 March 2002 From Visibility to Credibility
Following the release of 2001 4th quarter earnings, visibility is no longer an issue. Many companies are not only willing to make predictions for the coming quarters, in many instances they're raising expectations. This is consistent with economic reports that one by one are turning more encouraging. Nevertheless, stocks continued to slide in the first two months of 2002. In the wake of Enron's demise, questions of visibility have been replaced with others of accountability.
This is understandable given that so much of what happened to Enron was attributable to shoddy accounting. Only time will tell if it was outright fraud, poor auditing procedures, or a combination of both. Regardless, any earnings announcement, whether it be from a speculative tech or an old-line conglomerate, is viewed skeptically. Stock investing is risky enough without the additional fear that just about any company could be the next Enron. So far this year, these fears have been the driving force behind the financial markets. Bond investors are equally skittish -- perhaps even more so -- than equity investors. And why not? A major part of analyzing a fixed income investment is getting a fix on the credit worthiness of the issuer. If everyone's accounting is called into question, how can you possibly make an informed decision? You can't, and that's the problem. As a result, rumors have been driving the market. Investors have taken the approach of Marge Simpson's old-West ancestor: Shoot 'em all and sort 'em out later. Needless to say, this has created a volatile and often irrational market. The Good NewsThat's a shame, especially if all else were equal, we might be talking about a new bull market. The economy has started to send more positive than negative signals. Inventories and jobless claims are falling while productivity and home starts continue to rise. Consumer spending and confidence are still holding up.
The Fed also sent out a positive signal when they left rates unchanged in their January meeting. Up until now, rate cuts were viewed favorably, but after 11 and with rates near their 40-year lows, any additional easing would only imply that the economy is in much worse shape than it initially appeared. By taking no action, the Fed indicated that they believe they've already done enough and that the economy is now poised for recovery. With leading indicators turning back up, and the money supply growing at a rapid pace, things are coming together for a recovery in the second half of 2002. We suspect the next Fed move -- whenever it occurs -- will be up rather than down. Fixed income investors are starting to anticipate that, too. In the upside-down world of bonds, good news for the economy is usually taken as bad news for investors. Underlying this is the belief that a growing economy leads to inflation. Rising rates are the enemy of fixed income investors since yields on older holdings will fall below market taking bond values with them. So far, bonds have held up well, hanging near their cyclical highs. Unfortunately for fixed income investors, this is due more to the turbulence in the stock market than bond fundamentals. With rates so low, it's hard to believe they can fall much further. As more and more evidence points to the beginning of the economic recovery, expect rates to begin heading back up. We'd also expect the Fed to move rather quickly on any indication of inflation. With rates starting from such a low level, quick tightening may be needed to stave off inflationary acceleration in the economy. On the upside, the Fed's vigilance should more than keep inflation in check for the coming year. That's good for both stock and bond investors. The Bad NewsAll else being equal, low inflation and an impending economic recovery should be an excellent background for a bull market. But as of yet, there's still no compelling reason to be a buyer.Sure, earnings should improve in the coming quarters, but they haven't yet. Even though inventories are falling, companies still have more to go before it'll be necessary to replenish their supplies.
To top it all off, stocks already appear fully valued. In mid-February, 103 of the stocks in the S&P 500 were within 5% of their 52-week highs. Only 13 were within 5% of their 52-week lows. Overall the index had a P/E of 24.6 -- typical of a bull market high. With valuations so high, how much further can they go when the recovery truly begins? As long as Enron and the accounting witch hunt pervade the market, any stock investment is that much riskier. And unfortunately, these concerns may stay around for quite some time. Each day brings another revelation in Enron's complex fraud. Global Crossing may prove to be equally criminal. Regardless, Congressmen will take full advantage of all the free TV time they can get in an election year. Expect their politically motivated "hearings" to drag on. Until there's some reason to change focus -- whether it's positive news on the earnings front or developments in the war on terrorism -- rumors rather than fundamentals will rule the day. The PredictionNevertheless, the recovery should begin in earnest in the second half of 2002. The market usually anticipates it by 3-6 months, but due to the Enron induced distractions, the rally will be pushed back.Unlike previous recession-ending rallies, this year's won't be as spectacular. Although there may be a burst of buying when investors finally realize the world will continue turning despite a few companies' creative accounting, it should give way to a rather sedate rally. Why? Well just consider the fact that the market is already starting from a pretty fully valued position. Sure low inflation may allow for higher multiples, but not much higher. Also the fact that consumers have been spending right through the recession means the pent-up demand that usually accompanies the end of a recession won't be there this time. If there is an initial buying spree, it will be because investors don't want to get left behind as the bull market resumes, rather than because there's additional consumer demand. Additional cold water will be thrown on the recovery if, as we suspect, our friends at the Fed take quick action to slow the economy before it can overheat. Just as they overreacted in 2000 to cause the current recession, there's every reason to believe they'll do so again. History does not favor an active Fed.
Investors themselves may damp the recovery. Those who held stocks through the recession and all the volatility of the past few months may be tempted to "get even and get out". As their holdings approach their original purchase price, they may sell to seek other more conservative investments. Unfortunately, these newly chastened investors may be making the wrong move at the wrong time. It's our sense that interest rates are near their lows. New commitments to fixed income at these levels subjects the investor to the double whammy of locking in the lowest yields in 40 years while at the same time subjecting the portfolio to capital losses should rates rise. Given that, even a tepid equity rally will be better than bonds over the next 1-2 years. Stock investors may face increased volatility over the short-term, yet it's not unreasonable to expect a high single-digit return over the next 12 months. While that's lower than the historical average from the past century, it's still preferable to the alternatives. The IndicatorSo how can you tell when we've turned the corner? One thing's for sure: Focusing on Enron won't do it. That may be an enthralling soap opera, but it certainly isn't much of an indicator of market fundamentals.Instead, we'd suggest watching the Financial sector. Historically, Financials have led in bull markets. Rallies without Financial participation typically aren't sustained. More often than not, they're merely short-term trading rallies or bull-traps in a bear market. When Financials show strength for more than a day or two at a time, the next bull market will be ready to commence. The broader the Financial leadership, the more confident you can be in their prediction. Until then, investors can't be faulted for remaining on the sidelines. Search this site! Just enter you key word or words:
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UST A FEW SHORT MONTHS AGO companies were struggling to predict future earnings. This so-called "lack of visibility" was a function of the slowing economy and falling demand. Without better guidance, investors understandably avoided making long-term equity commitments and sent the market down for a second consecutive year.
Source: Baseline
Data Source: Baseline
