. Forecasters are again looking for gains of 5% to 6%. This time, however, the mavens may be on target. It comes down to this: A slowing economy, both here and especially abroad, could derail the earnings express and slow the thundering bull market.
Of course, there's a lot more to this once-in-a-lifetime bull market than just earnings. The upward move in stock prices comes from a long-term decline in inflation and interest rates; a massive restructuring of Corporate America that allows it to operate leaner; technology-driven productivity gains; and the public's almost insatiable appetite for equities. None of that has changed, and if anything, the recent cut in capital gains taxes makes stocks even more attractive.
"BEYOND HISTORY." Still, prudence should be the investor's watchword. It's time to review holdings and perhaps take some money off the table. And there is a lot of money on that table. Even after a scary 554-point drop on Oct. 27, the Dow Jones industrials have still amassed nearly 1500 points, and now stand at 7922, up 22.9% (through Dec. 15). The S&P 500--which millions of investors access through index funds--has made even larger gains, 30.1%. Mid-cap and small-cap stocks, are up 25.6% and 19.9%, respectively.
History offers investors little guidance now. The U.S. stock market has never produced three years in a row of 20%-plus gains. The most comparable three-year periods, 1943 through 1945, and 1963 through 1965, pale by comparison. "We're beyond history," says market analyst Laszlo Birinyi of Birinyi Associates Inc. "There are no road maps for what happens next."
Investors do have some tools to judge their positions on the investment map--valuation yardsticks such as price-earnings ratios and price-to-book ratios. These measures are stretched about as far as they ever were. So far, the valuations have been justified because of the strong earnings growth and the falling interest rates. But the danger is that when valuations are high, so are expectations, so there's no tolerance for disappointments, especially with high-profile market-leading stocks.
Just take a look at Oracle Corp. When the database software giant reported quarterly profits 4 cents short of analysts' forecasts, investors dumped the stock mercilessly, taking it down 29% in a single day. Among Oracle's explanations for its slipup: deteriorating sales in Asia. And global banker J.P. Morgan & Co. also blamed turmoil in Asia in delivering its disappointing earnings on Dec. 10.
Indeed, the troubles in Asia--with the Tiger nations shuttering financial institutions, scuttling capital investment, and laying off workers--could be one of the critical factors weighing on U.S. stocks in 1998. True, trade with Asia isn't all that significant and neither U.S. gross-domestic-product growth nor corporate profits growth should be terribly impaired by a slowdown on that side of the globe. Edward M. Kerschner, investment strategist for PaineWebber Inc., estimates that 40% to 45% of the revenues for U.S. multinationals--the sort of global stocks that dominate the S&P 500--come from abroad, half from Europe, and the rest split between Latin America and Asia. "Even if Asia doesn't do well, 90% of the revenue stream is still producing," says Kerschner.
Still, many economists are arguing that the Asian woes will slow U.S. GDP revenue growth in 1998, and will also put downward pressure on prices and drive the 2% inflation rate even lower.
CONTAGIOUS FLU? If this is indeed the case, earnings estimates may be too high. Analysts have not fully adjusted for the Asian flu. Charles L. Hill, research director for First Call Corp., says industry analysts are forecasting 14.3% earnings growth in 1998 for the companies in the S&P 500--down from just 14.8% before the Asian crisis hit. Hill says those revisions only reflect yearend tinkering rather than any actual rethinking of next year's profit outlook. It's unlikely that growth can slow without damaging some high-profile income statements.
But even without the Asia factor, the 1998 earnings picture looks a little suspect to some. H. Bradlee Perry, retired chairman of and now consultant to investment manager David L. Babson & Co., notes that over the last three years, the S&P 400 (the S&P 500 less the finance, transportation, and utility companies) has logged 13.2% average annual earnings gains on just 5.2% average annual revenue growth. During this same period, return on equity soared from the long-term average of 12%-to-13% to greater than 20%, and indeed for 1997, Perry estimates that return on equity will hit a record 25.5%.
He doesn't argue that returns on equity have to drop back to average, but only that the extraordinary rate of profitability of the last three years is unsustainable--and that next year's earnings reports may contain some nasty surprises. "You're already seeing serious competitive pressures," he says. "There's overcapacity worldwide in many industries such as autos and semiconductors, so you can't raise prices, yet a tight labor market keeps pushing wages up." Rising productivity has helped keep margins up, he says, but will it be enough in the face of slowing revenue growth?
With less of a rising tide in 1998, investors are going to have to work harder for their gains. Stock selection is paramount. Elaine M. Longer of Longer Investments Inc., which manages about $100 million in Fayetteville, Ark., says she's looking to invest in companies with revenue growth rather than just profit growth because "you can no longer count on margin expansion to create double-digit profit growth." She's finding most of the new opportunities among small- and mid-cap stocks.
Most pros agree that stocks are cheaper once you get away from the S&P 500 but prefer to stick with the tried and true. "Smaller stocks perform better when economic growth is accelerating," says Richard Bernstein, director of quantitative research at Merrill Lynch & Co. Bernstein's advice: Stick with high-quality companies in such sectors as drugs, household products, and retailing.
Analysts are also starting to put utilities on their buy lists for the first time in years. "They're great in a falling rate environment," says Bernstein, "and there's almost no exposure to Asia." And for much the same reasons, they're recommending real estate investment trusts.
Making money in 1998 will be tougher than in the last three years, but that doesn't mean you shouldn't try. The bull market isn't over. It's just slowing down.