January 2003
All Else Being Equal
| "There is nothing worse than a sharp image of a fuzzy concept." |
| -- Ansel Adams |
S THE NEW YEAR BEGINS, IT'S only natural to reflect on where you are and where you hope to be in the coming twelve months. After three years of declines, equity investors are understandably looking to the past for signs of things to come.
The one thing to bear in mind is that history can be a guide for the average, but in the short-term the average rarely occurs. There are always exogenous economic and political factors affecting financial markets, and these cannot be fully accounted by historical trends.
Last year we underestimated the depth of corporate corruption and had no way of anticipating the potential problems with Iraq and/or North Korea. Relying on historical trends, some of our errant predictions included:
- There would be at least one Fed rate increase before year-end.
- Interest rates would edge up with bonds -- especially government securities -- returning less than their coupons.
- By year end, fixed income investors and the Fed would again be obsessing over the specter of inflation.
- 2002 would be a better year for equities than 2001.
- Stocks would close the year higher than they began it, but the gains would be tame when compared to other post-bear market rallies.
All of these were sound predictions based on market and economic conditions at the end of 2001, but outside factors -- Enron, Worldcom, Global Crossing, Iraq, and the threat of terrorism -- dominated 2002.
Most of these are still around as we start 2003 and as they recede, others may pop up to replace them. Ironically, historical trends are clearer now than they were twelve months ago.
Policy Limits
As far as the overall domestic economy is concerned, prospects are better than last year at this time. While signals are still mixed, the economy does appear to have stabilized with growth continuing at a sluggish pace.Despite the recent rise in unemployment, 6% is still mild in comparison with the end of other recessions. Evidence has begun to suggest that inventories are now at the point where they will have to be replenished giving renewed hope for an increase in capital spending.
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 Source: Baseline Despite relatively tame inflation, gold and oil have shown dramatic increases in 2002. The CRB commodity index is also headed up, although much of the increase is attributable to global political uncertainty rather than domestic economic factors. |
Despite disappointing Christmas sales, consumer sentiment has remained strong. In the past it's been a mistake to underestimate the American consumer's determination to spend every available dollar so all else being equal, there's no reason to believe it would be different this time.
But what is different this time is the rising cost of energy. The potential conflict with Iraq and the internal turmoil in Venezuela have combined to send oil over $30 a barrel.
Some economists have argued that the shift in the U.S. economy from manufacturing to services has lessened the impact of the price of oil. While this is true, it still doesn't diminish the fact that consumers still depend on oil to heat their homes and power their cars.
Every additional dollar spent on fuel is another not driving the domestic economy. The high price of oil serves as a tax on the consumer and a drag on the economic recovery.
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 Source: Baseline For the past two years, the Fed has been lowering the benchmark interest rate. At the end of 2002 it was 1.25%, a level last seen in the Kennedy Administration. |
Gold is another commodity benefiting from economic and political uncertainty. For the first time in years gold has made a sustained move above $300/oz. Many investors are seeking it as a store of value in a low-rate environment that risks deflation. Others see it as a safer hedge than the weakening U.S. dollar.
Gold, unlike oil, is not a major component in industrial production. Its price level is more informative of investor sentiment than actual economic import. Nevertheless, when commodities begin to rise and hold their gains, those who fear inflation take notice.
The Fed -- the primary inflation-fearers -- have shown little concern. Their last and only move of 2002 left the Fed Funds rate at a miniscule 1.25%. These are levels last seen in the early 1960s yet the Fed seems prepared to keep them there until there are consistent signs of sustained economic recovery. Apparently they're of the opinion that it's better to keep rates low to avoid a deflationary recession than to try to lower them -- like Japan -- after the fact.
At any rate, with Fed Funds just above 1%, there's little ammunition left. Monetary policy can't really do anything to affect the political uncertainties that are driving oil and gold prices higher. The Fed seems smart enough to realize this.
Too bad Congress isn't. For the first time since President Clinton's first term, fiscal policy is back on the table. Whether it's the desire to win votes or sincere concern about jump starting the economy, Congress seems determined to pass some sort of stimulus package. Regardless, if the past is any guide to the future, whatever passes will be too late to have any meaningful effect on the economy but will increase the federal deficit.
Looking Up
So far at least, bond investors don't seem rattled by this prospect. The yield curve has remained relatively flat and steady.At the short end this indicates little likelihood of Fed moves -- either up or down. If correct, it means there's little risk of further economic deterioration requiring additional easing and the economy isn't expected to overheat setting off a new round of inflation and rate hikes.
At the long end, investors aren't demanding much of a premium for longer maturities indicating little fear of inflation. All else being equal, this would signal stable rates, low inflation, and a good environment for equities.
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 Source: Baseline The Treasury yield curve has been relatively steady predicting little change in short-term rates and no fear of inflation over the intermediate term. |
But again, all else isn't equal. War with Iraq (or North Korea) and/or oil prices lingering over $30/barrel could quickly set off a new bout of inflation. This, coupled with the sluggish economy, could resurrect the 1970's "stagflation" scenario where economic growth stalls while inflation cuts into real wealth.
In such a situation, the Fed would be confronted with the choice between supporting the ailing economy and fighting its traditional nemesis, inflation. If history serves as a guide, the Fed will take on rising prices and raise interest rates.
Even without stagflation, it's hard to believe the Fed's next move won't be up. Yes, we missed this call last year -- but then again, so did many acclaimed economists. Following the strong finish to 2001, most had called for a rate hike as early as the late first quarter of 2002. That, of course, was before the full impact of Enron, Worldcom, and all the other scandals were known. Blame it on those exogenous factors again.
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 Source: Baseline In 2002, the 10-Year Treasury Note fell to 40-year lows. At these levels, there's nowhere to go but up. |
Regardless, interest rates are 1/2% lower than they were last year at this time. The economy has found its footing, and maybe, just maybe, we can start to believe corporate earnings reports again.
If that's the case, it won't be necessary for credit to remain so loose and the Fed can begin to move rates back toward sustainable levels. The longer rates stay low, the more they tempt inflation.
Any move up -- or even serious consideration of increases -- could quickly end the two year old bond party. Rising rates send bond values down and it's quite possible that's the scenario to expect in 2003.
Last year we (incorrectly) predicted bonds would remain steady and return only their coupon. This year we're even more negative on bonds, in that this may be the first year since 1994 when fixed income investments actually lose ground. As it was nine years ago, a new generation of investors is poised to learn that it is possible to lose money in bonds.
Encouragement from the Past
Historically these economic and financial conditions have been good for equity performance. As the economy bottoms and begins to turn up, funds typically flow from defensive investments back into stocks. Improving economic conditions also boost corporate earnings, adding to stocks' appeal.As we enter 2003, there are three major factors working in stocks' favor:
Reversion to the Mean
Back in the late 1990s, many investors realized (but few acted on) the fact that stocks couldn't continue offer above-average returns indefinitely. Eventually returns had to come back to the average -- that's why it's the average. Now after three sub-par years, stocks again will revert to the mean.
According to Ibbotson and Associates, over the past seventy-seven years (through November 
2002), the S&P 500's annual arithmetic average has been 10.99% over 5-year holding periods. For the period 1992-1996, the S&P's annual average was 15.89%. For 1997-2001, the figure was 12.40%. Both were well above the average.
The 1998-2002 holding period included three bear market years, and the annual average dropped to 2.28%. Year-to-date through November 2002, the S&P 500 was off 17.24%, significantly below the average.
So what does this mean for the next few years? If 2002 is taken as the first of the 5-year cycle from 2002-2006, the next four years would have to average 18.05% just to get back to the 5-year average of 10.99%.
Of course coming out of a recession, that's exceptionally unlikely. But just to get back to the sub-par 2.28% of 1998-2002, the next four years would have to average a more reasonable 7.16%. After the long bear market, most equity investors would be happy with that. If, as we expect, bonds start to lose steam, such a return would be welcome indeed.
Valuation
The Price/Earnings (P/E) ratio is a quick way to get a handle on equity valuation. Essentially it measures what you today (the price) for a future dollar of earnings (the earnings). The smaller the ratio, the less you pay for that future dollar of earnings. All else being equal, you get a better bargain when you pay less.
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 Source: Baseline, December 9, 2002 As of late December 2002, the S&P 500 was much more reasonably valued than it had been in eight years. Valuations are even cheaper when still overvalued sectors such as Tech and Telecom are excluded. |
Back at the height of the market bubble, the S&P 500 had a collective P/E of 31.0. Historically market tops have occurred when the P/E is around 22.5 and the average has been around 15.
So where are we now? As of late December, the overall S&P 500 had a P/E of 18.8. If you exclude those sectors that are still overvalued (Tech and Telecom), the P/E drops to an even more reasonable 17.1.
Back in the 1990s, investors were falling over one another to buy hot stocks with triple-digit P/Es, now many are afraid to consider issues priced near their historical averages. For those wishing to buy low and sell high, it's hard not to see this as a buying opportunity.
Interest Rates
We've pointed out in The Premature Death of Buy and Hold that interest rates can be a guide to long-term investors. The Ibbotson numbers indicate that back to 1926 the best 10-year equity returns have occurred when stocks were purchased when intermediate-term interest rates were low or falling.
If the future's like the past, interest rates at 40-year lows are now signaling the best buying opportunity in decades. That is, of course, with all else being equal.
Long vs. Short Term
These are all good arguments to return to the equity markets, but so far stocks have been unable to sustain a rally. Brief spurts of buying have proven to be nothing more than bear market rallies. At the close of 2002, stocks are still locked in their downward trading channel established at the 2000 market peak.|
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 Source: A-T Financial Despite periodic rallies, the S&P 500 is still locked in a downward trading channel with lower highs and lower lows. One of the best indications of the end of the bear market would be a sustainable breakout from the channel. |
This isn't to say that the market is acting irrationally; quite the contrary, it's acting very rationally since international events are currently overshadowing historical trends. In the short-term it's only prudent to place more emphasis on Iraq, Venezuela, and the war on terrorism than on long-term averages.
It's our sense that the Iraq situation will be settled one way or another in six months. Venezuela will resolve its internal disputes even sooner, allowing oil prices to settle back into the mid-$20 range by the 2nd quarter of 2003. The war on terrorism will drag on for years with diminishing effect on domestic financial markets.
But like all predictions, accuracy improves as the time horizon lengthens. And that's the key point here: While all else is never equal in the short-term, it always is in the long-term.
Investors -- especially equity investors -- should always base their moves on long-term considerations. If they can look past short-term factors, they'll realize that history is telling them now is the time to begin returning to the stock market.
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