Review of Fiscal Year 1999 Market Conditions
Large capitalization stocks performed exceptionally well in the year ending March 31, 1999, returning 18.5% as measured by the S&P 500. Broader measures of stock performance significantly lagged the S&P 500. The Value Line index, which includes both large and small companies, declined 18% during that period. The Russell 2000 index, which covers mostly smaller companies, also declined, down 16% for the 12 months. Such broad divergences in the returns of large and small companies are quite unusual and we would be surprised to see them persist. We believe they were due to the global financial crisis which erupted last summer and which culminated in the panic lows of October 8, 1998. Investors sought the relative safety of large, well-established companies during this period of uncertainty. With the ebbing of the crisis and the beginning of economic recovery in many of the hardest-hit emerging economies, we think investors will once again begin to invest on the basis of hope instead of fear. This bodes well for the returns of small- and mid-size companies where valuations remain quite attractive.
Market Outlook: Near Term
As usual, we are agnostic about the market's near-term direction. A variety of valuation tools suggest that the S&P 500 and the DJIA approximate fair value, a view with which we concur. However, the extreme divergence of equity returns over the last twelve months, and a global economy that appears to be strengthening, suggests that the market's returns should broaden, leading to more balanced returns among the small-, mid-, and large-capitalization segments of the market.
Share prices have begun the calendar year with another strong advance, fueled by continued low inflation, stable monetary policy, a growing budget surplus, and high corporate profitability.
Mergers and acquisition activity remains extremely robust and is expected to remain so. The Financial Accounting Standards Board (FASS) has reached a tentative conclusion to eliminate pooling of interests accounting for mergers, thereby substituting one form of financial obfuscation for another. We think that change will spur many companies to accelerate acquisition activities before the deadline for pooling expires, expected to be January 1, 2001.
As the second quarter of 1999 gets underway, the market is experiencing a sharp change in leadership, with cyclical companies coming to life. The rebound in what are misleadingly referred to as value stocks (i.e., cyclicals) has been sufficiently strong that Caterpillar, Deere, and Alcoa have collectively outperformed Dell, Intel, and Cisco for the calendar year to date. We do not expect that simple-minded security classifications such as "growth" or "value" are likely to provide much guidance in stock selection or insight into the sources of market leadership. We do believe, as noted, that the narrow leadership of the last few years will give way to a more normal (Gaussian) distribution of returns.
Market Outlook: Long Term
"When we think about the future of the world, we always have in mind its being at the place where it would be if it continued to move as we see it moving now. We do not realize that it moves not in a straight line… and that its direction changes constantly."
—Wittgenstein
One year ago we reflected that the nearly 50% return of the S&P 500 in the previous 12 months was surprising and was driven by interest rates dropping from 7% to 6% while profits continued to advance. We said then, and still believe, that the era of extraordinary returns is over and that investors should expect equity market returns to fluctuate around the 9% to 10% area. Returns substantially above that would be driven by falling rates and rising profits, and returns substantially below by rising rates and falling profits. Over the past 12 months rates fell about 10% and profits rose, and the S&P 500 was up 18%, despite falling over 20% peak to trough in the July to early October period.
The U.S. economy looks solid, and global growth is expected to pick up over the next twelve months. Inflation is low, and although commodity prices have stopped declining, capacity is ample in all commodities and sustained price advances appear unlikely. The growing effect of the Internet is a powerful disinflationary force. As a consequence, interest rates should remain in the 6% area or lower, and profits should work moderately higher. Valuations, although high, are well underpinned by fundamentals.
The future is inherently unknowable, but it is bet-able. Our bet is that the next year will provide solid returns to equity investors.
Bill Miller, CFA
Legg Mason Fund Adviser, Inc.
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