As the Dow Jones industrial average and Russell 1000 and 3000 indexes hit record highs almost daily and the Standard & Poor’s 500 index inches toward a new record, many investors expect the upward trend to continue.
On May 11, the Dow closed at 13,326.22, up 6.92% year to date; the Russell 1000 hit 821.12, 6.63% year to date; and the Russell 3000 hit 875.69, up 6.51%. Meanwhile, the S&P 500 inched toward a record, closing at 1,505.85 on May 11, up 6.17% .
No one interviewed seemed afraid of a steep market drop like the last time the key stock indexes were so high.
Unlike in 2000, they said, the market today is supported by stronger corporate balance sheets, earnings that continue to exceed expectations and strong free cash flows, particularly in the large-cap universe.
“The market is embracing these (large-cap) stocks, driving the Dow Jones to new highs and giving the S&P traction as well,” said Peter Vanderlee, portfolio manager at ClearBridge Advisors, New York. “I don’t believe there’s a sense we’re overstretched on valuations or that stocks are overpriced.” Mr. Vanderlee is a member of the firm’s dividend strategy team, which manages $4.5 billion.
Bruce Dirks, a portfolio manager for the $1.6 billion Fidelity Large Cap Value Fund, added, “This time around, it’s being driven by a more broad-based rally. When we last set these records, it was driven by a narrow set of stocks in a narrow set of sectors.”
The Federal Reserve Board left interest rates unchanged after its most recent policy meeting, May 9, and the Dow climbed to a record of 13,362.87.
More records to come
While overall economic growth is slow in the U.S., there is no reason to believe the indexes won’t continue setting records, investors said.
“Periods of slow growth aren’t necessarily bad for stocks,” said Brian Gendreau, an investment strategist for ING Investment Management, New York. “If valuations were lofty, I would worry more” about a turn in the market, he added.
There are concerns about how the collapse of the subprime mortgage market will affect the market, but these worries are generally minor.
Opinions differ on where the opportunities are in the soaring market.
Growth managers interviewed are excited about the prospects of the technology sector, which has generally lagged since the 2000 bust. “There have been multiple years of underspending on technology from a capital expenditure standpoint,” said Daniel Brewer, a principal and senior equity portfolio manager who oversees $13 billion in growth strategies for Rainier Investment Management Inc., Seattle. Businesses now have the capital to make significant technology upgrades, he said.
While technology, as well as health care, have powered growth strategies in the past, now growth managers are focusing on other sectors as well, such as the industrial, financial, energy and basic materials sectors. Mr. Brewer said investors have to take advantage of opportunities outside the key sectors to beat benchmarks that invest heavily in those two areas.
Bruce Bartlett, a partner and director of $2.3 billion growth equity investments for Lord, Abbett & Co. LLC, Jersey City, N.J., is focusing on picking companies where strong, sustainable sales growth is a main contributor to the strength of the balance sheet. He named biotech companies like Gilead Sciences Inc. and Celgene Corp., or technology companies like Research in Motion Ltd., Cisco Systems Inc. and Akamai Technologies Inc. as examples.
Value managers also have some confidence in the technology sector and said the rise of the Dow is a reason for that.
Higher beta
“In a strong market, (the technology sector) has higher beta, so those stocks should do well,” said Arvind Sachdeva, chief investment officer for $3 billion in large-cap value at Victory Capital Management Inc., Cleveland. He named Dell Inc. and Motorola Inc. as particularly attractive companies because they have had some temporary operational difficulties that make their stocks cheaper. He believes the companies will overcome those difficulties.
Mr. Sachdeva said he has high expectations for the energy and materials sectors as well, particularly metals and mining businesses. “We see sustained demand for those products and services. Share prices haven’t reflected those attributes of strong, sustainable cash flow,” he said.
Fidelity’s Mr. Dirks said he is focusing on companies that derive much of their growth from non-U.S. consumers.
“We don’t want to have anything solely based on U.S. consumers,” he said. “We want a non-U.S. growth component to be part of their (the company’s) story.”
The non-U.S. consumer has played a large role in the records being set by the Dow, ING’s Mr. Gendreau said. He estimated that 48% of revenues for companies in the DJIA are coming from outside the U.S. That revenue stream from overseas is also growing about twice as fast for those companies as their domestic revenue, he said.
While equity investors mentioned some concerns about the effects of the leveraged buyout spree, that same binge is causing fixed-income managers to focus on the high-yield market.
Scott Amero, managing director and co-head of the fixed-income portfolio management team at BlackRock Inc., New York, explained that companies in leveraged buyouts are issuing more debt through high-yield corporate bonds. They are issuing so much high-yield debt that managers have pricing power and can negotiate covenants in the bonds that protect them, making new high-yield issues more attractive. BlackRock has $1.15 trillion in total assets under management, including $470.5 billion in fixed income.
“The companies have to come cheap to the market because these deals are so much bigger,” he said.
Mr. Amero noted that many of the companies in the current LBOs are also much more stable, well established businesses than in the past. He cited First Data Corp., Sallie Mae Inc. and Harrah’s Entertainment Inc. as examples.
Home equity opportunities
Nasri Toutoungi, a managing director at Hartford, Conn.-based Hartford Investment Management Co., overseeing $10 billion in core and core-plus fixed income, said there are also opportunities in the home equity market. Many investors have shied away from the entire housing market because of fear over the collapse of the subprime mortgage market.
But there is still value to be had in the fixed-rate market — a small portion of the subprime market that isn’t in floating rate loans — where people are less likely to default, he said. “The market has thrown the baby out with the bathwater.”
The subprime mortgage market is the only things that equity investors have voiced concerns over in the current market. But those concerns do little to dampen the positive outlook on the equity market as a whole, said Victory’s Mr. Sachdeva.
“The market has been hesitant to reflect all of those positive conditions” such as strong earnings and strong corporate balance sheets, he said. “We’re in a stage of market advance where values are being properly reflected. We’re getting very respectable potential return for the level of risk we might be taking.”
