October 18, 2005
WHO MOVED RISK'S PAYOFF?
Risk is taking a beating these days. Reaching for higher performance by way of greater risk is a time-honored means of boosting profits, of course. But the strategy can also bite back in times of uncertainty or worse, as this year's performance in various corners of the equity market suggest.
Consider that large-cap stocks are still in the black this year. The Russell 1000 posted a slight gain of 0.6% year-to-date through October 17. Small caps, on the other hand, have shed 2.1% over that stretch, based on the Russell 2000 index. And the truly tiny companies, represented by Russell Microcap, have fared even worse, losing 3.5% in 2005 through yesterday's close.
Is the fact that risk isn't rewarding investors this year a sign of tougher times ahead? What is Mr. Market telling us? Whatever it is, are investors inclined to listen?
In search of answer, keep in mind that when the stock market finally rebounded after equities collapse in 2000-2002 risk lived up to its billing as a returns booster. From December 31, 2002 through the end of last year, for instance, smaller was definitely better. The Russell Microcap earned an annualized total return of 32.1% over that two-year span, well ahead of the small-cap Russell 2000's 26.6%, or the Russell 1000's 16.7%.
But risk seems to have fallen out of favor this year, as year-to-date performances tallies imply. What might save equities from stumbling further? Continued earnings growth would help. But is earnings momentum up to the task at this point in the cycle?
Don't write off more earnings growth just yet, wrote Ed Yardeni, chief investment strategist with Oak Associates, in an email to clients today. "Last Friday, I raised my forecasts of analysts' consensus expected S&P 500 12-month forward earnings from $83 and $89 by the end of 2005 and 2006, respectively, to $85 and $91," Yardeni advised. "In other words, I predict that at the end of this year analysts will project that earnings will be $85 in 2006. At the end of next year, I predict that they will expect $91 for 2007."
Assuming that the S&P 500's current price-earnings ratio of 14 (by Yardeni's calculation) holds, the index would rise 7% between now and the end of 2006. If the Fed stops tightening, the p/e could rise to 16 (as Yardeni expects), in which case he thinks the S&P 500 would climb by more than 20% between now and 14 months hence.
One reason for remaining bullish is that once the Fed ends a cycle of interest-rate hikes the stock market responds with a rally, Yardeni added. "Since 1960, the S&P 500 has rallied 5 out of 9 times by an average of 7.5% and 14.1% three and six months later, respectively," he reports. "The four times the market fell after the rate peak, the average drop was 5.0% and 5.1% three and six months later. The market's P/E rose 6 out of 9 times following major cyclical peaks in the fed funds rate."
Mr. Market, however, was in no mood for optimism today. Losses dominated trading in equities today. Consumer discretionary companies were especially hard hit, shedding nearly 4% on the day. This despite the news today that sales at retail chain stores rose 0.4% last week, according to the International Council of Shopping Centers via Reuters. "Although consumers are still very worried about the sharply higher energy expenditures impacting their budgets, they also seem to be spending a bit more over the last four weeks, which is an encouraging sign," said Michael P. Niemira, ICSC's chief economist and director of research.
Suffice to say, as the holiday shopping season is set to begin in earnest, analysts will be watching Joe and his neighbors closely to gauge consumer sentiment where it counts most: spending. If Yardeni's bullish expectations are to have any chance of becoming reality, it's a safe bet that consumers will need to keep spending at a healthy pace through the end of the 2005. In turn, the willingness to spend will depend in no small way on energy markets.
Virtually every observer of the economics scene has been shocked and awed by Joe's ongoing enthusiasm for spending in the face of price spikes in oil, natural gas and gasoline. In earlier time, energy bull markets of this magnitude have turned otherwise bright-eyed consumers into frightened souls intent on little more than wearing an extra sweater and riding bicycles to work.
But that was yesteryear's response to energy shocks. Nonetheless, even in this era of heroic consumerism a pullback in energy prices could hardly come too soon to insure survival for the retail industry's holiday season. Alas, no sign of a pullback today, with crude oil prices rising sharply once again in New York futures trading.
In any case, Joe's maintained his lifestyle thus far, preferring to assume more debt rather than let the energy bull market spoil his party. Might there be more of the same on tap? Perhaps, but the risk of something else is rising. Top-line inflation rising, and so is unemployment (albeit modestly thus far). Joe's biggest hurdles, in short, may be yet to come. To judge by the relationship between risk and reward in the stock market, however, the jury's left the seats and is preparing to leave the courtroom. Or, as Bob Dylan once sang, "It's not dark yet, but it's getting there."
Posted by jp at October 18, 2005 4:37 PM
yardeni is overconfident in that he expects the fed to curtail it's hiking sometime in 2006 - with the arrival of a yet to be named FOMC chairman (and i hope to god bush does a better job with that than he's doing with the miers supreme court appointment) one must factor in the fact that the "new kid in town" will have to establish his bona fides (sorry for the declarative pronoun, but i don't believe there are any females on the short list) and that is not (in my experience of trading rooms) a quick process....so quoting "post cyclical peak returns" so soon is a bit premature
Posted by: franko at October 19, 2005 12:00 PM