September 2000
Valuation vs. Earnings
| "[T]here are two possible situations -- one can either do this or that. My honest opinion and my friendly advice is this: do it or do not do it -- you will regret both." |
| -- Søren Kierkegaard |
S VOTERS PREPARE TO HEAD FOR THE POLLS, there are all sorts of decisions to be made. Whose pork-barrel policies are more favorable to your particular lot in life? Who's more likely to tax the other guy more than you? Which candidate poses a lesser threat to the economy and your own economic well-being?
For investors, some of these choices are actually relevant. If elected, the democrats are offering to "protect us" from big business -- you know, the 
same companies you own in your portfolio. The republicans propose to cut your taxes and in the process, probably undo everything the Fed's done so well. You choose.
But perhaps the most important decision currently facing investors isn't directly related to politics; it's the choice between valuation and earnings. It's this dilemma that's caused the equity market to tread water throughout the summer. The way investors come down on this issue will determine what stocks outperform over the next six months or so.
The Fed's Platform
This decision has been framed by the actions of the Fed. By tightening credit for the past 18 months, Mr. Greenspan and company have successfully slowed the economy. The question now becomes, have they slowed it too much? Only about half of their 1-3/4% increase has had it's full impact and already there's tangible evidence of slowing. What will happen when the remainder hits?On the positive side, there's very little indication that inflation is now or will be a problem in the immediate future. Of course oil remains at levels not seen since the 1990 Iraq/Kuwait incident. This isn't inflation, it's a supply and demand thing.
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 Source: Baseline The bond market is signaling an end to the Fed's tightening cycle. Rates have fallen and the curve is beginning to return to its normal upward sloping configuration. Most importantly, it gives no indication of inflationary pressures. |
In the short-term, the higher price of gasoline and heating oil may actually act as a tax on consumers, resulting in a reduction in spending. Ironically, this is precisely what Mr. Greenspan hoped would happen when he targeted the stock market and its so-called "wealth effect".
As long as your current president doesn't attempt to build a heating oil supply to ostensibly "help the needy" -- a move that would further tighten supply and raise prices -- the current spike won't have a major effect on inflation.
Other commodities show little inflationary pressure. Wages, while on the rise, have been offset by increases in productivity. Even Mr. Greenspan has had to acknowledge this.
The usually fretful bond market also doesn't seem to be worried. Long-term bond yields have been heading downward and the futures market implies the Fed's next move will be an easing.
A Chicken in Every Pot and a Stock in Every Portfolio
Lower yields and higher bond prices typically make stocks look more favorable in comparison. But the equity market has been range-bound all summer. While some of this has to do with the low summer volume, the prospect of a moderating economy is also taking its toll.Although the 10-year old bull market may still live on, the easy money has already been made. For the past five years or so, all you had to do was buy the largest of the large cap stocks and watch your portfolio grow. It didn't matter what companies you owned as long as they were big. Earnings rose for all of them along with their stock prices.
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 Source: Baseline After bouncing back from the spring's sell-off, most of the major indexes floundered around throughout the summer. Perhaps the upward bias of the late summer was an attempt to front-run an upbeat fourth quarter. We can only hope. |
But this spring's NASDAQ blow-off turned dot-com stocks into dot-bombs. All of a sudden, investors started to realize their high-flying Internet "concept" stocks offered as much real earnings as politicians offer real substance. They finally awoke to the fact that profitable dot.coms were as hard to find as an honest politician. Once again, earnings mattered.
As the economy slows, the ability to grow earnings becomes even more important. You can't just buy the largest of the large caps anymore. Just consider what's happened in the past year with the likes of Lucent Technologies, Qualcomm, and Procter & Gamble. Now there's no more pork barrel returns. Now you've got to find companies that can actually show some internal growth while the economy slows around them.
Kissing Valuation Babies
For the past several years, if you wanted stocks with the best earnings growth, you didn't need to look any further than technology. The Microsofts and Ciscos of the world routinely exceeded analysts' expectations while blowing past the comparable quarter's numbers. Regardless of the short-term ups and downs in the economy, tech stocks grew earnings.And they still do, but now the question becomes, "At what price?" As more and more investors sought out tech stocks, they drove the prices up. Even after the spring correction, techs are still some of the most overvalued stocks out there. The more overvalued a stock, the harder it falls when earnings falter. As an example, consider Citrix Systems rapid descent from $122 to $15 or Qualcomm's equally precipitous rise and fall from grace.
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 Source: Baseline The promise of growth and the tech frenzy drove many stocks to unsustainable levels. At their peaks, both Citrix Systems and Qualcomm were significantly overvalued. When earnings stumbled, they quickly went from being overvalued to undervalued. As investors are rediscovering, valuation really does matter. |
Investors are once again considering valuation in stock selection. This is what's led to the halting rallies in healthcare, basic materials, and even utilities. It's these sectors that have been neglected over the past two years, and it's here that stocks show the most value.
Summer on the Stump
All through the summer investors were voting with their dollars. As economic reports were released, money moved from tech into healthcare and back again. Utilities actually outperformed tech for several months as investors sought their relatively high dividends and steady (albeit low) growth. Paper companies had their days and, given its valuation, even the dreadfully managed Boeing drew some attention.
With investors rotating from one sector to another on a daily basis, no one sector or stock showed much progress. The same was true for the major indexes. As the summer drew to a close, an upward bias did seem to evolve with more positive follow-through from day to day. Breadth -- the difference between the number of stocks that were up and those that were down -- also improved. Perhaps this marked the beginning of a year-end rally.
Just like the presidential election, the ultimate outcome lies in the hands of the voters. The winners in the market will be decided by how investors come down on the valuation vs. earnings issue. Should they favor earnings, look for tech to retake its leadership role. If valuation wins out, expect a major change from growth to value.
Which will win out? Nobody knows, but whichever does will ultimately determine the fate of the market as we end 2000 and enter 2001. Kinda like the presidential election, isn't it?
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