Thomas McManus, equity portfolio strategist at Banc of America Securities, isn't the best-known strategist on Wall Street. But for the past few years he has been among the very best. In fact, McManus was named
Guru of the Year for 2000, during which he continually lowered his recommended equity allocation and warned that big-cap tech stocks were dangerous to investors' health. Unlike others who made such proclamations, McManus is no "permabear," having recommended a "fully invested" posture from May 1999 until early 2000. This year, McManus continued to preach caution, arguing that earnings estimates remained too high and that the economy didn't justify aggressive equity bets. For much of the year, he retained a recommended equity allocation of about 60% to 65%, among the lowest of the so-called major strategists. By favoring defensive groups such as health care and a heavy dose of bonds, McManus again served Banc of America's clients well in the first eight months of 2001. Then came Sept. 11. In the wake of the attacks and the resulting selloff, McManus raised his recommended equity allocation on Sept. 24. But by mid-November, McManus reverted to a cautious stance, declaring that the market seems vulnerable to a retest -- at least -- of the September lows. McManus reiterated that view and explained his rationale in an interview with
Justin Lahart and Aaron Task on Wednesday, the day of the market's big breakout move, as fate would have it. The strategist also revealed the single market indicator he would want if he were stranded on a desert island.
TSC: What are your thoughts on the market now?
I think the consensus in the market is depending on some very circular reasoning: that we can use the rally in stocks from the September lows as support for the proposition that the economy is recovering sooner than previously expected. And then the assumption that the economy is recovering sooner than expected as support for jumping into stocks at these high valuations.
TSC: What's your take on what earnings growth is going to be next year?
We think about flat.
TSC: What's the market saying about earnings growth?
The consensus numbers are for a gain. This is really tough to measure because so many people are using a very low estimate for earnings in 2001. And maybe it's a little easier to look at the two-year change in profits. Because there weren't that many write-offs in 2000, and nobody is projecting write-offs in 2002. So you're comparing apples to apples. In that case the average two-year decline is about 9%. We're looking for 12%. But there's someone out there who's looking for a 35% decline. And there's someone out there who is actually anticipating that earnings will be up in 2002 vs. 2000. We reject both the extremes of the distribution. We think earnings will be down a bit more than the average strategist.
When we look at the bottom-up numbers, it looks like the average gain for next year is about 14%, and while we use a similar profile, we think that there will be three more negative quarters. That is the current quarter, and both of the quarters in the first half of next year will be negative, and that we'll be flipping into positive territory, at least in terms of a year-on-year comparison, in the second half. The consensus numbers are that the second quarter will be positive, and the market seems to be acting as if the first quarter will be positive.
'I find it troubling that the market is so circular in its reasoning.'
TSC: That's what I was trying to ask. What does the market, and the rally in the market, say to you about expectations for recovery?
That a lot of stocks will earn more in 2002 than they did in 2000. We think that will be very difficult. We think some companies will have difficulty earning more in 2003 than they earned in 2000.
TSC: Right now the estimate for 2003 for the S&P 500 is $64.13 vs. $49.50 in 2002. That's a tremendous gain.
Those numbers generally come down during the year. I think most people would say $64 is quite unlikely. We are penciling in that 2003 will match 2000. Obviously, some companies will be able to exceed 2000 earnings in 2001, like a lot of health care companies will, and they'll exceed them in 2002, and they'll exceed them in 2003. And some companies are going to be down so much in 2001 that even if they have a tremendous recovery in profits in 2002 and 2003, they still won't be earning more in 2003 than they did in 2000. That's where I think a lot of the technology companies are.
People are buying into technology based on nothing but the slope of the recovery, with very little thought toward the secular growth rate once we do recover.
TSC: It seems that what most investors remember is not how the market has done since 1998, but the blowoff top that occurred from late 1998 through early 2000. As a strategist, how do you factor in that kind of psychology? A lot of people who look at the fundamentals say this market is overvalued. But if people want to own stocks, it doesn't matter what the fundamentals look like. How do you factor that into your work?
One of the things about Sept. 11 is it has caused us all to consider the short window that we are members of this community. It helps you think about why you save and what your expectations are for saving. One of the things that comes back to me is that I'm a baby boomer, but I'm at the tail end of the boom, having been born in the mid-1950s.
TSC (Lahart): I thought you were much younger.
TSC (Task): Much younger.
Better looking, but ... You're going to edit this heavily I hope.
TSC: We're going to give you 10 cent words. You're going to say "quotidian" someplace.
I hope you give me some 50 cent words.
Anyway, we know that valuations have been rising as more Americans have embraced equities as an important part of their retirement planning. The question is, can we assume that stocks will be as fully valued when we need to be selling them as they are today. I calculated the weighted average return for three years for the 10 largest mutual funds, which have a total of $425 billion in assets, and I found that this was below 4% per year on average. And this is despite the fact that three years ago was widely presumed to have been an extraordinarily attractive time to have bought stocks.
What that might mean is that an investment in the stock market need not capture the full gain of the earnings of the underlying companies, because if you buy in at a price that is high relative to those earnings and you're forced out at a price that is low relative to those earnings, your compound growth, even over long periods of time, might be significantly lower than the rate at which value is being created in the market overall. Investors need to be sensitive. You can't just say "
dollar-cost average" because there are times that stocks are unattractive. You can't say, "You can't time the market," because, eventually, everyone is going to start redeeming. And at that point their investment starts to become very short, and it becomes a matter of saying, "Should I sell 12 months worth of expenses in my stocks today, or should I sell gradually over 12 months."
The reason I'm more sensitive to this is, being a young baby boomer, I'm basically traveling in the wake of the older boomers who are setting or establishing higher prices than have existed for some time in quotidian
that is, common stocks.
'Stock prices were lower in 1988 than they were in 1987. What you saw there was a disconnect. The market was so enthralled by the potential for strong earnings growth and a sharp recovery in the economy that stock prices just went up, up, up until they reached a point where the market had a heart attack.'
TSC: In your role as a strategist, what kind of time horizon do you judge yourself by? For much of last year and this year, you were defensive, and then shortly after Sept. 11, you suggested people should be a little more aggressive in equities, and then you took that off the table pretty quickly. Now we're having a pretty explosive rally. Are you comfortable being defensive at this point?
We have multiple time horizons because we have multiple constituencies. The reality is that most of the institutional investor community can't help but keep a sharp eye on the next year-end. That doesn't extend to December 2002. That extends to December 2001. People might say I made a great call in April or March, or that it was a good call in September, but in this business it's always what have you done for me lately. And I'll have to say we might have been a little bit too early in following the valuation discipline of our model, and we underestimated the extent to which the market would buy into the concept of a quick recovery.
Again, I find it troubling that the market is so circular in its reasoning. Saying that, we'll use the strength in stocks to justify our bullish view on the economy and we'll use our bullish view on the economy to suggest that stocks are the place to be.
What we have seen since the September lows has been the most dramatic increase in expectations for future
Fed tightening actions since the spring of 1987. On Sept. 14
this year the market was expecting that the cumulative easing by the Fed over the next year would be about 25 basis points. Admittedly very sharp easing in the near term, but that the Fed would be moving into a tightening mode in 2002 and that by September 2002 the
fed funds would be lower than they were Sept. 14. Remember that was 100 basis points ago, so fed funds was at 3 and people were expecting a rate of 2.75 by September of '02. Now the 12-month expectation for Fed action is an increase of 150 basis points from current levels. By December of '02 the market expects the fed funds rate to be 3.5%.
At some point, if this is correct, the Fed is going to stop easing, adopt a neutral bias, adopt a tightening bias, and we'll start to see these improving earnings expectations. At that point, you might see valuations return to such an attractive level that I might be able to get reinvested into the market with a lot more evidence that the economy has recovered and that earnings are improving. But I'll be able to get in at such a much better valuation that I might not have to pay that much more to buy my favorite stocks. On a risk-adjusted basis, even if I have to pay a higher price to buy stocks with more confidence and more visibility in the future, I'll feel it was a better purchase.
TSC: We were just talking about this. Looking at risk with hindsight. Someone was writing on our site that bonds were a riskier place to be in September than stocks. But really, they were just a better place to be. Bonds are always safer than stocks.
Well, bonds can get overvalued, too. With the
the CBOE's Market Volatility index, also called the
VIX at 45 on a closing basis for five days in a row -- 55 on an intraday basis on Sept. 20 -- one would have had to make some pretty ugly assumptions, indeed, to justify a lightening of equities at that point. We raised our equity weighting.
I'll tell you, if I had to be sent to a desert island with only one indicator on which to try and trade, it would be the volatility index. It's real-time. It's focused on what people are doing, not what they're saying. It's relatively linear. And it helps me understand, as a buyer or seller, whether I'm dealing with a motivated counterparty. When the VIX is very high, it's a good time to buy, even if you know nothing else, because you can presume that most of the bad news is pretty widely understood.
TSC: What are your current thoughts on the volatility index? In September it never got up to the extraordinarily high levels of 1998. It's now hovering in the mid-20s, which is not anywhere near historic lows, either. Are there absolute numbers you look at, or do you look at it in relative terms to where it's been?
The answer is both. I would look at in terms of an absolute. Something in the low 20s means there's very little fear in the market. And the fact that we are so very far away from a 52-week high tells you that there's been a marked reduction in the amount of fear out there. There's no magic number, per se, but there are ranges.
Right now the risks are high. I mentioned that statistic about 1987, thinking you guys would say, gee, what happened in 1987. Back then there was a sharp increase in profits, but something else happened first. That is, stock prices were lower by the time we got that dramatic improvement in profits that occurred in 1988. Stock prices were lower in 1988 than they were in 1987. What you saw there was a disconnect. The market was so enthralled by the potential for strong earnings growth and a sharp recovery in the economy that stock prices just went up, up, up until they reached a point where the market had a heart attack.
'We have to watch out that we're not dogmatic in our views. We have to be flexible. We have to make sure that when we see evidence that things are improving that we don't become a stopped clock.'
TSC: There's this sort of perception in the market now that capital spending is creeping up or about to creep up. We can argue whether that's true or not, but let's say it is. It's led to this idea that now you don't risk being wrong, you risk being early -- maybe without thinking about how wrong being early can be.
That's a great point. We have returned more quickly to an environment where people feel the only real risk is not owning enough. The only real risk is missing this tremendous rally. But I think there is a world of opportunity out there for people who are patient. And one of those opportunities is simply keeping your powder dry until you see an attractively valued investment. And usually there's plenty of time to take advantage of that attractively valued investment. It was bonds back in late 1999, early 2000. It was an opportunity that lasted for several months to buy bonds at what was clearly a level that presumed the Fed wasn't going to be successful at slowing down the economy, or that the Fed didn't need to be successful because, after all, it was a new era. Long-bond yields were, what, 6.70% or something.
TSC: Tom, if we can extrapolate that example of bonds to the stock market, are you saying that you would need to see a prolonged period of stocks either at an absolute basis or a valuation basis before you would feel confident the risk-reward scenario was in your favor. So what we're seeing now is just a short-term bounce?
We have used that terminology before, that this is an oversold bounce. One of the things that's surprised me is how fleeting that buying opportunity actually was. Usually, the market gives you more of a window to appreciate how attractively valued things were. We have to watch out that we're not dogmatic in our views. We have to be flexible. We have to make sure that when we see evidence that things are improving that we don't become a stopped clock.
That said, one can still pursue a strategy where one has a core investment in stocks and one increases or decreases that investment based on several major factors. First, an analysis of economic trends and likely earnings revisions. Second, average valuations. Third is the amount of liquidity that's out there that's able to drive higher valuations in stocks. And fourth is how investors feel about stocks generally, and whether there are changes in those feelings that might explain the recent movement in stock prices.
We're going to continue to apply these lessons we've learned over time and hope that we're not found to be inflexible or dogmatic. We're going to apply our best analysis to the new data coming down the pike.
For the life of me, I can't figure out why everybody is celebrating these economic indicators that are based on sequential measurements. Simply telling me that things were better in November than in October -- or that they were less bad in November than October -- simply isn't enough to get me confident that earnings will be good enough to justify stocks at these levels.