Meet the Street: The Shape of the Economy to Come

Forget letters -- the shape of this economy is best described in terms of dishes, as in saucers and soup bowls.

At least that's the viewpoint of John Waterman, chief investment officer for Rittenhouse Equities, a division of Nuveen Investments. Waterman, who recently held a press conference to lay out his predictions for 2002, thinks the current cycle more closely resembles a soup bowl, in which a gradual economic slowdown bottoms in the fourth quarter and is followed by a slow recovery.

Here Waterman describes in detail his view of the economy and where he's putting his company's money these days.

TSC: What's your outlook for the economy and the markets?

Waterman: We're comfortable that the economy is turning around and that corporate earnings will turn around. We believe that we will look back and see Sept. 21 as the bottom of the market. We believe the market's headed higher from here, but where we differ from the consensus is on the shape of the recovery. The consensus view seems to be the V-shaped recovery, and I'll get into that in a little more detail. That seems to really be driving the parts of the stock market that are performing well.

What I said in the briefing is that, for the past two years, everyone seems to be using letters to describe the economy, using V's or L's or U's, and there's even people out there who are using W's, meaning the economy slows, picks up and then slows again. What we've been doing all year is using dishes to describe the shape of the economy. So prior to Sept. 11, we had a saucer-shaped view of what would happen in the economy, where there would be a shallow bottom or slowdown, probably in the third quarter, and then the economy slowly starting to pick up in the fourth quarter of 2001 heading into 2002.

John Waterman, Chief Investment Officer, Rittenhouse Equities

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What Sept. 11 did is change the shape and time of that recovery, and we have seen since Sept. 11 more of a soup bowl, where there is a deeper bottom coming in the fourth quarter of this year, and then it does start to turn up next year, probably in the late first quarter, early second quarter.

The difference between our soup bowl and the V shape is that the V implies a very sharp, deep downturn, probably in the fourth quarter, and then it implies a fairly sharp acceleration or upturn in the economy next year. We're looking at a softer slowdown than the consensus and also a more gradual recovery.

TSC: What are some of the implications of a "soup-bowl"-shaped recovery?

Waterman: There are a couple of points to that. One is our scenario for a more gradual recovery is probably a better one. In other words, the concern we have about a V-shaped recovery is that things take off, the economy overheats and the Fed has to step on the brakes pretty quickly cause they have inflation worries. Our more gradual recovery creates a more sustainable growth scenario.

The second thing this has implications for is what's driving the market now. What has been the real surprise to us since Sept. 11 has been the strength in technology and the strength in cyclical stocks. We're growth managers and are in technology; we've stayed slightly underweighted but we own the leading names. We have about a market weighting in consumer cyclicals or retail stocks, so we're in these areas.

But when we look at the move of technology stocks, the Nasdaq up something like 39% from the market bottom, and if you look at the Morgan Stanley cyclical index, that index was up something like 15% from the end of September where the consumer index was only up 4%. With everyone believing in the V-shaped recovery, investors in the market seem to be looking for companies that meet specific criteria.

One is they have very depressed earnings this year, and two, they think they're economically sensitive so that their revenues will benefit from this recovery next year. So what they're hoping for is a very large cyclical bath on the earnings of these companies.

The reason we struggle with that scenario is valuation. We believe you are going to get a cyclical bounce in earnings for a Cisco(CSCO Quote) next year, but when you look at investing in cyclical stocks, the market's right in saying that you don't value them off of the current year earnings if they're depressed. You try to value them off a normalized earnings number.

One way to do it is value them off of earnings one year from now or two years from now, assuming that those earnings have recovered. The problem we have is when we look at Cisco, it's selling in the 40-to-50 times earnings range of next year's earnings. We think the market has really pounced on these stocks, and they've moved up sharply. But an awful lot of the turnaround in earnings next year is already priced into them. In fact, we think the valuations are on the high side.

TSC: So what do you see as some good places to put your money right now?

Waterman: Well, in the interest of full disclosure, our largest position is Pfizer(PFE Quote), and right up there with Pfizer is General Electric(GE Quote) and American International Group(AIG Quote).

Pfizer's selling at 27 times next year's earnings. The consensus Wall Street growth rate for Pfizer is 19%. It has very good earnings visibility and is very predictable. The company has a broad portfolio of products, the broadest of any pharmaceutical company. It sells at 27 times next year's earnings. We're saying there's no debate that Pfizer is a much more compelling buy than Cisco, and has a much stronger earnings story long term, and a lower valuation than Cisco.

We like Cisco, but we think Cisco's probably an 18% to 20% grower long term. So we see Pfizer as a more compelling earnings and valuation story than a Cisco, but the market seems so caught up on the V-shaped recovery that it seems to be ignoring the Pfizers. One could say the same thing for General Electric.

General Electric's relative price is the cheapest it's been in five years. The stock's done nothing this year; it's actually down year to date. They were hit by 9/11 in their insurance business, but absent that it's still delivering strong earnings this year. Its earnings next year are expected to be in the 12%-to-14% range. They actually will get somewhat of a cyclical play in their short cycle businesses the second half of next year if the economy turns around.

The third name I mentioned is AIG(AIG Quote), and that's a similar story. AIG is actually down about 20% year to date, and it's selling in and around a market multiple. It's going to grow its earnings long term in the 14%-to-15% range, faster than the market. Its earnings next year, in part because of the American General acquisition, will be up 25%. The stock's not participating in this rally. So it's like everyone has kind of latched onto this V and gone cyclical. We think an awful lot of that now is priced into the tech stocks, and we think you're likely to see some profit-taking with those stocks and a rotation into some of the names we're talking about.

TSC: What about the comment you made about hot return sectors and hot stocks? Are there any such things right now?

Waterman: Investors are always trying to figure out what's hot, so that was more of a general warning. I always hear people saying which sector do you want to be in? I made that comment in the context of preaching the fact that retail investors shouldn't be trying to pick the hot sector or hot stock; they should be trying to have fairly well-diversified portfolios, by sector, stock and asset class.

One of the most important lessons of the past year has been how important it is to be diversified and not have big bets. Especially if you're older and approaching retirement, it makes a lot of sense to own not just stocks but bonds in your portfolio. So I think investors are much better-served by having a well-diversified portfolio than trying to figure out what's going to be the next hot play this year.

My concern now is that they'll start to chase the tech 'cause they don't own it or they'll start to chase the cyclical names because they believe that's what's going to work. And just like they always do, the retail investor makes that decision looking in the rearview mirror because a stock is up a lot, and all of a sudden the market switches stocks or sectors. Investors often see this as a little too much like winning the lottery; they want to put it all on one thing and win big in any given year. That just doesn't work in investing.

TSC: What do you think will happen with the fed funds rate?

Waterman: What the studies have shown is that normally what the feds have done in the past is bring the fed funds rate down to a level that's equal to the rate of inflation. The message there is that inflation as measured by the CPI has been coming down, and we see it down to the 1.5-to-1.75% range. You could very well see the fed funds rate down to a level equal to the inflation rate before they've completed the stimulus they need to turn things around.

TSC: Anything else?

Waterman: We don't try to put a number on where we think the S&P's going to be next year, but we think a lot of ingredients are in place for the market to move higher, but it won't be in a straight line. It will be choppy because it won't all be good news. We'll see it pull back at times based on negative news, and I honestly think that choppiness is healthy. We don't want to see the market move up in a straight line.