08/30/02
“You know the sound of two hands clapping, but what is the
sound of one hand clapping?”
The answer to this Zen philosophical question is a good
description of the current economy and the state of equity
markets. The economy
has stopped declining, but the recovery is weak, and a further
relapse cannot be ruled out.
We interpret the stock market rally since mid-June as the
third rally in an ongoing bear market, which at its current peak
still leaves the DJI –19%, the S&P500 –22% and the Nasdaq –29%
from levels prevailing on 3/19/02, the date of our last comment
advising caution. The
next leg of the decline is expected to unfold in September and
October.
Previous modern-day bear markets in 1969 and 1973 lasted 18
and 23 months, losing 35% of 45% of peak values. The 2000 bear market is now
in its 30th month, recording losses of 34% in the DJI and 47% in
the S&P 500. The
unprecedented millennium bubble has lengthened the timing of index
troughs and deepened the extent of price erosion. Our estimates are ultimate
lows of 7500 and 730 for the DJI and S&P 500.
While the extended market decline has brought many issues
within the realm of statistical attractiveness, this only measures
some probability of future reward. It gives no promise of when
this might occur.
Inflation, interest rates and EPS are major determinants of
stock prices. Declines
in the first two to historic lows over the past decade account for
much of the ’99-’00 equity price bubble. Continuation of these two
factors at favorable levels for much longer is more than
questionable, and major forces are arrayed against an early sizable
increase in corporate earnings. The general outlook is for
price volatility with minimal net progress. Be wary of issues rated
favorably because the P/E is below the average of the last few
years, a period of demonstrable over-valuation. Many stocks trading at a small
fraction of previous highs are not bargains. Others are attractive from a
statistical view, but a catalyst for immediate appreciation is
lacking. Purchase of
such issues will reward those with patience, but gratification will
not be instant.
It is distressing, but not surprising, to see investors now
repeating the mistakes of the past decade, but in the opposite
direction. Equity
holdings purchased in huge amounts at ever higher prices during the
last half of the millenium, with no thought given to quite
attractive bond yields, are now being liquidated in record amounts
to chase ever lower bond returns. When will they ever
learn?
Conventional wisdom is that equity returns will be around
6%-7% for the next few years until all vestiges of the equity bubble
are wiped out. For
once, such a widely held assumption may be correct. Returns of this
magnitude and greater are readily available from a wide selection of
preferred stocks, busted convertibles, and straight corporates of
acceptable credit quality.
The investor assumes credit risk rather than equity
risk. In terms of the
averages and indices, equity risk is still substantial, in our
opinion.
There are some attractive stocks which qualify for purchase
now. We simply suggest
that the choices here are presently limited, while there are any
number of credit instruments available which we feel will give
equity-like returns over the intermediate term. Maturity yields
exceeding 8% on issues maturing or subject to put within five years
are an alternative to equities worth considering. With interest rates at
40-year lows, long-term bonds, regardless of quality, rank lowest in
investment attractiveness.
William Wright