Mr. Sit: I think we're in the flat to up 5% camp. In 1997 they were $44.75 and we think this year will be somewhere around $45 or $46 and we see it maybe up 5% from there. As we analyze these numbers, there are a couple of things to keep in mind. One is that in the last 10 years what really fueled this market was that earnings were able to rise at a rate of one and a half times the growth of GDP. Historically it was at like a 1.1 or 1.2 ratio and you had several factors favoring it. Number one was a decline in interest rates. The fact that pension funds were overfunded, and also the downsizing from the '80s also helped. I think going forward we're not going to have that same kind of benefit.
Mr. Holland: The peak in corporate earnings was in 1995, and we have been trending downward ever since, and I guess the first-call consensus now is about 4% for 1999. But, of course, you know our analytical community continues to bump these numbers down so my guess is the 4% number for 1999 won't hold up and that we will have something in the flattish to 1% range.
So, clearly, I think that earnings are going to be hard to come by. And as it relates to the overall stock market with multiples of about 25 times next year's earnings, surprises on the downside with regard to earnings will not be viewed very well, I think, by the stock market.
Mr. Paulsen: I think earnings will probably be low to nominal single digits, but probably still positive. The whole key to earnings here in a world that's disinflation and deflation driven is constant perpetual cost cutting to lower your cost structure as prices keep going lower. We used to do that with one-time fixes for much of the early part of the decade, with white collar layoffs and interest rate adjustments.
Now the thing that gives me some good feel is there are two perpetual ways that I see becoming dominant in the globe that I think could continue theoretically forever. The first is tech spending, which always lowers unit cost. And what I'm seeing is whenever the economy slows you see a surge in tech spending, which is just the opposite of what you would anticipate from the rules of old.
The second way is through economies of scale. We are just having a massive monopolization of the world not because anybody is abusing power but because they know they have to constantly lower costs. I think that could go on and on.
The other thing I would say is that unlike coming right off an inflationary peak and falling into deflation, this country is going into deflation over a 20-year time horizon. That is really beneficial for corporate earnings looking forward because in essence the CEOs of America and elsewhere have been training for deflation for 20 years now - how to make money, changing their mind sets on how to do that, and some of them are getting pretty good at it.
That's why the retail industry can still be doing 7% real unit growth on 3% top line sales. We're starting to learn how to do that and I think we're going to be better at it than we think.
Mr. Holland: To go back to something that Alan said, productivity, I believe, has been the really great driver of this bull market. Back in the mid-'80s the Japanese and the Germans had great productivity and ours was very poor, and to think here we are in 1998 and look at how our productivity has improved.
We are now the global exporter of choice. So we went from the high-cost producer back in the mid-'80s to the global low-cost producer and ergo we're able to export this technology all over the world. There are no Microsofts or Ciscos or Intels anywhere in the world so clearly this is a wonderful thing for us, I think, from an earnings point of view going forward.
Even though the growth rates may be coming down, technology, of course, is still relatively high, ergo, people say Microsoft, why is it selling at 50 times the earnings or some number like that? Well, they have 32% net margins, $15 billion on the balance sheet, they've got cash everywhere, they've got $6 billion or $7 billion that they're carrying at cost on the books and they are the world's best company.
P&I: This has all been leading up to the real nut question everybody wants to know which is the U.S. stock market returns as a whole for 1999. This is where Alan made his reputation.
Mr. Bond: It has been just an extremely long bull market cycle and I don't think it is over yet. I think that in 1999 we could see returns between - I'm going out there on the limb again - of 18% to 25%.
I think that you still are going to be in an environment where you want to be very selective.
There are going to be pockets of opportunity. I think the technology sector still looks very attractive. Like anything, it won't be straight up. You won't just be able to just throw your money in one direction. One thing I have learned this year is just because it is cheap doesn't mean you should buy it because it may stay cheap for a long time.
We have had an environment where larger-cap stocks have been rewarded more than smaller and midcap stocks. And even though theoretically speaking you are taking more risks on the smaller and midcap companies and therefore you should get a greater reward for owning those stocks, the market has not rewarded them. So there is an opportunity for more appreciation in that sector of the market where there are technically greater inefficiencies, in, let's say, the first six to nine months of next year.
But, on the other hand, the big companies have learned how to do it and they're doing it right. It's almost like when you look at our economy maybe we have learned how to do it and to do it right and that's why we've been able to stay at this cruise altitude.
P&I: So you're somewhere between 15% and 25%?
Mr. Bond: Yes.
Mr. Hansen: I guess you could put me in the 5% to 10% range, closer to the 10% category because, as I mentioned previously, we look for pretty flat corporate profits over that time period so obviously we're implying some degree of improvement in valuations.
I guess I would describe that improvement to come from a broadening of the market. I don't expect the really high ones, the nifty 25s, to get higher valuations. But if the market were to broaden and some of the smaller or out-of-favor companies get higher valuations, that is what would cause the overall level of the market valuation to get you this 8% to 10% level of appreciation.
If you can deliver 10% earnings growth next year, I think you're going to get some good stock price action.
Mr. Sit: Three general comments and then a couple of specifics.
One is I think we're going to be in a consolidation mode in terms of the stock market, and what kind of range are we talking about? I would say the low of this summer of 7,500 and a high maybe about 10,000 over the next couple of years. If you work through these numbers, this would mean something like a 6% to 8% return a year for the next couple of years.
Why? I think on the plus side the economy is fine, kind of a stable, moderate growth type of environment. Valuations got ahead of themselves so we need some catch-up. Thirdly, I don't think we can see a new bull market until we get a better handle on two things. One is Y2K. I think we all feel pretty good, but you don't know what kind of headwind it will cause or what's going to happen until you get there.
Number two is that this whole bull market started back in 1981 because of the Reagan policy and the Reagan policy lasted 12 years and basically is continuing for another eight under Bill Clinton. Bill Clinton talks like a liberal, but he acts like a centrist.
So we come down to maybe about 6% to 8% return for maybe the next couple of years. It is kind of a consolidation in the marketplace after this very rapid run-up for the last dozen years. Then I think we're going to be okay as we see that the concerns were overly dramatized and then we get back to what I call the economic strength of American industry prevailing once again and then I think we'll see the beginning of a new bull market at that point in time.
I think the area to focus on is growth at reasonable value and that's a word we all love. I think small will do better than large and that finally unit growth and niche companies will outperform the broad-based companies.
Mr. Holland: I think there are basically two drivers with regard to stock prices, one of them being p/e ratios, the other being earnings. P/E ratios are at historically high levels in terms of the S&P 500. That isn't to say that there aren't a lot of stocks that are cheaper, but the S&P 500 is trading at about 25 times '99 earnings. However, during periods of low inflation, you have been able to have relatively high p/e ratios. So to the extent that inflation or disinflation, which is what we're in and probably will continue, it is conceivable we won't have much traction with regard to p/e ratios.
With regard to earnings, however, as most of us have concluded, we're talking in that zero to 5% kind of range, maybe it is 5% to 10%, maybe we're not so smart, so if p/e ratios don't move at all and we get 5% to 10% earnings growth, then maybe you can translate that into a 5% to 10% increase in the price of the stock. Maybe we could broaden out a little bit. But I think generally speaking, in relation to the capitalization-weighted nature of the indices, it's inconceivable that we could have anywhere near the kind of year that we've had this year. And so if we're up 5% to 10% by next year, I'd be a very happy camper. I think that it's going to require some consolidation in this period.
P&I: Jim, your market expectations?
Mr. Paulsen: I think we're in an environment characterized by extremely high-return potential with extremely high risk.
The reason I come down with that is because I think there is not much in between from here. We either hit the sweet spot of zero inflation and we've got a bull market, which might be every bit as good as what we have already experienced in the past 10 years, and closer to what Alan is thinking about. I think that's the most likely outcome.
Or, if it's wrong, it could be wrong for two reasons: either the price level re-accelerates, which will kill us because of multiples, or we'll deflate and have a rerun of the '30s. I think the most likely outcome is we're in the sweet spot and we're likely to stay, and there will be a continued wall of worries, but I think it's going to continue to go higher.
I think with Asia, what we've experienced this year is the first of what we're going to have recurring for many many years, and that is the first deflationary scare. We used to have - for 30 years - inflationary scares, but the world survived and persevered and we went on.
I think that earnings are in single digits, but the p/e ratio, I think, not only might not contract but could expand. Not necessarily with rates at this moment but because of risk premiums. We just went through a period where sentiment on risk went way up and that's why we've got spreads in bond yields going on. If those correct and improve, then the risk premium and the discount rate could also come down, leading to some higher multiple push in the next year.
Mr. Holland: I hope you're right.
Mr. Paulsen: For the next year I would put it at more like 15% to 20%. I know a lot can happen in any given year, but I kind of reflect on this point: given current conditions, I almost look at the current environment we're in, and maybe the next year, as a reverse OPEC.
I think about the first OPEC and what was going on was we had inflation rising, the Fed was tight and monetary growth was coming down, and we had a strong economy that we were fighting against in the stock and bond markets.
Today we have almost the opposite. We have a collapsing pricing structure in inflation; we've got tons of liquidity being poured in; we've got falling interest rates; and I just can't help but think that the economy and the markets will do better than we think.
I like the fact that sentiment on earnings is, I think, by and large negative, looking for contraction year over year and could come in better overall.
And there is some sense that we can't keep going with this bull market without a correction. I looked at this last correction we had, and that only lasted three months. We had about a 15% decline in blue chip pricing and a 30% decline in small-caps or whatever, and that was mild by historic standards.
But if you look at the other bear markets, and you look at the revaluation of equity and what I mean by that is where equities were valued relative to bonds . . . there was an over 40% revaluation of stocks relative to bonds in that three-month period. That is larger than any other bear market revaluation in the post-war period. Even in '73 to '74, stock prices fell 45%, but interest rates went up 25%, so the revaluation or relative cheapness of the stocks only got 20% cheaper by the bottom.
We had a record-setting revaluation, and I think that the difference is that everyone still feels like there should be a correction and I would suggest maybe we've had a hell of a big one. It's just that most of the pain of this bear came out in lower yields as opposed to lower stock prices but at the end of the day the value is still there.
Mr. Sit: I've got two points. One, of course, if we have Social Security reform and either the Moynihan or the Bob Kerrey plan is adopted . . .
Mr. Hansen: We get to change our forecast, right?
Mr. Sit: I think that the last point to keep in mind is that there is no economy in the world that is sounder than the
American economy today. And the secular outlook will continue to be favorable unless we start to pull the underpinnings from the economy and that's fiscal policy, incentive economics, and tax policy.