By Arnie Kaufman We at S&P see decent percentage gains in 2003 from current depressed levels. Our forecast is based on expected improvement in corporate profits and in earnings quality, as well as on the assumption that the plunge in stocks to five-year lows as of early October made reasonable allowance for the hazards.
The legacy of the worst bear market of the postwar period, however, is an investor with low tolerance for disappointments and a high appreciation of risk. Thus, the recovery is bound to be erratic and may often seem in peril.
Stocks just now have some historical patterns in their favor. Supporting the view that the worst is behind: A major low has occurred roughly every four years over many decades, and one was due just about when the S&P 500 bottomed in October.
The upturns from the four-year lows may reflect anticipation of better business conditions in the third year of the presidential term, presumably because the party at the helm begins priming the economic pump in a bid for re-election.
The year 2003 will be the third of the presidential term. The S&P 500 hasn't declined in year three of the term since 1939. From 1928 on, the third year saw gains averaging 14% vs. only 3% in the first year of the term, 5% in the second year and 7% in the fourth.
Also, the S&P 500 in 2003 will be coming off three consecutive annual declines, and the bear rarely shows that much staying power. The last instance of three losses in a row, 1939 to 1941, was followed by four straight double-digit gains averaging 19% annually.
Potential returns from alternatives to equities, meanwhile, are uninspiring. Treasuries, though a hedge against stock weakness, provide low yields and would be expected to ease in price as credit demand picks up in a strengthening economy. Returns from cash equivalents are paltry, and real estate looks expensive.
Stock valuations seem high for the beginning of a bull market. But they should be viewed in the context of a different, if not new, economy and the possibility that a multi-year earnings expansion lies ahead. Thanks to new technologies, labor productivity uncharacteristically rose through the recent recession and remains in a strong upward trend. Although job losses occur as productivity increases, unemployment is modest for this stage of the economic cycle and should turn down around mid-year.
Productivity gains are helping companies improve profits even as keen global competition makes it difficult for them to raise prices. Our analysts expect operating earnings on the S&P 500 to climb 19% in 2003.
With inflation likely to be contained, the Fed will be in no hurry to push up short-term rates. And we doubt that the yield of the 10-year Treasury note will get as high as 5% in 2003. Low inflation and interest rates help support elevated price-to-earnings ratios.
Recoveries from postwar bear markets have averaged 33% in nine months and 42% in 15 months. Applying such gains to the S&P 500's October 2002 low of 777 puts the index around 1030 at mid-2003 and 1100 at yearend.
Our forecast is more conservative. We're looking for the "500," which is now around 890, to rise 11% to 990 by the middle of the year and 18% to 1050 by the close. We recommend an asset allocation of 65% stocks, 15% bonds and 20% reserves. Kaufman is editor of Standard & Poor's weekly investing newsletter, The Outlook