During the first half, the market, like the worm Ourobouros, began and ended in about the same place, but used the time to explore a lot of territory. The tech-laden NASDAQ started the year at 4,186, soared to 5,132 on March 10, fell to 3,042 on May 24, and at this writing is 4,093. The S&P displayed less volatility, but likewise managed to make little progress.
Over the past year, the S&P has returned a little more than a passbook savings account, but has generated considerably more angst. The NASDAQ, in contrast, has compensated investors for its vicissitudes with a total return of almost 45% in the last twelve months. This is terrific, but the momentum has clearly gone out of that index, and is unlikely to return in anything like its former glory, in our opinion. In early March, the NASDAQ was up over 24% year to date and 100% in twelve months. In the last ninety days it fell 6%, and now stands below where it started the year.
The problem for both markets has been interest rates, not earnings, or at least not current earnings. The Fed has been tightening for about a year and its attempt to slow the economy has begun to show some results. Earnings have been fine and the current earnings season looks to be no exception. In the first quarter of this year, S&P earnings rose 23% year over year. For all of 1999, they rose 19%. For the quarter just ended, it looks like another 20% year over year gain.
A different trend becomes evident when you slice the data this way: over the past five years, S&P earnings have risen from $32.68 in 1994 to an estimated $57.70 this year, an increase of 77%. The market has risen 254% with dividends reinvested over the same period. Earnings grew a little over 10% per year and the market went up over 20% per year. Valuations expanded sharply.
In 1999 the market's gain slowed to that of earnings, rising 19.6% while earnings rose 19%. The market's multiple thus stayed the same as it had been in 1998. Now it has begun to decline.
In the first quarter, earnings were up 23%, and the S&P was up 2%. In the second quarter, with earnings estimated to be up 20%, the market fell almost 3%.
Markets are discounting mechanisms; prices and the path of prices reflect visible fundamentals and expectations about the future. In the mid to late 90's the market correctly discerned that the U.S. economy was on a path of rising earnings growth rates, from the 7% long-term post-war average to one that exceeded 10%, fueled by rising productivity that permitted speedier growth without an accompanying increase in inflation. The rising productivity of capital coupled with an increasing growth rate of earnings led to a sharp rise in the market's overall valuation. That rise was concentrated in technology stocks, which began the second half of the decade at modest, and ended at monstrous, valuations.
At the beginning of 1995, technology stocks represented 10% of the S&P 500; today they total over 30% of the market's value. In 1995 they were demonstrably undervalued; today valuations hover at all-time highs and require superior growth in order to be maintained.
The inability of the market to make progress despite powerful current earnings growth is not just the result of the drag of interest rates brought on by Fed tightening, but of what those rates portend: slowing growth. As the rate of earnings growth slows, so too does the justifiable valuation of the market.
For the market to make much progress, I think investors will need to believe they see the end of Fed tightening. Good earnings by themselves will just be incorporated into the market via lower multiples, not via higher prices (unless those earnings arrive at companies with suitably modest valuations).
Over time, market prices have tended to track fundamentals. The long-term return of stocks has been a function of beginning dividend yields and long-term earnings growth. During the past five years, prices have risen much faster than earnings as positive fundamentals have been incorporated into prices on a leveraged basis.
The combination of long-term evidence and short-term experience has led investors to believe positive near-term fundamentals are highly correlated with positive stock price behavior. Valuation seems to have been forgotten, due in part to its apparent absence in the price/performance equation over the last several years, and no doubt in part by the dismal record of value investors over the same period.
The question for investors is always: where is the best value in the market? Five years ago, growth was undervalued and technology was particularly undervalued. After years of spectacular outperformance, we think growth is at best fairly valued and that many (not all) of the largest, most visible technology names are overpriced.
In contrast, outside of the growth indices, many stocks appear undervalued, with the median price-earnings ratio of the 1,700 stocks in the Value Line index at only 13.3x earnings. The re-appearance of dormant former corporate raiders such as Carl Icahn and the formation of numerous buy-out funds testify to the opportunities presented by modest valuations in many "old economy" companies; We believe that in the next few years growth investors will become reacquainted with valuation as high growth names underperform their fundamentals, and that value investors will once again become reacquainted with solid performance in their portfolios.
Bill Miller, CFA
July 21, 2000
DJIA 10733.56
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