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Markets: Has the Stock Market Peaked?
New York: August 25, 2004
By John R. Stephenson

For the last year, we have seen strong growth in corporate earnings. The potent combination of low interest rates and strong productivity has led corporate earnings to surge by some 26% in the second quarter of 2004 with most of this growth coming from the financial, energy and technology sectors. The big question is — can it continue?

If you listen to most pundits, it can. But does it really make sense that corporate earnings can continue to grow at a clip that is considerably faster than that of the economy as a whole? I think not. Most analysts make the same mistake that the average investor makes — extrapolating the current trend out into the future. Although one can always point to individual stocks which are huge winners and losers in any kind of stock market, it seems irrational to think that the overall stock market can soar when the overall economy is growing in the four percent range. In fact, over long periods of time, the average rate of return for a stock portfolio is in the seven percent range. That seven percent is roughly comprised of GDP growth plus dividends plus inflation.

But can't the market continue to move upward even if the economy slows down? Perhaps. But only for a while until investors begin to realize that they are simply paying too much today for a dollar of future earnings (high P/E ratios). But expectations for future returns are set in the market by past trends and the overly optimistic forecasts of equity analysts. These analysts in turn rely upon the opinions of the group with the greatest vested interest, company management, who through their large stock option grants have an interest in seeing higher valuations for their company stock.

There is already some evidence that, in spite of all of the cheerleading, the stock market is slowing down. Among the chief concerns for investors is the high price of oil coupled with weak job growth and softening conditions overseas. This is starting to be reflected in stock market data. Equity mutual fund sales are beginning to experience modest outflows and the ultimate barometer of an equity bull market, the IPO market, is essentially stalled. Initial Public Offferings (IPO's) are completely dependent on a strong stock market in order to ensure that there is sufficient demand for the shares of these new companies. Investors need to believe in the prospects of strong future stock markets for them to decide to take a risk on investing in a new company (IPO) over shares in a more established and proven company. The status of the IPO market today? Deals are being delayed, cut in size, reduced in price (roughly 40% of IPO's have been priced below their filed ranges), or pulled altogether.

On the economic front, we are facing rising interest rates and significant budget and trade deficits. In essence, the United States is spending more than it makes and importing more than it exports. Just who is financing this extensive spending spree? It is primarily Asian investors through the purchase of U.S. securities. In addition to the potential for a gain on the purchase of U.S. securities, the other rationale for buying U.S. dollar securities is that it artificially keeps the U.S. dollar strong which, by comparison, weakens Asian currencies and keeps products and services from these countries competitively priced. If the prospects for the U.S. stock markets worsen, the dollar weakens, or demand slackens, foreign investors could push the panic button and reduce their exposure to U.S. stocks and bonds. The result? Lower stock markets. As Morgan Stanley's chief economist Stephen Roach has said: "The funding of America is an accident waiting to happen." The extent of this financing? Foreign investors are currently funding the United States imbalances to the tune of roughly US $86-billion a month.

So just where should a scared investor look for value in a market that might be a little overheated? Well, research conducted on previous periods where earnings expectations have started to be revised downward and in instances where the Federal Reserve has been tightening (raising interest rates) has revealed that energy, healthcare and consumer staples sectors have outperformed the overall market. In our view, the technology sector with its heavy reliance on stock options (a form of compensation that will be coming home to roost) and weak overseas prospects is a sector for investors to exercise with caution. The markets for technology companies are generally less robust internationally because of the higher reliance on the manufacturing sector as opposed to the U.S. where the focus is on services — a heavy user of technology products and services. Other sectors to avoid in a rising interest rate environment are economically sensitive stocks (industrial companies), as well as those that are susceptible to a deteriorating credit environment. The sector that we believe will perform the best in weaker stock markets is energy. We believe that the risk of declining commodity prices (and hence stock prices) is more than offset by risks of supply disruption, lower swing capacity (from Saudi Arabia) and, at worst, neutral valuations.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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