25 Oct 2002 Still Bumpy, But A Better View
We are nearing the end of October – Hallelujah! EVERY bear market since the end of WWII has ended before November 1st of that bear market year. EVERY seasonally strong period (November to April) in the second year of the presidential election cycle (like this one) has produced an up market. And as Don Hays points out, we know that every time since the 1930’s that six-months of Dow weakness equaled or exceeded by the prior six months, is followed by a six-month period producing gains of at least 40%.
There are only two other times in the last 65 years when the stock market plunged as dramatically as it has recently – the 1930’s and the period of 1973–74. You can see in the graph below prepared by Don Hays, the similarity of the 1973-74 period to today’s market action is astonishing.
In the two years following the low of the S&P 500 in October of 1974 (blue line) the index increased by 75%. Hays notes that we often mark the beginning of this nation’s unprecedented massive bull market in 1982, but a strong argument could be made that it began eight years earlier in that September-December period of 1974. Are we in a similar period of building for the next great bull market?
According to First Call, this is the second of the two peak reporting weeks for 3Q02. As of today, almost three-fourths of the S&P 500 companies will have reported. Also by today, most industries with the exception of the retailers will have been heard from in a meaningful way.
First Call also tells us that S&P 500 companies’ earnings reports are running 3.5% ahead of the final estimated earnings for those companies and ahead of the average 2.8% margin. The relatively high level of negative pre-announcements for 3Q02 undoubtedly included a lot of purposely low-ball guidance that inflated the 3Q03 surprise factor. Prior to the hugely positive Microsoft surprise (Microsoft, one of the largest companies in the S&P500, beat the 43 cent consensus by 12 cents), it had been running about 2.3% or 2.4%. Assuming there is not another blockbuster like Microsoft, the Microsoft impact will be dampened out as the others report. First Call estimates that the final results will likely be about the same as the 2.8% average, which is better than the 1.3% actual-over-estimate margin of the second quarter.
The significance of this year’s slowdown is evident when we look at the reductions in earnings as a whole. At the beginning of 2Q02 the year-over-year earnings growth expected by analysts for the S&P 500 stood at 16.6%. By the start of the 3Q02 reporting season that expectation had been slashed to 4.9%, clearly much more than the typical 2.8% decline, according to First Call.
What about managements’ outlooks for the future? Again, First Call tells us that the 1.8 ratio of negative to positive earnings pre-announcements for 4Q02 is running somewhat better than the 3Q02 ratio of 2.3 at the same date in July, but much worse than the 1.6 and 0.9 ratios at the equivalent times for 1Q02 and 2Q02, respectively. In summary, according to the 3Q02 reporting season to date has been okay, neither great nor bad.
Economic indicators, like corporate earnings, continue to be mixed and difficult to predict. This morning, Durable Goods orders fell unexpectedly by 5.9%, the biggest drop since last November. Much of the drop is accounted for in reduced orders for autos, airplanes, and computers. Orders excluding transportation dropped 1%, much closer to expectations.
Our belief (and that of many others) that the recovery will be choppy and sluggish is reflected in the asset allocations of our model portfolios. While we see compelling long-term values throughout the market, we continue to provide greater weight to risk-aversion than to capital appreciation. We hold more cash, treasuries, and corporate bonds than usual for income and for dampening volatility. We also continue to hold a number of growth-oriented assets that, for the most part, trade at levels offering little downside price risk in uncertain markets. Current asset allocations of the three primary models appear below.
We believe that this economy will pull out of its funk, but think that it will take four to six months before the stock market settles down sufficiently to foster adopting a more complete growth strategy. We expect stimulus measures from the Administration and from Congress following the elections that will spur business and stock market investment. The war in Iraq will likely have run its course by January or February and the probability of reprisals will be better known then. Oil prices will likely fall substantially in the event of a successful outcome. One or two more corporate reporting quarters will have taken place to better reinforce the recovery thesis. The U.S. economy is building the foundation for another long-term period of economic expansion and prosperity. We will once again lead the global economy with what we do best; innovation, productivity, and capital formation. The lessons of the past three years, as well as industry consolidation and improved productivity will only serve to make U.S. businesses stronger in the face of new competition from China and existing competition from Europe. Opportunities have never been brighter. But continued patience will be required before it is evident to all.