Remember the Pied Piper???

The stock market is very much in what could be called its “Pied Piper” phase. Remember Grimm’s fairy tale The Pied Piper of Hamelin? In today’s financial world, the man with brightly colored clothes and a long feather in his hat is the S&P Index. Day after day the sound of the Pied Piper’s pipe can be heard drawing investors in as the Index marches to new record highs.

Forgotten are the fundamentals of security evaluation and the lessons of past markets. Billions of new dollars are still coming into the market monthly. Barrons reported in its June 29th issue that stocks, as a percentage of household financial assets, are nearing 40%, one of the highest percentages ever recorded. Yet, we at AAMG know that the Piper will extract his payment, demanding a market that sees increases, but not the double digit ones that have been seen over the last several years.

The primary ingredient for stock price improvement appears to be liquidity, reflecting the public’s attitude towards a perceived need to buy mutual funds and contribute to 401K pension programs, regardless of short-term valuation concerns. The asset allocation shift in favor of equities is enormous and is outstripping any other period in stock market history. The public does not care about individual company earnings or P/E’s. It is just centered on making the structural shift as quickly as possible. The investor is demanding a full-throttle expansion of its equity holdings and is encouraging investment advisors to do the same in its belief that future returns will emulate past performance.

For the time being the economy has been surprisingly strong, due to a healthy consumer environment. Total retail sales are rising at a faster clip today than they have at any time in the last eight years. Sales are balanced between durables and non-durables. Production continues to follow this enthusiasm, anticipating it somewhat, so that production gains in the economy continue to surprise on the upside, helping to offset the negative impact of exports which are affected by the Asian crisis. This has kept unemployment low and job growth healthy. High consumer confidence reflects these conditions. This single factor probably explains the stock market’s strength since the public is investing with an enthusiasm that reflects their continuing favorable outlook for the economy into the next century.

As the market reaches for new highs, some money managers are concerned with current valuation levels. Momentum may slow and there could be a change in the wind. What we have seen over the past two months or so may well be the start of a new consolidation phase in which the market may be exercising some damage control and crisis management in anticipation of lower earnings for the next two or three quarters. A good indication of this will be forthcoming over the next several weeks as many major corporations report second quarter profits (or losses). As was reported in a late June issue of Investors Intelligence, “36% of all NYSE stocks, trading over $5, have declined 20% or more since recording their 1998 interday high.” The reason for declining stock prices is a decline in corporate earnings. Total corporate earnings were only up, year over year, by 2.9% in the first quarter, well below what was expected by most investors. It seems that earnings growth exceptions has been extrapolated as double digit well into the future. Yet, the most optimistic forecasters are now only projecting six to eight percent, year over year, growth for 1998.

Investors may be close to a “wake-up” call in their earning expectations. For the last two years or so complacency has been the order of the day. That may be changing as can be seen by the action in the NASDAQ market where price declines of 50% have been commonplace over the last six months. Investors do not like huge volatility in profits; as a result, multiples in many of these overvalued stocks have made a 180 degree turn and have headed South.

For the next two to three months we can expect the market to move in a broad trading range of between 8400 and 9400 as measured by the Dow Jones Industrial Averages. During this time Money Managers will be measuring the impact of the Asian economic crisis on U.S. companies. This will cause them to rethink their earnings estimates. Unfortunately many of the surprises may be on the downside. When interest rates are low, small changes in long-term earning estimates have a magnified effect on current equity prices.

The Piper must be paid. We at AAMG think his payment can come in the form of an installment plan where moderate growth plus dividend income will lead to excellent total returns.

Gordon B. Lamb
Jeffrey M. Campbell

July 14, 1998