Waiting for Reality to Catch Up

The Street is likely to pull back after recent gains, says Evergreen Investments' John Lynch. After that, he says the climb will continue

The market needs some good economic news to justify its 25% climb in the last three months or so. That's the opinion of John Lynch, chief market analyst for Evergreen Investments, who particularly wants to see improvement in jobs and manufacturing. Although Lynch expects the market to be "taking a breather" for the next six weeks, he thinks a rise of 7% to 8% is possible before yearend, to around 1050 on the Standard & Poor's 500-stock index. The sectors he sees as most promising now are financials, technology, and health care.

One of the measures Lynch considers most important is the price-earnings ratio, but he notes that too many investors get caught up in trailing price-earnings (p-e) ratios, based on past earnings, rather than expectations for the future. Cautions Lynch: "Buy a stock based on what you expect it to do, not on what it did."

These were some of the points Lynch made in an investing chat presented July 24 by BusinessWeek Online on America Online, in replying to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from the chat. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: John, how do you see the market? Does the rally have legs?


I think the rally does have legs -- we're up about 25% in the last three months or so. I think at this point, though, for the next six weeks, we'll be taking a breather. What we'll need to see are economic data justifying this move. We've seen a repricing due to Iraq, and one due to the tax cut. We have about another 7% to 8% upside before yearend, I would say.

Q: The drop in jobless claims today helped buoy the market -- do you attach a lot of importance to the labor market? Lots of concern about a jobless recovery.


No question, the job market is a major factor in the outlook. Unfortunately for the unemployed, productivity is strong and businesses will take their time before they commit to new hires. I suspect we can see economic growth over the next two or three quarters, yet this growth will be accompanied by limited job growth.

The good news there is that this will help keep the Fed on the sidelines, keeping interest rates low to sustain growth going forward.... The 6% range of unemployment that we envision for this year -- when compared to the prior economic recoveries in the '80s and '90s, we exceeded 10.5% in the early '80s, and 8.5% in the '90s. So this 6% is historically a healthy number when emerging from a recession.

Q: What are the measures you consider most important to watch in making investment decisions?


First off, I like to take a top-down approach and look at the overall economy, check on the level of interest rates. But most important should be price relative to earnings, and using more of a growth-at-a-reasonable-price method. Too many investors can get caught up in trailing p-e ratios.

For example, you'll see that the S&P right now can be trading at 30 times earnings. That's 30 times trailing 12-month earnings on a reported basis during an economic trough. That's not an appropriate way for individual investors to invest. They need to look at earnings on a forward basis. Buy a stock based on what you expect it to do, not on what it did.

Q: Has real estate peaked?


I think we certainly have seen extremes. When you look at the overall economy, I think the housing market still is going to be able to sustain decent strength relative to history. That may seem like a dramatic decline compared to the last few years.

If we created 1 million new homes last year, can that fall to 950,000 next year? Absolutely. Is that going to be enough to topple housing into a recession? Absolutely not...from an overall annual average nationally, we've seen 8% housing appreciation in the last two or three years -- that will fall to a more normal 2% to 3%, but that will not be enough to topple housing.

Q: What do you think of health-care stocks?


I like health care. I think from a big-picture standpoint, it has a lot going for it -- namely, the vast investment in technology. We've seen improvements in the time from compound discovery to product on the shelf. I also like the demographics, which will just keep getting stronger. They've got good growth potential, yet investors also buy them during difficult times for the perceived safety. Finally, they're trading in line with their growth rate for next year, and I think that's a good opportunity for investors.

Q: What sector do you see as the most promising at this time?


I'd call health care my third. First, I like financials. I think the strengthening markets are going to help, but banks have done a good job diversifying businesses. They're trading in line with their growth rate for next year, but I think they should be trading at a premium to their growth rate based on their reliance on residual or fee-based income -- it makes them less cyclical, less dependent on the interest-rate cycle.

I also like technology. But tech going forward for investors should not be the tech we've experienced in the last few years. I'm recommending focusing on scale in the tech industry. Don't focus on finding the next Microsoft (MSFT ) -- go with companies that dominate their respective industries. At this point in the cycle, [looking for] brands and those companies able to afford significant R&D products and companies that can grow through reasonable acquisition strategies, while focusing on a reasonable 8%-to-10% growth strategy in that sector, can lead to success for investors.

Q: It appears to me that both bonds and stocks are pricey here and should decline, maybe substantially -- comment?


I think stocks are still undervalued. I think we can approach fair value for the S&P 500 at about 1050 by yearend, considering interest rates, inflation, earnings yield -- for all those reasons, I think equities are still within reason for investors, and from a bond situation the 10-year has obviously been through a lot in the last few months. You also had the Fed, which has said it no longer will purchase Treasuries to keep rates lower.... There's quite a bit of opportunity left in the corporate bond market. While spreads have contracted, they're still at very healthy levels compared to history, and I think investors can profit there as well.

Q: Given the state of the market, is now the time to get out of bonds and head back into equities?


If you're overweight in Treasury bonds, yes, I think you need to start backing off. There's still an opportunity in equities -- we're 7% to 8% undervalued, and those are some healthy returns. I think there's an opportunity there.

Q: Does the high level of consumer debt concern you?


No, it doesn't. I think the consumer is in very good shape, when you consider real disposable incomes have been rising, the savings rate has been rising, and debt as a percentage of household net worth is no worse and no greater than it has been the last 20 years, on average. Consumers have been more conservative with refinancing, and we're seeing debt being paid down, so all in all I think those consumer debt concerns are overblown.

Q: Are any Internet stocks a good investment now? You gave us some interesting criteria for tech stocks a few minutes ago -- do you have any names to go along?


In the tech area, Cisco (CSCO ), Microsoft, and Intel (INTC ). I'd also like to include Dell (DELL ), IBM (IBM ), and Oracle (ORCL ).

On the Internet side, I think investors should be very careful. There will be consolidation in that area. Amazon (AMZN ) and eBay (EBAY ) have shown a propensity to survive, but I'm still very conservative on making Internet plays.

Q: At Evergreen Investments, have you been buying? And what kind of stocks?


We have over 90 mutual funds at Evergreen, so we're always buying. Our growth, value, large-cap, small-cap -- all our managers are very active within their sectors. Over the last few months, we've seen strength in all those categories based on repricing from Iraq and from the tax cut. Going forward, each of those styles will be focusing on their mandates, for diversification in the portfolios of all of our investors.

Q: John, do you favor any of those styles or sizes more than any others? I know a lot of folks favor small-cap stocks now.


We're making a strong effort in the small-cap arena. From a valuation standpoint, they look very attractive relative to large caps. Traditionally, small caps outperform large caps as the economy is emerging from recession. Small caps tend to be more flexible.

Also, market technicals are also supporting small caps right now. There's also an opportunity in that we're seeing a lot of merger and acquisition activity pick up, which tends to bode well for them.

Q: You mentioned Internet stocks earlier. What do you think of Yahoo!'s big runup?


Earlier, I mentioned more established Internet plays, but I neglected to mention Yahoo (YHOO ). Without question, they've established themselves. They've been oversold, and people are getting back behind them. I would be careful going forward after the recent move.

Q: John, besides improving employment numbers, what are the other signs you're looking for that would indicate the recovery is for real and sustainable this time? A: Manufacturing growth. It has certainly been weak over the last few years, but what I strongly believe investors don't appreciate is the strength in the services sector. They represent 75% of output -- manufacturing is less than 25%, yet it's manufacturing that gets all the ink.

Services have generated an underlying strength, yet manufacturing has only recently begun to show signs of improvement. We need confirmation...even a mild increase in demand should ramp up production. That's critical. I'm also looking for capital investment, which will increase about 5% this year. Going into next year, I think that pace will double, for a 10% year-over-year increase in capital investment, which is also increased by the recent tax law. Finally, the consumer doesn't have to shoot for the stars. The consumer can spend in the healthier 3% range to help sustain demand going forward.

Q: What about non-U.S. companies? What foreign stocks do you like now?


I'll speak generally here. I think you've got good opportunities in Asia. Most recently we've picked up our investments in Japan. There's a good restructuring going on, and an underappreciation of that restructuring. Sony (SNE ) just reported a big loss, yet the stock was up as a result of investors being more and more comfortable with the restructuring.

Non-Japan Asia offers great opportunities with a little more risk. In Europe, we can expect profit growth around half of what we expect in the U.S., namely around 4% to 5%.

Q: What are good, stable dividend stocks or areas?


The utilities are a classic dividend play, but going forward, because of this new tax law, I'd rather see investors buy stocks with 2% yields, but with a cash flow that could increase the yield 50% over the next few years.

The utilities are offering 4% to 4.5%, yet because of a weak operating situation have limited ability to increase that yield. Buy a lower-yielding company with a greater cash flow that has the chance to increase that yield going forward.

Q: John, any final suggestions for the investors in our audience?


I strongly recommend that investors focus on rational expectations for an economy that's recovering -- returns of 2% to 3% over the next few quarters, in an environment of low inflation yet limited job growth. If investors focus on quality companies, I think annual returns in equities of 8% to 10% are in reach.

Edited by Jack Dierdorff

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