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Phil Orlando: Value from Value Line
02/28/2003 12:00 am EST
Value Line has been around since the 1920s, and it remains one of the most successful and respected members of the financial commuity. Its famous ranking system covers 1700 stocks. The top 100 stocks have shown a compound annualized return of 17% since 1965, when the system was introduced. That compares to a 6% annual return from the S&P 500. Here, Phil Orlando, chief investment officer of Value Line Asset Management, highlights five "very compelling reasons" why he believes we have already reached a market bottom.
"Right now our asset allocation model is very bullish for stocks. It has an allocation to stocks of between 75% to 85%. Our bond allocation is only 10% to 15% and our cash allocation is only 5% to 10%. So we are very aggressive and very comfortable for the prospects of the equity markets going forward. The obvious question is why? What is going on in the market, and why do we believe that things are about to turn for the better?
"One key element of our thesis is that there has been a significant shift in the way Wall Street works over the last several years. Over the decades, Wall Street has been trained to look forward. The market is a discounting mechanism. Our job as analysts is to try and anticipate what is going to happen six, or nine, or 12 months in the future, and then discount the probability of that event into current share prices. But what we have seen over the past 15 months or so, is that Wall Street has shifted its focus from being anticipatory, and focusing on the future fundamentals of the economy, the markets, and individual companies, to being coincident , and reacting more to investor psychology, and issues of fear and concern.
"If we look at the year 2000, which was the first bad year for the stock market, the outsized negative returns came from the NASDAQ, due to technology stocks that had been bid up aggressively in previous years. Investors began selling once they realized that the pace of activity in that sector was unlikely to continue at that rate of growth. As we moved into 2001, the US economy slipped into recession. And then of course we had the horrific events of Sept. 11th. In retrospect, it is reasonable to understand why these were poor years. 1999's extraordinary rate of growth began to decelerate, we slipped into recession, and there was a real shock to the system from 9-11. But as we look at 2002, we can begin to see the shift from anticipatory to a coincident point of view. Following a post-9-11 sell off, the market found its legs and began a significant rally. That continued until January - to the day when the Enron situation broke. Then came Tyco, WorldCom, etc. The market then became transfigured, not with the fundamentals of the market or the economy, but it became focused on corporate malfeasance, accounting scandals, and brokerage industry conflicts. So even though the economy was beginning to recover, the market still went down. It was the first time since 1912 that you had an economic recovery on one hand, and a declining stock market on the other. I would argue that was due to the shift towards negative investor psychology.
"Now we have a new set of risks to consider, and those are the geopolitical risks of Iraq, Venezuela, and North Korea. All we have done is changed the things we are worried about. And as a result, the market is still depressed. The market hates uncertainty, and as a result we are mired in this situation. On the other hand, I would like to share with you five very compelling reasons why the markets will do materially better over the near and intermediate term future.
"The first of these reasons is fiscal policy. The Republican sweep in the mid-term election gave President Bush and his cabinet the support to propose a very aggressive fiscal stimulus package. I don't believe that package will pass unscathed, and there will likely be four or five months of debate. But I do believe that some fiscal stimulus will emerge from these discussions by the middle of this year.
"Second , the monetary backdrop is very favorable. The Federal Reserve has dropped interest rates 12 times over 15 months, and rates are now at a 41-year low. And since last July, the Fed has been very aggressively adding liquidity to the banking system. There tends to be a very direct correlation between the Fed adding liquidity to the banking system, and the markets subsequently doing better. Given the aggressive nature of the addition to liquidity to the banking system from the Fed, in the form of open market operations, I believe that there is a catch-up effect in financial market performance that is yet to come.
"The third positive is the economy. We are out of recession. And I do not believe that we are going to double dip. As we look forward over calendar 2003, the economy will recover nicely. We will probably see 2% growth in the first or second quarters of this year and probably see 3%-4% growth in the second half. And there is upside to those numbers based on the timing and the scope of the president's fiscal policy program, which we believe will be retroactive to January 1st . The more aggressive the program is, the greater will be the potential for economic growth in the second half of the year. Meanwhile, we believe that the successful resolution of issues in Venezuela, and Iraq, and North Korea, has the potential to reverse the price of crude from around $37, back to $20. That probability would be a material boost to GDP, and could quite possible add another 1% or 2% to growth on a sustainable, long-term basis. So we could be looking at 4%, 5%, or even 6% growth, depending on how events play out over the next quarter or two. Granted, there are a lot of moving parts and variables in this scenario, but I think there is economic upside.
"The fourth point is corporate earnings. Earnings have been improving for the last three quarters. Positive surprises have outnumbered negative surprises by a ratio of 3 to 1. That is significant. What have managements done to improve earnings? They've taken advantage of the fact that with share prices at 52-week lows, they can aggressively repurchase shares in the open market. The retirement of shares means that the share base has been reduced. As the economy picks up and net earnings increase, earnings per share will increase at an exponentially larger rate of growth because the share count has been reduced as a result of the share repurchase program. So the fact that company's have used their cash to repurchase shares at lows is a smart thing going forward, as earnings per share will then increase at a sharper pace. Also companies have taken advantage of the 41-year lows in interest rates, by retiring higher cost debt with lower rate debt, and therefore reducing interest expenses. That will improve operating leverage. At the same time, companies have closed old and inefficient plants, laid off employees, and reduced operating expenses. Once the economy starts to pick up, that all will result in a much sharper increase in earnings per share. Right now, managements are being cautious in terms of their forward guidance. That is also good because at the appropriate time, when the economy kicks into gear, the numbers are going to be very strong compared to the year ago comparisons, the sequential comparisons, and the conservative guidance that company managements have provided. I think all of this will come together and provide a positive stimulus to the market.
"Finally, the fifth point is valuation. Alan Greenspan has done a lot of work that suggests that there is a tight, inverse, mathematical relationship between interest rates and inflation on the one hand, and price-earnings ratios on the other. Conceptually, when interest rates are low, p/e's should be high, and visa versa. Last October, I thought we saw a bottom in the market. On October 10th , which is still the bottom for this market, the ten-year Treasury bond troughed at 3.57%. The way Dr. Greenspan's model works is to take the inverse of the ten-year Treasury yield, and that translates into the implied future price-to-earnings ratio target for the S&P 500. The 3.57% Treasury yield translates into a p/e of 28 times earnings. At the same time, on October 10th , the S&P was selling at just 14 times earnings. That means that there was a 50% valuation imbalance between where Dr. Greenspan thought the S&P should sell based on the low level of interest rates, and where it was actually selling. If we take a look at the end of calendar 2003, the 28 multiple implied by the bond market and the 14 multiple at which the S&P was selling, we would think things should meet somewhere in between, say 20-21 times earnings. If that were to happen, then going from a 14 multiple to a 20-21 multiple, over a 15-month period would imply 50% share price appreciation for the S&P 500. That seems ludicrous, except for the fact that that is exactly what happened the last time we were in the same set of valuation circumstances.
"The bear market we have seen since 2000 is virtually identical to the bear market that we saw back in the 1972- 1974 period. From peak to trough, the S&P declined more than 48%. The decline in the current bear market, from peak to trough has been 51% - virtually the same amount. That intrigued me. If they went down by the same amount, over the same amount of time, what was the performance out of the bear market in 74? What we saw was that the S&P 500, off of it's trough, increased by 54% in that first recovery year. This is virtually identical to the 51% valuation imbalance that I calculate from the Fed's Treasury bond model. That is why I believe we have an outsized opportunity for a snap back in the markets over the course of the next year or so. The Fed model now suggests a 38% valuation imbalance. We think we now find ourselves in an environment where there is an opportunity to make some money. Even though I am looking for a strong, snap back rally, I do not believe that we are going to go back to the environment of the 1990s, where everyone felt it was their birthright to make 30%, 40%, or 50% a year. Those days are over. Once we get back to fair value, what I do believe is possible, is that stock prices will reflect the underlying rate of earnings growth in the economy, which we estimate at about 7% to 8%. When you add a 1% or 2% dividend yield, you're looking at the potential for 8% to 10% annualized returns. That's the forecast. Once the issues of geopolitical risk recede, I think we have the potential to realize a 35% to 40% rally looking out over the next 12 months. And then, once we reach a valuation balance again, we can reasonably expect ongoing 8% to 10% normalized annual returns."
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