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October
17, 2002, 9:00 a.m. |
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fter
six negative weeks, the Dow has distanced itself from its low of 7,197
on October 10. Can the stock market move higher? Sure.
The turnaround in the stock market — despite Wednesday's dip — started last Thursday and achieved both good volume and breadth. But the market still has a lot to sort out.
Consensus earnings for the fourth quarter of 2002 show a gain of 18%. But if we see revisions like the ones we saw in the third quarter, that 18% figure may be high. While most economists still expect third-quarter real GDP to increase 3.5%, the fourth quarter is beginning to be revised to an approximate 2.5% gain.
The inventory-to-sales
ratio, currently at 1.34 (a new low), is not expected to show more than
a modest rebound, but it will add to future growth according to Dick Rippe,
chief economist for Prudential Financial. The catalyst for really big
GDP gains — strong capital spending — is not yet apparent either
domestically or among our major global trading partners.
It is not surprising that many market sectors seemed to do especially
well on the nearly 5% market rally on Tuesday, October 15, while Intel
experienced a 13% price decline in late trading due to a disappointing
earnings outlook. The future stock market will not be like the old bull
market. Leadership will change, but it is not yet evident what that change
will look like.
In the meantime, those sectors that should continue to experience decent revenue growth are health care, consumer staples, and select financials. Consumer cyclical, industrial, and material stocks will experience sluggish revenue gains while the less-important transports and utility sectors will be mixed.
The energy sector will be subject to continued oil price/war uncertainty. The technology and communications sectors (two sectors that still trade at a premium multiple to the stock market) may continue to experience negative revenue growth. The rest of the market has been better rationalized to future prospects. General Electric is a case in point as its P/E valuation is currently 13 on 2003 earnings expectations versus the stock markets 15 P/E valuation.
If we continue to experience a modest recovery and if corporate pricing power remains weak, then those companies with strong balance sheets, desirable products, a secure dividend, and honest management will be the best investment opportunities. Boring? Yes.
As for the bond market, there is still value there. Through October 1, 2002, the 10-year U.S. Treasury bond has rallied 140 basis points to yield 3.75%, resulting in a positive 11% total return. During the same period the S&P 500 declined 28%. Are bonds still a good bet? Sure.
It is time to consider another sector of the bond market. Corporate bonds, which are more comparable to the stock market, have seen their yields widen dramatically higher to the Treasury yield curve this year. For example, GMAC 10-year bonds, rated A2/BBB+, are now trading 455 basis points higher in yield than 10-year Treasury bonds versus a spread of 330 one month ago. This spread widening is the result of massive downgrades of over-leveraged companies by the major rating agencies. While this process has not ended, there is value in the corporate sector if one does proper due diligence.
So the bond market (continue to stay away from junk bonds) has value in the 7-to-10-year corporate sector with very attractive yield spreads. If one already owns Treasury securities purchased earlier this year, or in previous years when yields were 5% to 6% or higher, they remain a hold in one's balanced portfolio. Owning a portion of one's total portfolio in U.S. Treasury securities is a good and safe investment. With inflation estimated at approximately 2.5% over the coming years, a 3% or more real return remains attractive in bonds. And hopefully in the future one can realize an even higher real return of 5% in select corporate bonds and the stock market.
Remember what Ed Yardeni, investment strategist at Prudential Financial, says: In nominal terms, "7 is the magic number" for the trend growth rate of the economy, sales, and reported earnings since the early 1960s. Continue to be realistic and seek long term value.
— Patricia A. Small is a partner with KCM Investment Advisors, and is the former Treasurer, University of California.