In the halcyon days of the late 1990s, the old joke that a dart-throwing monkey could pick stocks as well as the highest-paid portfolio managers on Wall Street was probably not far from being true. Five years after the tech-bubble burst, the investing environment has gotten a lot murkier. But we can again turn to our distant cousins on the evolutionary scale for some tips. Scientists have recently observed gorillas in Congo for the first time using "sticks to test the depth of muddy water and to cross swampy areas," according to BBC News. And at the outset of the fourth quarter, the investing environment outlook seems very much like those muddy waters in Congo. S&P 500 such as Alcoa ( AA), FedEx ( FDX) and Union Pacific ( UP) have already lowered their guidance. In the coming weeks, other firms may declare special charges in the aftermath of Hurricanes Katrina and Rita; such charges don't impact operating earnings but can still weigh on share prices. In addition, many companies may guide fourth-quarter earnings lower due to higher energy and commodity costs and a murkier economic outlook. "It's going to be hard for the market to separate the truth between the real impact from
Hurricane Katrina and whether the economy is really slowing," says Owen Fitzpatrick, head of U.S. equities at Deutsche Bank. "How that will unfold, and especially any 2006 outlook, will be more of a factor for investors than actual third-quarter earnings and fourth-quarter outlooks." Still, strategists such as Fitzpatrick are already sticking their necks out to come up with some forecasts. It might be worthwhile to listen, just to put things in perspective. Bulls hope that up to $200 billion of governmental spending to rebuild southeastern states hit by Katrina and Rita will jumpstart the economy and profits next year. While the extent of the fiscal stimulus remains debatable, the huge projected injection of government money is also fueling further inflation concerns.
First, a large share of the money will be spent on building materials, boosting their prices further and raising input costs for businesses. Second, the vast government outlays will exacerbate the federal deficit, potentially putting downward pressure on the dollar. Third, the additional supply of government debt issued to pay for recovery could put upward pressure on rates. Such potential inflationary pressures help explain why the Federal Reserve seems poised to continue raising interest rates well into next year, fueling fears the central bank may break the back of the economy and cause a recession. But for now, the dollar remains remarkably strong -- hitting new multimonth highs against other major currencies last week -- while Treasury yields are remarkably low; the yield on the benchmark 10-year note closed Friday at 4.33%. While the 10-year's yield is up from its recent lows below 4%, it remains pretty tame by historical standards. As a result, the stock market is currently 25% undervalued based on the so-called Fed model, according to Citigroup strategist Tobias Levkovich. The Fed model compares the S&P 500's earnings yield (the inverse of its price-to-earnings ratio) to Treasury yields. Based on this metric, the strategist comes up with a target of 1450 to 1500 for the S&P 500 in 2006. This would represent an 18% to 22% gain from current levels and an 11% to 15% rise from Levkovich's 2005 year-end target of 1300. However, the strategist ratcheted down his 2006 target on the S&P to a "more conservative" 1400, leaving room for the possibility that energy costs will start taking a bite out of earnings growth, and to take into account decreasing corporate profit margins from currently high levels. (Crude approached $67 per barrel last week before ending Friday at $66.24; natural gas futures, meanwhile, hit at an all-time record high last week.)
But relying on low bond yields as an indication of valuation is misplaced, according to J.P. Morgan strategist Abhijit Chakrabortti. The Fed model does not take into account a starting point of equity valuations nor that interest rates are very likely to move higher from here, he says. Putting things back in perspective, earnings have rebounded some 155% since hitting a post-bubble trough in 2001, Chakrabortti notes. The magnitude of an earnings rebound has been on average 150% after the previous equity bubble periods in the U.S. in 1919, 1947 and 1933. Furthermore, stock valuations eventually declined to pre-bubble levels following prior market manias. "If this were to occur, the market P/E ratio would need to decline a further 20% (or more) from the current level," Chakrabortti notes. While he hasn't come up with an S&P target yet, Chakrabortti believes the broad index (and the market) will drop next year and finish 2006 well below current levels. A middle-of-the-road estimate of next year's performance comes from Jack Ablin, chief investment officer at Harris Trust, who, appropriately enough, sees the market as currently fair-valued. Profits for most firms have remained sound and the third-quarter promises to be the eleventh consecutive quarter of double-digit earnings growth for S&P 500 companies, he notes. And combined with still relatively low interest rates, the market could be seen as slightly undervalued. But because of all the uncertainties plaguing the economic outlook, a flattening yield curve, rising energy prices, inflationary pressures, and underlying bullish sentiment for stocks "we're fairly valued," Ablin says. "Until I see higher interest rates, energy and inflation really start taking their toll on
stock prices , I'll remain neutral on this market." As things stand, he does expect stocks to move lower next year, which means "we'll move to an underweight position" in stocks and move into cash.
Again, a lot will depend on how much the market has already discounted existing risks, which could provide buying opportunities if some of those risks don't become reality. Fitzpatrick, for one, believes the market has already discounted some economic anxiety related to Katrina and Rita, but that there is still more to come because of the uncertain impact on profits. In reality, trying to determine what is and isn't "priced in" to the market is very hard. Even the most highly educated estimates by the most astute market pros amount only to a slightly more evolved version of gorillas using sticks to test muddy waters.