P&I: More writeoffs coming.
MR. O'NEILL: More writeoffs coming. And something that could come quite significantly out of the blue - that is very much in our forecast - that short rates are going to continue to go up. That is a shock that could hit the system.
I certainly agree with the potential for international crisis, as I look at the great potential of the emerging markets in the Russias and the Chinas and the South Americas. I do feel there's not enough risk premium that's been built into some of these countries.
Investors are saying, 'Well, that's par for the course,' but that isn't. There is real significant potential - more significant than investors are paying attention to now - for something to go wrong there.
Also, the Whitewater investigation, which has been glossed over. That is very much going to come to the fore with the new Republican Congress. We have not seen the end of that and, at a minimum, I would expect it's going to get a lot more embarrassing if something more than that could also materialize.
MS. BRAMWELL: I agree with that. I think now we're in a situation where you appear to have these coverups. If you go back to Watergate, you then had a Republican president in office with a Democratic Congress, both Houses; now we have the reverse situation.
MR. GREEN: As far as foreign investment, we've been accustomed to an economy and a political system that's pretty stable. But the example of the assassination of two Mexican leaders, that's a very real concern in foreign countries. That political upheaval and its effect on capital is something that as yet we have not experienced because we have not had a massive investment - as is going on right now - in foreign economies. Those kinds of things could prove to be some real upheaval to foreign investment.
P&I: Let's go into the second question, and we'll start with you, Gary. What is your outlook for equities in the U.S.?
MR. BERGSTROM: Simply put, our prognosis for U.S. equities for the next year is rather unexciting. It's a little hard to project returns more than around 8% or 10% - from these valuation levels or the kind of earnings growth we're projecting for U.S. equities 1995, the kind of interest rate environment we're having and where we are in the economic cycle.
We probably have 99% of our money outside of the U.S. now, so we don't particularly hold ourselves up as great specialists on sectors within the U.S. market.
One sector we do look fairly favorably on at the moment is energy. Typically, it's a late-in-the-stock-market-cycle kind of industry in terms of its traditional periods of outperformance. Obviously, energy prices haven't been too exciting lately, but something of a favorable sort could kick into play over the next year and help out that sector.
MS. BRAMWELL: I think that corporate profits can be up around 8% to 10%, using S&P as a proxy, and you're getting maybe a 3% yield, so I think you may be making 10% or 12% in the equity markets this coming year, assuming prices sort of track along with profit gains.
P&I: What about sectors?
MS. BRAMWELL: Well, I think some of the industrial product sectors may be stronger than people think; they've had a big correction here, so they're coming off sort of a slump. So paper, steel, construction, engineering - they could be stronger than anticipated.
MR. GREEN: I'm a little more optimistic than Gary is about domestic equities, being that's my playground. I think the 9% to 10% earnings growth rate is good. The only threat out there is the Fed and how interest rates are going to affect it.
The downsizing and the reinvestment, the heavy reinvestment that I'm seeing in some of the industries that we watch, bodes well for earnings going forward. I think companies have really geared down, pared down the debt, and have reinvested heavily in the ongoing business.
We're seeing a lot of spinoffs of businesses that don't fit well with the core industry or going concern, and a lot more refocusing on the main business. With that kind of thing going on, we see profits sustainable for a longer term.
Among the industries I like right now is technology - not esoteric technology, but a very basic technology to the increased use of computers. I like a company called American Power Conversion, for example. It makes a lot of basic, uninterrupted power source kinds of equipment for computers.
Another is telecommunications. The buzz word - the information superhighway - has taken fruition in various forms, not as much as what the hype earlier this year would suggest, but it's taking shape. So, various forms of usable telecommunications technology are being invested in very heavily, so we think that's a good sector.
MR. MALLON: Well, again, we start with the idea that we have a very good economic backdrop with no recession forecast now.
We also think you do have a more svelte manufacturing sector, which is likely to mean we're going to continue to see pretty good profits in a number of sectors.
Unfortunately, we think these kinds of positive things already are in valuations. We thought coming into '94 that it would be a good year, but the expectations were very high and the market would have trouble moving ahead. Year to date, that's what's happened. We've had excellent earnings reported, but in fact, the market has struggled, we think because it was very overvalued.
At the same time, valuation concerns us. Monetary policies clearly moved from being a positive to being a negative during '94. While that may have favorable implications in a longer-term sense, it has pretty straightforward shorter-term implications, which have been evidenced over a number of recent cycles, and that would be negative.
Also, some of the internal technical measures of the market that we follow are starting to cause us some concern. They're starting to move to be more negative.
So we think the combination of overvaluation, tighter money and deteriorating technicals are likely to overwhelm the favorable economic backdrop.
Under that kind of a scenario, there are basically two branches of the road. One is that tighter money evidences its effects in '95, that you see more of the precursors to recession, and that you get a coincident bear market moving forward in stocks. The rotation among various cyclical sectors in '94 would be considered normal in retrospect if that were to occur, so it causes some concern.
The other thing we point out is that if you do move into a bear market, it could be severe from a valuation viewpoint. We think that valuation is not very helpful as a timing indicator, but it does tell you something about the degree of pain you could feel once the market turns down. In this case, again, a number of standard measures of valuation have looked pretty poor for some time.
The second type of scenario would be that you continue to have earnings growth, that you have overvaluation corrected over time simply by favorable earnings, dividends, book value growth, in a sideways market. In that kind of environment, the market probably would have bouts of significant volatility, but overall, it would just keep moving in a sideways fashion. We think that's possible. That's the sort of softer landing direction.
Summing all of that up, our expectations in '95 are for very modest returns from the U.S. equity market, with significant risks on the downside. This outlook suggests a need for some degree of defensiveness. Typically, where permitted, we would have cash balances. Those would be up to about 15% of assets available for equity investment.
For plan sponsors who have fully invested managers, we would suggest they be thinking about their asset allocation and be considering reducing equities if they haven't already. In other words, we think the risks are fairly significant. In balanced accounts, we would favor bonds and, in fact, have moved in that direction recently.
Sectors that appear undervalued include interest rate sensitive issues. That should surprise no one here. We've had a substantial upward move in interest rates, and that's caused some pretty significant price declines among insurance stocks, banks, utilities.
In the banking sector, I agree with the earlier comment that there continues to be fear of further losses from the impact of swaps and derivatives, and also from just very liability-sensitive balance sheets. Our models suggest that even after adjusting by lowering earnings significantly, these concerns might be overdone, but we would certainly suggest selectivity in the banking sector. We would favor companies like First Union and First Interstate. We also like insurers, and we favor Lincoln National and American General.
We also think the defense electronics industry is interesting. Here we've already had evidence that managements can prosper in a current downsizing environment, and the recent election results could provide some upside surprises on the procurement budget side. There we would point to stocks like Raytheon, Martin Marietta and E Systems.