With the stock market rally of 25 percent for the Nasdaq and 15 percent for the S&P 500 since the first of the year, it is time to be cautious. The recent rally needs to consolidate if the gains are to be real for the remainder of 2003 and into 2004.
This rally was fuelled by investors looking for bargains in anticipation of better economic times ahead. While corporate earnings are improving from the very steep decline of 2001, they are being primarily led by cost cutting. The unit volume gains remain elusive for a while longer. Economic growth remains positive but subdued. Debt levels and delinquencies remain high and sales incentives remain in vogue in order to attract modest consumer spending.
The bond market has been equally impressive lately — on top of excellent gains the last three years. This has been due to the Federal Reserve policy of stimulating the economy primarily through lower intermediate to long-term interest rates. Credit spreads have narrowed significantly and refinancing activity seems to have no top. But we all know that over-stimulation of one asset class — ie. real estate — can be very dangerous. The Economist magazine recently had a very detailed article on European and U.S. real estate markets. A must read.
The third quarter of 2003 should feel the positive impact of President’s Bush stimulative tax package and the stock market has now acknowledged that improvement. The valuations on stocks have moved up to an approximate price-to-earnings ratio of 20, which might be a good sign that the stock market is now fully valued at current levels.
So where do we go from here? Quality stocks with decent valuations should do well along with quality corporate bonds with inflation running at a 2 percent rate. Core inflation is running at a lesser rate, closer to 1.6 percent. That suggests that the Fed should not be cutting short-term interest rates further with GDP running at a near 2 percent rate with a higher rate of growth expected in the second half of 2003(possibly in the 3.5 percent range). However the Fed might feel obligated to lower interest rates further at their late-June meeting.
So take a good hard look at your stock portfolio and continue to weed out the high-beta, higher-risk securities that have limited prospects. Add stocks that have a positive cash flow with decent revenue gains, a decent yield, and a modest P/E. You’ll find these in consumer stables, health care, energy, old-fashioned utilities, and select industrials.
Don’t get overexcited about market rallies as they are never assured and they should never be chased.
— Patricia A. Small is a partner with KCM Investment Advisors [visit their new site], and is the former Treasurer, University of California.