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Jubak's Journal
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5 keys for a big finish to 2004
Stocks could end the year as much as 10% higher if the right stars align. These are the crucial factors I see.
By Jim Jubak
On Dec. 31, 2001, the price-to-earnings ratio of the Standard & Poors 500 stock index ($INX) stood at 46.5. A year later, it was down to 31.9. As many investors may remember all too well, 2002 was a terrible year as earnings per share for the S&P 500 fell from $50 in 2001 to $27.59 in December 2002. The index itself finished down for the year by 23%.
That plunge in the price-to-earnings ratio of the index continued in 2003. From 31.9 on Dec. 31, 2002, it tumbled to 23.11 one year later. But 2003, as many investors may also remember, was a great year. Earnings per share for the S&P 500 stocks climbed nearly 77% to $48.74, and the S&P 500 index climbed by 26% in 2003.
So which will it be this year? Earnings, according to Standard & Poors projections, will jump an additional 20% to $58.71 in 2004. But many Wall Street analysts expect that the price-to-earnings ratio will continue to contract to something like 15.6, the historical average (on as-reported earnings) since 1935.
At a price-to-earnings ratio of 19.5, stocks, as measured by the S&P 500 index anyway, would finish flat for 2004, even if the companies in the index delivered the 20% earnings growth now forecast for the year. At a P/E ratio of 21.5, stocks would end 2004 up about 11%. At a P/E ratio of 17.5, stocks would finish the year down about 10%.
What determines the price-to-earnings ratio, the price the investors are willing to pay for a dollar of earnings? And where will this ratio stand on Dec. 31?
Let me lay out the five factors that I think will decide how valuable a dollar of earnings is likely to be to investors in December and where stock prices might stand as a result.
Earnings growth in 2005. Its not current earnings growth that sets the stock markets price-to-earnings ratio, but expectations for future earnings growth. Investors were willing to pay so much for a dollar of 2002 earnings, a year when S&P 500 earnings fell by almost 45% from the previous year, because expectations for 2003 earnings were so high. And the expectations were right.
And the 2003 price-to-earnings ratio remained so high, compared with the historical average of 15.6, because investors were anticipating another great earnings year, with 20% earnings per share growth this year.
But now, Standard & Poors projections call for just 5% earnings per share growth in 2005. I think thats low, given the strength of the U.S. economy in late 2003 and early 2004, but there is no escaping the logic of the economic cycle. By the end of 2004, we will be more than four years removed from the last earnings peak of $53.62 in the 12 months ending with the third quarter of 2000. The recovery will certainly qualify as mature, and, in all likelihood, the economy will be closer to the end of the growth part of its cycle than to the beginning.
How tech earnings fare. No single sector is as important to the performance of the stock market for the rest of 2004 as technology.
Wall Street analysts are sharply divided in their opinions on how close we are to the end of the recovery in technology earnings. Normally, the up leg of most technology cycles last longer than this one has. But is this a normal cycle? Huge overcapacity built up at the end of the bubble, the lack of a big new killer application to make users clamor for new and more expensive chips, and additional capacity still coming on line in Asia all suggest that the profit peak of this cycle wont be as high as 2000.
Right now, calculates Banc of America Securities, most chip companies are making about half as much on their invested capital as they were at the peak in 2000. Analog Devices (ADI, news, msgs) showed a March 2004 return on capital of 11% vs. 22% at the 2000 peak. For Intel (INTC, news, msgs), the difference is 15% in March 2004 vs. 24% in 2000. At Texas Instruments (TXN, news, msgs) 10% vs. 18%. And at Xilinx (XLNX, news, msgs) 10% in March 2004 vs. 18% in 2000.
Sure, this could mean that these companies have a long way to go before they reach their profitability peaks, but I think it is more accurate to conclude that the peak in this cycle wont be as high as in 2000. The technology sector, with its higher price-to-earnings ratio stocks, has enough seasonal and cyclical strength to lead this market higher in the second half of 2004, but I wouldnt count on much for 2005.
Where bond yields will be. In my May 14 column, My formula for buying stocks in a rocky market, I laid out the relationship between stock prices and interest rates. To grossly simplify, the lower interest rates are, the higher the multiple that investors are willing to pay for stocks. (Please note that, due to the limitations of the data Ive been able to find, I havent been able to use comparable earnings per share estimates for that column and this one. My apologies.) At the time, and this still holds true, stocks had priced in an increase to about 5.5% in the yield on the 10-year-Treasury note from recent yields of about 4.8%.
For todays exercise, however, we need to ask a slightly different question: When we get to December 2004, what yield will investors be anticipating for 2005? If 5.5% seems a likely top for interest rates, then rates have a neutral effect on price-to earnings ratios. If the market starts to anticipate another round of rate increases beyond 5.5% or so, then youll see a lower price-to-earnings ratio for the market.
The Federal Reserves behavior at the next two meetings, at the end of this month and in August, will go a long way to setting investor expectations.
The worry right now is that the Fed wont act, letting inflation get out of control and requiring drastic interest rate increases in 2005. A 25-basis-point hike or two over the summer would put those fears to rest, for a while. (A basis point is one one-hundredth of a percent.)
Earnings quality: Is the growth real or the result of tricks? Sustainable earnings from organic growth are the most valuable and anything, such as cheap credit, that causes investors to question the sustainability of earnings will probably result in a lower price-to-earnings multiple in the stock market for those earnings. Current sales of cars and homes have been propped up by the availability of low-cost credit, which makes it tough to tell what the sustainable sales growth rate might actually be in these sectors.
Right now, earnings are being increased by such one-time or short-term events as lower tax rates, accelerated deductions for equipment purchases, boosts from translating foreign currency earnings into a weak dollar, cost savings from pension returns or restructurings. Looking at the life cycle of many of these events, it looks like theyve played a relatively big role in 2004 earnings results, and they wont boost earnings as much in 2005. The result is probably a minor ding to the price-to-earnings ratio but a ding nonetheless.
The terror premium for crude oil. Wall Street estimates that there may be a $6-a-barrel terrorist premium to each barrel of oil right now. I can see that premium moving up or down a few dollars with the ebb and flow of the news, but I dont see it going away in the time period Im looking at here. As depressing as the thought is, I dont see the world becoming a much safer place in the next 12 months. The terror premium could even rise if, say, the Saudi royal family looks like its losing its internal battle against the more extreme and violent Islamic fundamentalist groups in that country. That means the current downward pressure that this kind of geopolitical uncertainty exerts on stock prices is likely to persist.
A lot of things have to go right
So heres where I come out.
Although I think were closer to the end of this up leg in the cycle than to the beginning, I think the S&P estimate of 5% earnings growth for 2005 is low. Modest inflation will ride to the rescue and prolong the life of the cycle by giving companies something theyre lacked for a long time: the ability to raise prices. When all is said and done, I think its reasonable with what we know now to project 10% earnings growth for 2005.
If thats an accurate earnings projection, then some other things must go right for the P/E ratio to drop to 21.5 and stocks to finish the year up 10%. These include:
- The Fed moves quickly to raise interest rates in June so that the financial markets can regain some faith in monetary policy.
- The technology sector delivers a normal second half surge.
- Credit gets more expensive so gradually that it doesnt choke off sales in critical consumer sectors.
- No geopolitical event inflicts lasting damage to the world economys most vulnerable and critical raw material, oil.
What makes me most nervous about that prediction, however, is the number of things that have to go right in order for stocks to deliver what is a roughly average historical return. To me, that signals that this isnt a time to take excessive risk. The likely reward just doesnt make that an attractive proposition.
In my June 1 column, I wrote about a much more dire alternative, arguing that bubbles almost always pop (although not before the end of 2004, in my opinion, hence my short-term relative optimism). That being the case, I wondered about the odds the cheap money bubble thats built up since early 2001 will burst and do significant damage to the stock market and the economy. I received a huge amount of mail from readers who essentially agreed with my assessment. They took me to task, however, for frightening people but not giving them any concrete advice about what to do. I think thats a fair criticism, and, in my next column, Ill look at investment strategies to protect a portfolio in case my mild optimism doesnt work out.
New developments on past columns
Why all market bubbles end with a bang
U.S. consumers went deeper in debt in April but at a slower pace than economists had projected. Consumer borrowing (excluding mortgage debt) rose by $4 billion in April to a total of $2.03 trillion, according to the Federal Reserve. Thats an annual rate of 2.3%, down from the 5.5% rate of increase in March. Economists were predicting an increase of $6 billion.
Revolving debt, which includes credit card debt, actually fell in April by $3.2 billion. The percentage of credit card loans written off as uncollectible fell to 6.8% in April from 7% in March. At the same time, non-revolving debt, which includes car loans and education loans, climbed by $7.1 billion in April on top of a March increase of $5.5 billion. Non-revolving debt accounts for more than 60% of all non-mortgage household debt.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak did not own shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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