Markets: Breakdown or Breakout?
New York: November 15, 2004
By John R. Stephenson

In the week following the U.S. election, stock markets turned in one of their better performances surging some 7%. So, are we in for better markets in the near-term? According to some market prognosticators, we are. On November 5'th Goldman Sachs declared in a note to clients: "Time for a move. The S&P 500 has traded in a 100-point range in 2004. We believe the S&P may now break out as uncertainty surrounding the election and third quarter earnings has ended." The Wall Street Journal Online recently quoted Morgan Stanley's Internet analyst Mary Meeker who reportedly said that the "Internet Boom is Under Way". The question for investors is: are they right?

To be sure, there is much to be optimistic about. In the last few weeks we have been buffeted by some surprisingly good numbers including a surge in the employment report (337,000 jobs created in October), lower energy prices and the easing of geopolitical/terrorism fears. With the Republicans sweeping not only the Presidency but also the two houses, the prospect of lower taxes and the privatization of social security are appearing real. As well, the balance sheets of corporate America continue to improve as companies have used the low interest rate environment to pay down debt. The reason markets have rallied is because investors love to cheer on good news - at least until it stops. And with corporate profits at a 40 year high and after tax profits of 7.6% of GDP, it doesn't get much better. As market commentator Jim Cramer recently said, "The only way to catch up is to join the crowd.They are buying Google because, what the heck, when the market's up, buy Google". But the stock market is driven not just by fundamentals but also by expectations. So are expectations too high?

For our money - yes! The price earnings ratio (a measure of valuation) for core earnings for the S&P 500 now stands at 21.58 versus a long-run (100 years) average of 14 times. In other words, the price on average that investors are currently willing to pony up to buy your typical share in the S&P 500 index is 21.58 times the earnings for that company (or 21.58 years for the company to earn back your investment). When you look at the tech heavy Nasdaq market, the picture seems even more extreme with the P/E ratio for the largest ten stocks on Nasdaq being a whopping 41 times If you examine some of the biggies - companies such as Amazon, eBay, Google and Yahoo you will notice that the P/E ratios for these companies are respectively 43.7, 92.7, 222.0 and 126.4 times or an average of 121.2 times! How can this be sustained?

It can be sustained until it can't. Investors will continue to bid up shares in stocks they love to nosebleed levels until something causes them to change their perceptions. That's when the markets turn from bull markets to bear markets sending participants scurring for the exits. Just what will cause that change in perception is hard to say, but most likely it will be a couple of quarters of earnings disappointments. Stock market analysts and investors are no different than you and me in that they tend to anchor their expectations of future performance based on past performance. That's not to say that some of the technology high flyers aren't excellent companies that produce valuable goods and services but that is very different than saying that these same companies are fairly valued.

With each surge in the market stock, market analysts up their price targets for the market as a whole, fully expecting that the trend that they are currently witnessing will continue indefinitely. Of course, companies can't continue to grow faster than the economy and the market overall indefinitely. And that is when they start to have earnings disappointments. Not just once, but over and over again. Yesterday's darling is tomorrow's dog. Once that perception changes, investors sell and in droves. That is when the long bear market begins and investors exclaim, "How could I have been so stupid!"

While the current rally might have some steam yet, it might be time to think about lightening up on some of your favorite technology and financial services companies. Other areas that investors should consider avoiding include Consumer staples and Discretionary where likely interest rate increases by the Federal Reserve, coupled with high debt levels, are likely to choke off consumer demand. For our investment dollar, we continue to favor the Energy, Health Care and Materials sectors where the fundamentals are more in sync with the valuations.