What's Next for the Bull Despite investors' worries, this bull looks as though it has a lot further to run
(MONEY Magazine) – The bull market celebrated its first birthday on March 11, and that anniversary should be cause for widespread happiness. But for many investors, a tinge of anxiety has undercut both their enthusiasm about recent profits and their expectations of future gains. Many stockholders are still feeling the aftershocks of the worst bear market in more than 20 years. And while the psychological impact of the recent downturn may be only subconscious, it discourages many people from pursuing the smartest stock strategies. Moreover, investor unease seems to have grown since the stock market began treading water after more than nine months of strong gains.
In fact, though, there's nothing really wrong--either with the economy or with the market. Economic growth was about average for 2003 as a whole and picked up in the second half. This year, growth is projected to run even faster, at a rate of 4% to 5%. Earnings are booming too. After-tax profits declined in three out of the four years from 1998 through 2001 and then rose less than 13% in both 2002 and 2003. This year and next, by contrast, corporate profits should gain more than 20%. Inflation and interest rates are no threat--they're close to their lowest levels in decades.
Why, then, are so many investors feeling queasy? In part, it's because the last bear market was so awful that birthday celebrations for the recovery seem like tempting fate. The slump that ended in late 2002 lasted almost three years, during which the S&P 500 plummeted 40%. After this drop, stock prices bumped along for another nine months, hitting bottom again in March 2003. So not only was the decline substantial, it also lasted far, far longer than a typical bear market. There hasn't been such a protracted slump, in fact, since the early 1980s. So for many investors--who were used to fast comebacks like the one after the 1987 crash and the one after the 1990 recession--the most recent bear market seemed like an irreparable breakdown.
As a result, investors seem to be having a hard time believing that the current rebound is real, even though historical patterns are quite encouraging. Essentially, shareholders have two basic worries--that the recovery will falter and that stock prices have run up so fast that they are vulnerable to a big pullback.
The first concern has a little truth behind it. Despite the generally bright economic outlook, there are some soft spots. The one that seems most disconcerting is the disappointing rate of job creation. From its peak in June 2003, the unemployment rate has come down only 0.7 percentage points to 5.6%. This slow reduction in joblessness is unfortunate, but it doesn't mean that the recovery is stalling. Job creation always lags at major economic turning points, especially when productivity is strong and businesses can ramp up output for a while without hiring additional workers. But as long as unemployment is coming down, whatever the speed, it shouldn't pose a threat to the recovery.
Investors' second concern--that stocks have run up too fast and are vulnerable to a correction--is based on an overly simplistic view of price/earnings ratios. It's true that the S&P 500 is now trading at a P/E above 20, based on estimated earnings for 2004. And the historical average P/E for the index is only 16. But that doesn't necessarily mean stock prices are due for a 20% pullback. A more sophisticated analysis leads to quite a different conclusion.
Most stock valuation models compare the stream of earnings or dividends that stocks are expected to generate with the alternative returns offered by high-quality bonds, which have the advantage of being more predictable. These models indicate that blue chips are at least 10% below fair valuation.
How can stocks be undervalued when their P/Es are higher than the historical average? There's an explanation: Bond yields are so low right now that the potential returns offered by stocks look unusually attractive by comparison. There is a catch, however. A rise of less than one percentage point in long-term bond yields would erase the undervaluation that now exists for stocks. I don't expect a rapid rate rise, but interest rates generally do creep up in the course of an economic recovery.
The real conclusion of this debate is that it's pointless to spend too much time on such calculations. They work best on analysts' computer spreadsheets and provide little guidance in the real world. And in any event, no one can reliably predict temporary market setbacks.
What counts is the long-term outlook, based on historical data. One of the few patterns that hold up fairly consistently is that full-fledged bear markets are normally followed by sizable rebounds. If, for example, the S&P 500 falls more than 20% over the space of nine months or so, that index is likely to gain at least 80% over two years or longer once a sustainable recovery finally takes hold. Moreover, when such a bull market begins, it generally continues until the Federal Reserve raises interest rates at least three times in succession. The Fed normally hikes rates that much when the economy is clearly overextended or inflation is on its way. But so far, neither of those threats has loomed large--and the Fed hasn't raised rates even once.
BALANCING A PORTFOLIO
At this point in the recovery, there's a compelling case for adding money to stocks, especially if you sold a lot during the protracted bear market. And there are two basic principles of portfolio management that will help maximize your returns as this yearling bull market grows to maturity. First, build your portfolio around a core of high-quality growth stocks. Second, broaden your stock mix as much as possible.
Stock market theoreticians endlessly debate how many stocks you need to be fully diversified. One side says you need more than 35; the other says you can get away with as few as eight. It's true that you need a very large number of stocks to eliminate all diversifiable risk (as unnecessary volatility is called). But you can get rid of a lot of it with fewer than 10 stocks, as long as they are as varied as possible. The simplest way to do this is to make sure that each stock you buy is in a different industry. My full list of large, high-quality stocks suitable for conservative, long-term growth investors appears on the preceding page. But obviously, it makes the most sense to put together a diverse mix of stocks with superior earnings growth and build out from there, adding companies that provide diversification as well as stocks that are especially timely.
Here's a look at choices in each of those groups. You don't need to buy them all; just choose the ones that best complement what you already own. I'll devote more space to companies that are less widely known; those that I've written about many times before will get briefer mentions.
CORE GROWTH STOCKS
Over the long term, stocks with above-average rates of earnings growth are most likely to outperform the broad market. Sometimes it's possible to find a superior stock in a slow-growing industry, but most potential market beaters are in industries that represent the fastest-growing parts of the economy.
Such star growth stocks are widely recognized, so I'll just quickly tick them off. Citigroup is a favorite pick among financial services. Cash-rich Microsoft remains a heavyweight in technology. Pfizer is a pharmaceutical powerhouse. Procter & Gamble is a superb collection of widely recognized consumer brands. Viacom is the media giant with the fewest complications.
Two companies I recommended in January's "Forecast 2004" have narrowly focused businesses that would enrich a mix of growth stocks. First Data provides money transfers through Western Union, as well as credit- and debit-card transaction processing. The company is in the process of completing its acquisition of Concord, which operates STAR, the largest ATM and PIN debit network. Staples is a leading office-supply retail chain. The company is renovating stores, adding more profitable house brands and focusing more on small business customers. Neither stock has moved more than a couple of dollars since the January issue.
Once you have assembled your core growth holdings, you should look for other choices that will fill gaps in your portfolio. My list of 70 stocks includes companies that may not have standout growth rates but can provide additional diversification because they are linked to specific economic sectors.
ConocoPhillips and ExxonMobil are worth considering, for instance, because their performance depends chiefly on the level of oil prices. As a result, in the event that oil prices rise, these two stocks would offer valuable inflation protection. Boeing and United Technologies have important franchises that will benefit greatly once the aerospace cycle, which is currently depressed, turns up again. Gannett, the publisher of USA Today and a host of local newspapers, should be a prime beneficiary as advertising comes back. Ad spending typically moves on a different timetable from the overall economy, often with a lag.
Specific economic circumstances shine a spotlight on other stocks that are less well known. Here are three that score well for value and timeliness.
BAXTER INTERNATIONAL. A top maker of medical equipment, Baxter operates in three major areas: drug-delivery systems, blood collection and dialysis. Half of its sales come from overseas. I recommended the stock as a potential turnaround this past August because the share price was depressed as a result of sluggish earnings growth. Since then, the stock has moved up from $25 to $30. Earnings rose 47% in the most recent quarter, but the company has warned that 2004 earnings may be below expectations. Nonetheless, the company's profit trends are expected to improve, and the 1.9% dividend is a further attraction. The shares look cheap at 16.4 times estimated 2004 earnings.
HARLEY-DAVIDSON. The dominant U.S. motorcycle producer with a passionate following both here and abroad, Harley is a prime beneficiary of the falling U.S. currency. With the dollar at long-term lows against both the euro and the yen, Harley sales are up strongly in Europe and Japan. The company's latest quarter was a winner, with earnings gains of 21%. That marks Harley's 18th straight year of record results. Over the next five years, earnings are projected to grow at a compound annual rate of 17%. The $54 stock trades at a 19.3 P/E.
UNION PACIFIC. Transportation stocks often lag an upturn in industrials. But as of last fall, the recovery finally started boosting business for the largest U.S. railroad. As a result, Union Pacific is buying locomotives and hiring more staff; overall, the railroad plans $2 billion in capital spending this year. Earnings gains have been strong for the past couple of quarters, and Union Pacific recently raised its dividend 30%, giving the $64 stock a 1.9% yield. With a projected annual total return of more than 13%, Union Pacific trades at less than a 14 P/E.