Last week was my 2003 year-in-review column. This time it’s about 2004, the year ahead. I do think we’ll have another good year. I’ll explain why, but I’ll also talk about what I see as one significant risk factor. And I’ll give you an idea for how to invest in a way that optimizes your chances to take advantage of both good news and bad news at the same time.
First, the causes for optimism. The economic revival — triggered by massive pro-growth tax cuts, accommodative Federal Reserve policy and significant resolution of geopolitical uncertainties — should continue to boom. That will be good for earnings, and for stock prices.
And don’t worry about valuations. Even with the market up almost 29% last year, stocks are actually about as cheap today as they were one year ago. Sure, prices are higher. But the earnings that you can buy for those prices are higher, too. Forecasted S&P 500 earnings are up 13% year-over-year.
On top of that, thanks to last year’s cuts in the tax rates for dividends and capital gains, investors get to keep more of those earnings. At my firm, Trend Macrolytics, we’ve calculated that on average across all investors, the effect of the tax cuts is the equivalent of a 10% jump in earnings. Combine this tax effect with the underlying growth in nominal earnings, and you’ve justified pretty much all of last year’s market gains.
Last year at this time, my firm’s valuation model said that the S&P 500 should rise 24% — and it rose about 29%. Now, based on today’s higher earnings forecasts and the tax effect, that same model is calling for gains of 19% in 2004. It should be a good year.
What can go wrong? Readers of this column know that my major worry now is a resurgence of inflation. Now, after a year of highly accommodative monetary policy, the Fed is going too far. Surging gold and commodity prices and the collapsing US dollar are virtually infallible indicators that inflation is just around the corner. But the Fed seems utterly blind to these concerns. At the Fed, it seems the catchphrase is: nothing succeeds like excess.
But the Fed’s excesses always lead to economic troubles. Inflation is corrosive to long-term economic growth, and destructive to equity valuations. And the Fed’s inevitably heavy-handed attempts to rein it in — after it’s too late — invariably cause even more damage.
Strangely, though, in the short term a little inflation can seem like a good thing. Everybody loves it when they feel like they have more money, and the result can be a strong burst of economic activity and a rise in the stock market. But inevitably people learn that it was just funny money all along — and it always ends in tears.
That’s what happened in 1987, the last time there began a marked rise in the rate of inflation in the U.S. For most of the year, all the same things that are happening now happened then. Gold and commodities prices soared, the dollar and bonds fell — and stocks soared.
And then there was that little difficulty that happened on October 19, 1987. Perhaps you’ve heard of it.
After that it took almost four years to get inflation back under control, and the Fed had to raise the fed-funds rate to almost 10% to do it. Those were four years of mediocre equity returns — with lots of volatility.
A worst-case scenario? Sure.
If you buy the optimistic core of my analysis, then it’s easy to figure out what to do. Buy stocks. Buy the most volatile stocks you can find. The low-priced tech stocks that led the charge last year will probably do it again. Risk is good.
But suppose you don’t want to be quite that bold — or that greedy. There’s another way to get into the market that should do very well indeed if the economic recovery continues — and should probably do well even if inflationary pressures start becoming more visible.
Consider investing in the basic-materials sector — metals, chemicals, fertilizers, papers, packaging. That’s right. The really boring stuff. This is the same stuff whose prices soar when the economy goes into a cyclical upswing. And it’s also the same stuff whose prices soar in an inflationary economy. You win either way.
And the boring companies that make and sell this boring stuff have some very unboring characteristics.
You probably think of basic-materials companies as stodgy large-cap giants. But take another look. Of the 10 major S&P industry sectors, the basic-materials companies have the lowest average market capitalization, at less than half the market cap of the average S&P 1500 Supercomposite company.
Basic-materials companies also have the highest debt/equity ratio of any sector other than utilities. That means leverage, and that means taking full earnings advantage of a recovering economy and rising materials prices.
And for the basic-materials sector, those earnings are likely to actually get to shareholders. The average basic-materials company pays out 76% of its earnings as dividends each year, almost three times the payout ratio of the average company.
The only bad news about the sector is that basic-materials companies aren’t especially cheap based on forecast earnings. There’s nothing wildly overvalued about the sector, but most other sectors are undervalued at this point. But all that said, I think that consensus forecast earnings are too conservative. Track those earnings against rising commodities prices — the prices that fuel the earnings of these companies — and you’ll see that there are probably lots of upside surprises in store.
How to play basic materials? It’s easy — lots of these companies are old-line household names. But why take the risk of picking stocks when you can buy the whole sector through exchange-traded funds? Take a look at the Select Sector SPDR Materials Fund (XLB), the iShares Dow Jones US Basic Materials Fund (IYM) or the iShares Goldman Sachs Natural Resources Fund (IGE).
The above is a version of an “Ahead of the Curve” column published January 9, 2004 on SmartMoney.com, where Luskin is a Contributing Editor.
