The Hindu Business Line : US equities outlook is weakly positive

The outlook for American stocks is neither exciting nor gloomy, as the prices reflect lower earnings multiples. As oil prices climb, some profit-taking can be expected early in the New Year, followed by some stability. But anything more than a modest rise is unsustainable. If operating earnings continue to drift further away from reported and economic figures, then one should be prepared to trust American stocks far less, says V. Anantha Nageswaran.

IN MY previous column, I had promised to cover the outlook for global equities. Well, I meant US equities. Until today, US equities set the trend for the rest of the world. Hence, regardless of domestic fundamentals, if one gets the direction of the US equities correct, the job is more than half done.

2004 in retrospect

The year began with bulls predicting a good run. After all, it was the Presidential election year and markets were expected to do well. Historical evidence suggested that. Bears pointed to the fact that the market had a strong run in 2003. Standard and Poor's 500 Index earned a total return of 28.7 per cent in dollars USD in 2003, including returns from dividend of 2.3 per cent. Further, they pointed to the fact that the Price/Earnings (P/E) multiple was just under 23 at the end of 2003. It was well above the 70-year average of 15.6 for the last 70 years and just a shade under the average of the last 16 years from 1988. That was 23.6.

To them, the American bear market never bottomed out. The stock indices favoured the bears for much of 2004. Until end-September, indices were negative. Then came the spurt as equity investors in America began to celebrate the possible return of Mr George W. Bush as President. One might say that neither the bears nor the bulls had a convincing victory or defeat. The jury is still open.

Low inflation allows higher multiples

Bears tend to overlook one aspect. The expansion of the Price/Earnings multiple in the US started at the precise time the major central banks decided to target inflation rates rather than the money supply. This resulted in a long-term secular decline in long-maturity interest rates. That tends to elevate the present value of future earnings, other things being equal. There is a deeper angle to it.

This period also coincided with the decline of organised labour unions. Their bargaining power began to wane in the US from the 1980s. Hence, wages did not rise as much as they used, prior to the 1980s. This put a lid on inflation which, in turn, put a lid on inflation-indexed payments to workers. One reinforced the other. The result was that rewards to capital rose. The absence of traditional goods and services price inflation triggers such as wage costs (and perhaps, commodities) meant that loose monetary policy invariably boosted asset prices.

Therefore, as long as the goal of monetary policy remains inflation (in goods and services) control, one should expect asset prices to remain somewhat more elevated than in the past. This means that historical averages would be somewhat poorer guides to gauge the overvaluation of stock indices.

Valuation ratios are not expensive

What does it mean for 2005? For one, the Price-Earnings multiple based on four-quarter trailing reported earnings for Standard and Poor's 500 is a shade under 21. It may be above the long-term historical average but is well below the average of the last 16 years and the peak multiple of over 30 seen in 1999-2000.

Further, relative to the 10-year government bond yield, the earnings yield on the Standard and Poor's 500 Index is attractive. The standard name for this is called the `Fed model'. The Federal Reserve allegedly uses this as the risk premium measure to gauge the risk of a significant decline in stock prices. No one knows if they actually do that. Besides, there are sound conceptual arguments as to why this is a flawed measure. One, earnings yield on stocks should always be higher than that of the bond yield. After all, stocks are riskier. There is no terminal price for stocks (as it is for bonds) and earnings are uncertain (bonds earn fixed coupons). Two, earnings yield on a stock index should be compared with yields on corporate bonds rather than on the Treasury notes.

Despite these sound conceptual arguments, investors tend to look at these metrics, ignoring these flaws and take positions accordingly. In the past (see chart 1), when the risk premium was well below its own six-month moving average, the stock market had begun to decline shortly thereafter. Prominent examples were end-September 1987 and in early 2002. Now, there is no such trigger. The risk premium is just in line with its six-month moving average. Prices have to rise much higher before the risk premium becomes smaller indicating that stocks are pricey.

Further, nominal GDP growth of 4.5-5 per cent expected in the New Year should support average the earnings growth. Therefore, even if S&P500 reported earnings per share were to be at $60, a multiple of around 22 attached to these earnings should see the S&P 500 reach 1320 for 2005. This is in line with consensus forecasts for the index.

Dollar and crude price, the chief risks

However, risks abound. Chief among them are the dollar risk and that of a further rise in oil price. We had discussed the outlook for the dollar at length in the last several columns. The marked reluctance of investors to bid up the dollar despite a higher interest rate in the US (compared to the Eurozone) and brisk economic growth suggests that their confidence in the future purchasing power of the dollar is wearing thin.

If Washington does not credibly address the national savings issue, the orderly correction in the currency could turn out to be rather ugly. That would push up bond yields in turn and render the stock price valuation unsustainable, not to mention the impact of higher rates on home prices, automobile sales, consumer finances, etc.

The retreat in the oil price soon after the end of the Presidential elections is rather interesting. One is at a loss to find economic motives for the surge prior to and the abrupt decline after the election. However, it is clear that there is a firm floor at $40 a barrel. In the last week, the price of West Texas Intermediate crude has crept back to $46.3 a barrel from a low of $40.7. The worst winter months in Europe and in the US are still ahead of us and not behind us.

Further, on a secular basis, there are considerable uncertainties about the extent of oil reserves and production capacity in OPEC countries, particularly in the Persian Gulf. Therefore, recent lull in the oil front might give way to renewed concerns.

Watch out for earnings manipulation

Over and above these two familiar risk factors, one has to keep a wary eye out for the attitude of American corporations towards investors. There has been a seeming trend towards improved disclosure. But there has been no real need to resort to accounting and other tricks to spruce up earnings as corporations intelligently wrote off all their losses in 2002 and depressed reported earnings so much that the path from then on, had to be only up. However, what remains to be seen is whether they return to the bad habits when earnings growth vanishes.

Two aspects of third quarter earnings are worth mentioning. S&P 500 Operating Earnings, with 98 per cent of the companies reporting, is at $16.87 per share, only 11 cents lower than the $16.98 seen in the second quarter. Readers should know that operating earnings are what companies report to the investment community and not to the Internal Revenue Service. Reported earnings are what they report to the Securities and Exchange Commission and out of which dividends are paid. They represent real earnings. Reported earnings dropped $1.21 in the third quarter (from $15.25 per share to $14.04). Indeed, even in the second quarter, the reported earnings went up only by seven cents over the previous quarter, whereas operating earnings climbed by more than a dollar and ten cents. These are warning signs.

Deviation is also noticed between Operating earnings and National Income measure of corporate profits (see Chart 2). The annual growth in corporate profits reported in national income peaked at 27.8 per cent in the first quarter, dropping to 19.0 per cent in the second quarter and further to 8.4 per cent in the third quarter.

Retreat followed by advance or a big slide

In sum, the outlook for American stocks is neither exciting nor is it gloomy. This is to be expected as stock prices reflect lower earnings multiples. As oil prices climb, some profit-taking can be expected in the early weeks and months of the New Year, followed by some stability. If earnings climb, even at a slower pace, then a modest increase in index values can be expected.

Anything more than a modest rise would be unsustainable. If earnings falter and operating earnings continue to drift further apart from reported and economic earnings, then one should be prepared to trust American stocks far less - just as they did in 2002.

(The author is founder-director, Libran Asset Management (Pte) Ltd., Singapore. The views are personal. Address feedback to van@libranfund.com)

More Stories on : Stock Markets | Insight | Global Finance & Overview

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Agricultural credit — Case for mitigating lending risks

How boom can go bust

The balanced scorecard — Manufacturing change

Poised for faster growth?

Plantation problems

Lesson for India

US equities outlook is weakly positive

The right to protection

PURA for development

Interest on SDS