Hesitation in a Bull Market, or the Onset of a Bear Market

Without a doubt, the stock market has been overvalued for quite some time. To maintain the extreme valuation would require a picture perfect economic environment in both the domestic and global scenes. That in itself would be an investor’s impossible dream. Since the Dow Jones Industrial Average reached its market high of 9337.97 on July 17th, we have come to see a realization on the part of the investor that world economies are starting to deflate, reflecting involuntary debt contraction in Asia, Russia and Latin America. These investors are seeing that some of these problems are creeping into healthier regions of the world as well. Therefore, over the last three months we have seen a correction that has been deeper than any since 1990. This overbought market is best illustrated as an old overweight bull waiting to retire to a pleasant sunny pasture. How long he will remain in the ring will depend on the extent of the public’s understanding of the consequences of world deflation. The bear is out of his den and on the market’s doorstep. He wants nothing more than to replace the bull in the ring and begin the asset deflation process reminiscent of what he did in 1973-74. Because of this, we will likely witness major swings in sentiment regarding the attractiveness of the investment environment.

The speed at which the Federal Reserve continues to lower short-term rates will go a long way toward stabilizing the markets and helping our economy continue to grow at a healthy pace. With inflation benign, commodity prices in a terrible decline and debt deflation burdening the financial area, it appears that the wisest course for the Fed to follow is a lowering of short-term rates and maintaining money supply growth at a double-digit level. Corporate earnings are beginning to slow down (more on this below). Therefore, the Fed’s number one priority should be maintaining economic growth domestically to offset foreign negatives and help the world economy to stabilize

Over the past three years, the momentum behind the rapid rise in stock prices has been double-digit earnings growth for almost every sector of the corporate world. This began to change in the fourth quarter of 1997 and has continued into 1998. Earnings dropped 2% in the first quarter of this year when compared to the first quarter of last year. For all of 1998, corporate earnings could be off by 3% or more. It is natural to blame the deceleration of earnings on the Asian crisis, but it’s not that simple. Pressure on corporate profits has been slowly building during the past several years. Wages have been rising and tough competitive conditions have restricted the ability of companies to raise prices. The real problem faced by companies is a lack of pricing power that prevents them from passing on any increases in labor costs. This has put a squeeze on profit margins that no amount of internal cost cutting can overcome.

Wall Street analysts appear optimistic that earnings growth will soon recover and move back to the double-digit growth of years past. First Call, a consensus of analysts’ forecasts, indicates that the growth in S&P 500 operating earnings will accelerate by 23% for the fourth quarter over the fourth quarter of last year. For all of 1998 they estimate a year over year increase of 8%. Looking ahead to 1999, First Call’s consensus estimate equals a 9% earnings increase. The common practice by analysts today is to revise earnings projections sharply downward as companies warn of a less profitable period. This has been such a common occurrence over the last several years to the point that we spend a good amount of time and energy revising earnings estimates downward on the companies we hold in our portfolios. By the time third quarter results are reported, companies will have manipulated analysts’ forecasts down to a level that is low enough to ensure that most reports will come in above expectations. Those companies that fail to play this “guide the analyst” game and come in with earnings that are below expectations are hammered in the market place. It was written in one of the publications that comes through our office that “earnings weakness will probably be the first indication that the ‘Cinderella’ economy of the past three years is over.”

In the real world, earnings increases and declines are taken in stride. The problem that we have encountered in the late stages of this bull market is that the price-to-earnings (P-E) ratio has increased to the point that investors were discounting earnings growth well into the next century. Even with slowing S&P 500 earnings, this index is selling at 22.9 times estimated 1998 earnings as of Tuesday, October 6th.

On a historical basis, this P-E ratio is very high. The same can be said for the P-E of the Dow Jones Industrial Average, which was 19.6 as of the same date. Looking at past data compiled by Value Line Publishing, Inc., the average P-E ratio for three year periods was 15.1 and 15.3 for five year periods. With today’s ratios so much higher than the historic norm, the majority of shareholders do not understand that it’s not the decline in earnings that hurts stock price, it’s declining P-E ratios that are the “killer”. First Call’s earnings estimate for the S&P 500 for 1998 is $42.80, up 8% from the actual earnings of $39.72 earned in 1997. So what could a contracting P-E do for value? Here is an example:

S&P Earnings P/E Ratio Value
$42.80 22.9 980.12
$42.80 15.3 654.84
$42.80 15.1 646.2


An adjustment from a P/E of 22.9 to just the average P/E of 15.3 would lower the S&P500 average by 33%.

Looking to 1999, First Call is estimating a 9% increase in S&P earnings to $46.84. Using the same P-E ratios as above we have:

S&P Earnings P/E Ratio Value
$46.84 22.9 1072.64
$46.84 15.3 716.65
$46.84 15.1 707.2


Interestingly, the First Call estimates are lower than the expectations that many analysts are forecasting for the second half of 1998 and for all of 1999. It should also be noted that the values for the averages are lower in all cases than the average was at its high in July.

With all this pessimism about declining earnings growth, could the U.S. economy be headed for a recession in the near future? At present, unemployment, inflation and interest rates are low. Incomes are growing, with wages rising faster than prices. From our viewpoint, we feel that the odds of a recession are slim, provided that the Fed lowers the Fed Funds rate in the near future. At present, there is only a 64 basis point difference between the three-month T-Bill and the thirty-year Bond. The yield curve is not inverted, but the yield curve does have an excellent record of predicting economic growth. This indicator is telling us that the economy is slowing, but not necessarily heading into negative territory. On the other hand, the Fed Funds rate, the rate that banks are charged when borrowing overnight from other banks, is at 5.25%, 37 basis points higher then the 30-year bond.

These interest rate indicators are a warning sign of a mild slowdown, which should not be a menace to the economy. The world economic crisis, starting with Asia and now spreading to Latin America and Russia, could definitely be harmful and affect Gross Domestic Product (GDP) growth. The Blue Chip Economic Indicators forecast GDP growth of 2.2% for 1999. We think this is high. When considering all factors, commodity deflation, our expanding trade deficit, slowing earnings growth and world product overcapacity, we see next year’s GDP growth more in the neighborhood of one percent. This is slower than the fast pace of the first quarter of this year but should still be a soft landing in economic terms.

Many analysts are saying that we are in a new era and the old measurements of market analysis are no longer valid. Maybe so, but there are several aspects of this line of thinking that are bothersome. The current generation of equity investors has only experienced a secular bull market. They are far too complacent in their outlook regarding future corporate earnings and where these earnings will take equity prices. Alan Abelson best expressed the inexperience of this generation of investors in his column in the September 7th issue of Barron’s. In it, he relates some interesting data from Jim Bianco of Bianco Research. The most striking of these, was the fact that 90% of all monies ($1.06 trillion) in equity Mutual Funds (since their beginning in 1924) has only been invested since October of 1990. Using Bianco numbers, Abelson goes on to point out that “at the May 1998 highs, these (Mutual Fund) investors had unrealized profits of $647 billion, or an appreciation on their investment of 61%. When the Dow Industrials sagged to 7539, this grand pile of dough melted by 43%, he figures. He calculates the extent of the meltdown by using the investor’s average Dow Jones Industrial purchase price since October 1990”. At what point will these investors come to the realization that trees do not grow to the sky and that their Mutual Funds do not always go up. Will market liquidity slow when they come to this realization? Time will tell, as it will answer the question of whether or not we are in a new era.

Another major question that remains to be answered is what affect will the unraveling of derivatives in the financial marketplace have on banks, brokers and trading companies? At this point, all we know is that there are trillions of dollars of these security proxies outstanding. In recent weeks, we have seen the unraveling of John Meriwether’s hedge fund, Long-Term Capital Management, and there may be hundreds more to drop out of the market. There have been rumors of large losses in Hong Kong and Japan, with the reserves of many of these country’s banks in peril. This may be why there has been government intervention in these two markets. From our experience, we find it is very unusual for a government to step into the market and support securities prices.

One additional cause for concern is the outstanding margin loans to finance stock purchases. According to Federal Reserve figures, these loans increased from $127 billion at the end of 1997 to $143 billion on May 31st. During 1997, all commercial loans made by financial institutions totaled $365 billion. Of this total, $125 billion, or 34.3%, was extended for securities transactions. Should this market correction deepen, investors on margin would have to deposit additional cash or sell shares to meet margin calls. Neither is positive for the market.

As we enter the fourth quarter of 1998, we are reminded of the risks in the stock market. At this writing, the majority of the stocks listed on the New York Stock Exchange are 20% or more off their yearly highs. Over one third are off over 30%, and for those investors that own stocks on the NASDAQ, many are holding stocks off 50% to 70% from their highs. Those factors that most often move stocks higher are missing at this point in time. Earnings, as described above, are trending lower. The economy is slowing and market momentum is disappearing. Mutual Fund investors are slowing their purchases and in recent weeks redemption’s have been increasing. So the question is: “What will take the market higher?” For now, nothing. But time is on our side. The market will be higher in a year or two, so now is the time to exercise patience.

Our discipline has kept our investment strategy along a straight and narrow path. We have adhered to a dividend growth philosophy with the yields on the portfolios under our management being one to one and a half percent higher than the popular averages. During the coming year, stocks with high dividend yields will likely weather difficulties better then most stocks. One area of the market that has a standout dividend yield and good growth potential is the Real Estate Investment Trust (REIT) sector.

By many measures, REIT valuations are at levels not seen since the real estate depression of the early 1990’s, when rampant overbuilding in virtually every sector led to an over-supply. REIT funds from operations (FFO) multiples are less than one-half the price-earnings multiple of the S&P 500, dividend yields are at high levels relative to Treasury Bonds, and the shares of a majority of REITs are trading below the net asset value of their real estate assets. Through September 30, 1998, the total return for the NAREIT Equity REIT Index was negative 15.02%, compared with a gain of 6.01% for the S&P 500 and a loss of 16.21% for the small-cap Russell 2000 Index. This has occurred even though many REITs continue to report double-digit FFO per-share growth.

Today, most real estate markets or sectors are in or nearing equilibrium. At this stage of the cycle, our focus is on REITs operating in high barrier-to-entry markets, property types having long-term leases, and consolidators that are able to bring professional management to a fragmented sector. In any case, we seek the dominant companies in either their market area or industry sector, with strong entrepreneurial management’s that can implement a strategy to generate internal as well as external growth. With the consolidation of the industry continuing, two of our holdings are involved in merger transactions: Merry Land & Investment (MRY) is merging with Equity Residential Properties (EQR), an apartment REIT consolidator with the largest portfolio in the country; and New Plan Realty (NPR) has merged with Excel Realty Trust (XEL), combining the financial strength of NPR with XEL’s entrepreneurial and development capabilities.

Other positions include BRE Properties (BRE), an apartment REIT with holdings in high barrier-to-entry West Coast markets, and First Industrial Realty (FR), a consolidator of industrial properties.

We believe it is a fortuitous time to be selectively buying REITs. The average dividend yield for equity REITs has risen to 6.88%, more than four times the yield on the S&P 500. With payout ratios at all-time lows, the mandate that REITs distribute at least 95% of taxable income as dividends will lead to excellent growth of income. Moreover, with shares trading below the combined net asset value of the properties they own, total return prospects are very attractive.

Gordon B. Lamb
David M. Taube, CFA, CPA
Jeffrey M. Campbell

October 7, 1998