This week's market commentary
- 1999 9 Sep
Wednesday, September 29, 1999
While tech stock prices have been extremely volatile over the past week, they pale in comparison with the price of gold.
Whos to say what the proper value for stocks is? Stock prices skidded last week - particularly for tech stocks - after Microsoft President Steve Ballmer characterized the market action of technology stocks as a gold rush of speculation. While Ballmers comments clearly depressed a market that had already been volatile, it remains to be seen whether the shelf life of Ballmers warning on stocks is any longer than that of Alan Greenspans pronouncements. The Fed Chairmans warnings have been more remembered than they have been heeded. Even after the recent market slide, the S&P 500 is up two-thirds from December 1996 when Greenspan issued his first irrational exuberance alert. Ballmers opinion on stock prices may be even less heeded; perhaps this is because Microsoft generally has a conservative take on things, such as consistently lowballing sales and earnings forecasts.
At the opposite extreme from Greenspan and Ballmer are James Glassman and Kevin Hassett, authors of Dow 36,000. These two academics argue that since stocks have outperformed bonds over virtually all 20-year time horizons, they are no riskier than bonds and therefore ought to be discounted on a par with bonds. That is, stock prices ought to rise to the point at which dividend yields plus dividend growth rates are equal to Treasury bond yields -- in other words, to Dow 36,000 today. The math is as follows: forecast DJIA dividends ($180) divided by the difference between Treasury yields (5.5%) and the long-term rate of dividend growth (5%). Many holes have already been shot in this model, the most obvious being the huge declines in stock prices that the model produces for relatively small increases in bond yields: a 50 basis-point rise in T-bond yields (from 5.5% to 6%) would occasion a 50% plunge in stock prices. Whats more, the ultimate fallacy of DJIA 36,000 is its underlying assumption that stocks history of big excess returns over bonds should induce several more years of premium returns until stocks are priced so that expected stock returns would equal bond returns going forward.
Unlike Greenspan/Ballmer and Glassman/Hassett, Wall Streets Abby Cohen finds the stock market close to fair value. This week, the Goldman Sachs strategist expressed her view that stocks are modestly undervalued and that mainline technology stocks can be expected to perform well. This contrasts with the Federal Reserves valuation model, which puts fair value for the S&P 500 at close to 1000, down around 22% from todays level and off nearly 30% from the July 16 market peak. (Glassman and Hassetts Dow 36,000 equates to roughly 4,500 for the S&P 500.) Cohen recently increased her year-end 2000 target for the S&P 500 to 1450 (14% above the current level) on the basis of her revised estimates of operating profits (+15% in 1999 and +8% in 2000) and the expectation that most of the bond markets weakness has already been seen. While one can quibble about the valuations underlying these projections for the market, the basic drivers of Cohens forecast -- solid increases in corporate profits and flat to lower bond yields -- appear to us to be sound.
The key to determining the fair value of equities is finding the proper level of interest rates. For the most part, ten-year Treasury bond yields continue to trade in the 5.8% to 6.0% range that has prevailed since May. So long as inflation remains in the 2.0%-2.5% range (which Wright believes is the most likely case for 1999-2000), T-bond yields near 6% offer real returns that are generous by historical terms. History reveals exceptional periods when real returns have gotten higher (1983, 1988 and 1994), but investments at these levels proved highly rewarding. While history isnt the only guide for valuing bonds, there is something to be said for staying ahead of the game in terms of purchasing power.
A bona fide gold rush has pushed the price of gold up 20% in little more than one week. With todays nearly 10% jump, the December gold futures contract price is now $310 an ounce, the highest reading in a year. This happened less than one month after gold hit a 20-year low. Having previously used the moderation in gold prices as an indication that inflation remained under control, are we now to move over into the camp of the inflation hawks with gold back above $300? Granted, the rise in gold, oil and commodities prices is a test of our benign inflation outlook. Still, considering the special circumstance of golds rise -- the surprise deferral of sales of gold reserves by Europes 15 nations for five years -- we believe that the inflation implications of higher gold prices are probably limited. To some extent, producers of gold, oil and other commodities are trying to resist the creative destruction that accompanies the development of new technologies and the passing of old ones. In the face of sluggish, maturing growth in demand, commodity producers are attempting to push prices and profits higher by restricting supply. Such a strategy may work in the short run, but the march of technology and competition will ultimately prevail.
The 10% correction now under way in the S&P 500 may get deeper before it ends. But given our forecast of solid earnings growth and lower bond yields, the current sell-off is viewed as a buying opportunity for investors with longer-term horizons.