January 2004
A QUICK LOOK BACK AT 2003 - For the first time in three years, investors will have a smile on their face when they read their year-end investment results for their retirement accounts or personal portfolios. The popular stock market indices ended 2003 near their highs for the year after achieving some spectacular returns that were reminiscent of the kinds of returns we became accustomed to in the "irrationally exuberant" 1990's. The Dow Jones Industrial Average climbed 25%, the S&P 500 Index earned 26% and the Nasdaq embarrassed both with a gain of 50%! And this all happened while American soldiers were fighting and dying in Iraq, the Homeland Security Department was intermittently raising the terrorism alert, and governance scandals disgraced the mutual fund industry as well as the New York Stock Exchange itself. In the end it was the historically low interest rates and the accelerating growth of both the economy and corporate profitability that investors were focusing on. Momentum is clearly on the side of investors going into 2004 but the easy money has been made and significant challenges for higher equity prices lie just around the corner.
Not that I want to rain on this parade but I do feel the need to put these equity returns in perspective. While they were impressive, they were not extraordinary from an historical standpoint. Big gains are the general rule following the end of bear markets. Studies show that the average annual stock market return in the first year of an economic recovery is around 50% so this recent rally wasn't even up to par. Part of the reason for that below average result was that the stock market remained highly valued even after the tough 2000-2002 market rout. Corporate profits fell faster and farther than stock prices, which helped keep valuations elevated.
Also, most investors have a long way to go just to get back to even, especially for those who got caught up in the technology stock craze. The stock market is just now returning to 1998 levels and is still way below its record highs. Even after last year's 50% and 26% returns, the Nasdaq and the S&P 500 indices still need to rise about 60% and 40%, respectively, to reclaim their all-time highs that they achieved in 2000. Realistically, we don't see that in the cards any time soon.
Our Cautious Forecast for 2004
As we look into our crystal ball to come up with a 2004 forecast for the economy and the financial markets in particular, we see conflicting forces between potentially better than expected economic and profitability growth and high stock and bond market valuations that have already priced in perfection. At the moment, economic and market momentum are now overshadowing valuation concerns, which explains why this stock market rally continues.
Recent economic statistics show that the U.S. economy is growing nicely and it isn't just the consumer who is responsible. Rising demand from overseas, especially in China, is boosting exports and business managers are becoming confident enough to begin to invest in equipment again. After the dismal three year slowdown, manufacturing is picking up with new orders surging in December. Many economists are expecting the U.S. economy to grow at an inflation-adjusted rate of 4.0-4.5% or more in 2004 after expanding at an estimated rate of 3.5% in 2003. We would agree with these forecasts.
A Synchronized Global Expansion, Low Inflation and Profit Growth
The United States and China are not the only countries experiencing faster growth. Most European, Asian, and Latin American countries have witnessed improving economic conditions in 2003 and are optimistic for even stronger economies in 2004. Even Japan is experiencing a long-awaited and better balanced recovery that should prove to be more sustainable than in prior years. This will have a very positive effect on both export growth and international sales for U.S. companies.
Inflation has remained low despite this surge in economic activity and substantial increases in most industrial commodity prices. Record increases in labor productivity and excess capacity have limited the upward pressure on prices of finished goods and services and kept new job growth below what one would expect at this point in the economic cycle. The major beneficiary of these various economic forces has been corporate profits.
Companies that focused on reducing costs when sales were harder to come by are now seeing their profit margins expand as sales increase. Corporate profitability in the last half of 2003 has greatly surpassed early expectations and there is reason to expect at least 10-15% earnings growth in 2004. There is an argument being made by the raging bulls on Wall Street that corporate earnings in 2004 will far exceed current consensus estimates.
If the global economic outlook for 2004 is so favorable then why aren't we more bullish on the outlook for the stock market? After all, one would think that the combination of low interest rates and rising corporate profits would provide strong support for rising stock prices. But as you likely know, we worry for a living.
What We Worry About
We are not perpetual bears and certainly acknowledge that the economy is very investor friendly at the moment but we are concerned that the momentum is peaking and will be slowing in the second half of the year. Since investors in stocks are forward looking, current stock prices reflect what investors think that the levels of corporate profits and interest rates will be 6-12 months from now and what the earnings growth rates will be at that time. We think the current expectations about the future might be a little too optimistic because of the growth we see today.
We also believe that the combination of the stronger global economy, a weakening U.S. dollar, and the Federal Reserve's current easy monetary policy will soon put upward pressure on inflation. The excess capacity in this economy is diminishing so a number of businesses may soon discover that they have some pricing power again. The weaker dollar makes foreign goods more expensive for Americans to buy, which also allows U.S. competitors to raise prices. Higher inflation means higher interest rates, which also depresses stock and bond valuations. This is why we will continue a defensive strategy of limited maturities in our client's bond portfolios.
It is possible that future economic growth won't live up to its high expectations because of our debt-burdened society. It is an unfortunate fact that the average consumer did not take advantage of very low interest rates to pay off debt with the help of the income tax refunds and cash-out mortgage refinancing. Instead most people have used up their borrowing power with the purchase of new cars, big houses, and just spending more than their income justified. A good example of this is to realize that the average credit card holder who doesn't pay off the balance every month is carrying an $11,000 outstanding balance on the card.
Finally, as depressing and negative as it sounds, the world remains a dangerous place and the risk of terrorist attacks will likely always be with us. While difficult to formulate an investment strategy around this threat, anybody managing money during September 2001 will never completely set it aside.
Despite our guarded outlook we continue to look for new investment ideas. We concede that we may be underestimating the growth prospects of the economy and future corporate profits, especially if inflation remains well contained and the rise in interest rates is limited. Our crystal ball is calibrated to highlight the risks and provide more conservative estimated returns so we can increase the odds for positive surprises in the New Year.
John W. Gudritz, CFA
john@frontstreet.com