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Like investor’s galloping to buy a piece of an IPO in the late 1990s, many speculators purchased Smarty Jones collectables before the Belmont Stakes. These Smarty collectors hoped that a victory at Belmont – which would have made Smarty Jones the first Triple Crown winner in more than 25-years - would entice other collectors to pay still higher prices for Smarty items. However, unlike those who were lucky enough to lock in profits before the 1990s tech/internet IPO machine exploded, Smarty Jones collectors quickly went bust: Smarty Jones lost the race…
It isn’t difficult to understanding why some collectors chased Smarty Jones items. Rather, with Smarty’s impressive win in the Preakness the horse had supposedly become a ‘sure thing’ at Belmont. Yes, racing fans quickly forgot that Funny Cide - running for the Triple Crown last year - was also thought to be a ‘sure thing’ at Belmont.
In short, Smarty’s second place finish is noteworthy because of opportunities lost: the book deal will be a modest one, Smarty’s defeat may, or may not be “Good for Gambling Industry”, and the ‘Seabiscuit’ like movie is not likely not arrive. More on Smarty in a moment…
Still Naïve
According to a recent survey from American Century Investments, the majority of ‘investors’ (400 people polled) do not understand that bond prices fall when interest rates rise. According to John Hancock Financial Service, “more than 60 percent of respondents don't know they can lose money in a government bond fund [and] Nearly 45 percent think money market funds contain stocks.” These two surveys – recently mentioned by Bloomberg’s Currier – suggest that despite the bear market investors have become none the savvier.
Still Ignoring The Core
Jim Jubak recently speculated that “Stocks could end the year as much as 10% higher if the right stars align.” Some of the highlights are as follows:
“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%.”
Surprisingly, after pointing out that the average historical P/E on the S&P 500 is roughly 15.6 (excel), the lowest P/E scenario Mr. Jubak offers for 2004 is 17.5. Perhaps this is nitpicking given that Jubak tries to offer a rounded opinion. Nevertheless, given that P/Es of 17.5 and higher are more of an historical anomaly than P/Es around 15.6, a question deserves to be asked: why won’t stock valuations retreat to their average in 2004? As for the ‘as reported’ estimates Jubak refers to – estimates that are heavily used by Wall Street – the investor should understand that these estimates may not be as reliable as they seem.
* If you use S&P 500 Core earnings estimates the S&P 500 would have to fall by more than 20% to reach an average P/E of 15.6 by the end of 2004. Such a decline in the S&P 500 – a decline that would simply bring stocks back to their historical P/E average - is double the decline of the worst scenario Jubak cares to mention.
Options Soon an Expense?
While hardly as reckless as the commentaries circulating during the late 1990s, the usually objective Mr. Jubak nonetheless demonstrates how little things have changed since the 1990s. For another example, consider this quote:
“But now, Standard & Poor’s projections call for just 5% earnings per share growth in 2005. I think that’s low…”
What Mr. Jubak does not mention is that ‘as reported’ earnings are expected to be up by a mere 0.15% in 2005 if stock options are expensed. Is this tidbit is worth reporting? Definitely! After all, even Standard & Poor’s is plugging options expenses into their as reported estimates:
“*** Please note that the 2005 As Reported estimate includes option expense that is expected to become mandatory.” Excel
Needless to say, if someone like Jubak - who suggested today that “The end of cheap money could bring a market disaster” – paints a potentially slanted bullish picture, it goes without saying that many Wall Street bulls are raging about earnings growth.
Fund Flows
The last horse to win the triple crown was ‘Affirmed’ in 1978. In 1978 US stocks were 4-years from away from reaching a bottom, and mutual funds were amidst what would turn out to be an 11-year slump (from 1971-1982 funds recorded net outflows nearly every month). 26-years later and mutual funds are hot: despite modest outflows in 2002 (-$27.75 Billion) funds have attracted new capital for more than a decade.
Before suggesting that capital inflows into stocks will remain ‘hot’, it is worth remembering that last years Fed rate cut helped kick off mania like flows into equities (the logic being that ‘Greenspan will tax your money markets so you might as well throw your money in stocks’). With the Fed about to raise interest rates a different set of jumps sits before investors.
Bearish Stance Re-Affirmed
Like horse racing fans willing to forget the debacle that was Funny Cide, investors have been able to forget the 2000-2003 bear market because an exciting market rally has come along. However, investor’s should keep in mind that despite the 2003 stock market rally the markets are down thus far in 2004…the markets are trading lower on the year despite super strong inflows into equity funds through out the year!
I’ll admit that when Smarty Jones rounded the final turn at Belmont I was on the edge of my seat. Quite frankly, watching a historic event unfold – whether in sports, aviation, diplomacy, or the financial markets – is exciting. Nevertheless, when a silence broke over the crowd as Smarty lost the lead I was quick to forget about the whole event. After all, there is another important event nearing that promises to be worth watching: the beginning of the Fed tightening cycle.
Equity funds attracted $110 billion in the first four months of 2004. However, the bulk of this money arrived in January and February, or when the Dow was trading above 10,400, and the Nasdaq above 2,000. Leading into the first rate hike in years and the majority of new capital coming into the markets this year is profitless. If higher interest rates dull US economic growth and/or some viable alternatives flash green to the average investor (i.e. bonds are a buy when interest rates peak), how long will it be before stock mutual fund collectors become disenfranchised [again]?
You don’t have to be smart to be scared: if the S&P 500 were to simply stay at its current level until the end of 2005 the index would be trading at 18.5 times ‘as reported’ earnings. Many opportunities can be quickly lost between now and the end of 2005. Remember, 18.5 is the anomaly not 15.6.
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