By LAUREN R. RUBLIN
The gravity-defying Dow Jones Industrial Average has doubled, and then some, in the past three years. The economy's stamina has put the Energizer Bunny to shame. Inflation is on the endangered-species list. Alan Greenspan sits atop Mount Olympus, and by dint of Viagra alone, sex has surpassed investing as the national obsession. All of which begs a familiar question for U.S. investors: Does it get any better than this?
In a word, yes. That's the view of the portfolio managers participating in our latest Big Money Poll. Fully 40% of those Barron's polled last month confess to feeling bullish about the stock market's prospects through mid-1998, while just 19% describe themselves as bears. The bulls' ranks have remained virtually unchanged since our last poll, in November. But a lot of folks have moved to a neutral stance from a bearish one. For a lot of respondents, it's hard to be remain glum in the face of the ripsnorting rally that has marked this year's first four months.
Of the portfolio managers who were willing to venture a guess on the fate of the overall market, nearly 18% say the Dow will reach or top 10,000 sometime this year. Admittedly, hitting 10,000 represents a jump of 10% from the Dow's current level. Yet a jaunty journey to the neighborhood of 10,000 would mean a glowing gain of almost 27% for the Dow since the end of 1997.
Like many poll respondents, Donald Gher, of Coldstream Capital Management in Bellevue, Washington, sees ample reason for the bull to stay the course. "The end of the Cold War helped change the dynamics around the globe," he says. "It opened up previously closed economies to capitalism, and the U.S. makes the products the world wants to buy."
Beyond that, he notes, the Federal Reserve has done "a great job" of keeping inflation, and thus interest rates, in check. The recent drop in oil prices, he says, effectively has meant a healthy tax cut. Add to the mix an aging population concerned with funding its retirement, and the path seems greased for further stock-market gains.
Gher's office, midway between Microsoft's bustling headquarters and Chairman Bill Gates's home, has a birds-eye view of the wondrous riches this market already has wrought. And he thinks there's more in store. He sees the Dow ringing out the year at a lofty 10,200. "There could be a 5%-10% correction at any time," he concedes. "But in the absence of a full-blown recession or exogenous shock, we continue to believe the market can work its way higher over the next year."
Because of the bull's gargantuan strides in this decade, not to mention the virtually unprecedented length of the current economic boom, it's tempting to reason that the market is due for a rest, if not something significantly more unpleasant. Indeed, the overwhelming majority of Big Money poll participants -- 89% in all -- foresee a market correction of some kind within the next 12 months.
That's the bad news. The good news, and it merits emphasizing, is that most of our correspondents expect the damage to the major averages to be limited to declines of about 10%, in part because they anticipate corrections to roll from one sector of the market to another. Such self-contained upheavals, such as last winter's selloff in oil-service shares, typically lead professional investors to shuffle money from one industry group to another, without ever jumping out of the market entirely. This, of course, limits the downside damage.
The market also has grown expert at adjusting to corporate missteps, our upbeat panelists note. Shareholder retaliation can be brutal, but at least it is swift. "When companies disappoint in this market, they're taken out and shot," says hedge-fund manager Cappy McGarr, of Dallas-based McGarr Capital Management.
"That's very cathartic," he adds approvingly.
Many Big Money managers, it seems, have bought into the "staircase" analogy promulgated by Goldman Sachs strategist Abby Joseph Cohen, whose aptly bullish market analyses have won her a wide and loyal following in the past few years. Cohen likens the upward thrust of U.S. stock prices to a staircase, in which sizable price gains (the step up) are followed by a trading range (the flat part of the step). Last week she cautioned clients that the market appeared to be entering another trading range, amid concerns about possible Federal Reserve tightening and the prospects for corporate profits.
A respite could be just what the doctor ordered, says Paul Jackson, of Paul J. Jackson & Associates, in Newton, Massachusetts. "I would love to see a plateau or a pullback here, for the sake of the market's health," he says. "This is not a sprint. It's a marathon."
Above all else these days, the Big Money bulls are awed -- and alarmed -- by stock valuations, which have climbed relentlessly since the start of this year. At current levels, the S&P 500 is fetching a near-record 28 times last year's operating earnings, compared with a price-to-earnings multiple of just under 20 a year ago. The Dow Industrials sport a multiple of 23 times '97 earnings, versus last spring's considerably less flashy P/E of 17-18.
And what of Coca-Cola and Microsoft, stocks the Big Money men and women overwhelmingly knocked in this poll as the market's most excessively valued issues? Coke, at 76, sells for 40 times this year's estimated earnings of $1.90 a share, while Microsoft, at 90, goes for 44 times net.
Small wonder managers such as Clyde McGregor, a partner at Chicago-based Harris Associates and manager of the $475 million Oakmark Equity & Income fund, find it "intellectually most satisfying" to be bearish. "We've had three-and-a-quarter years of wonderful stock-market returns," he observes. "Who would have thought that seven years into an economic expansion, companies would tell us they have to cut prices to get customers? So, I would prefer to be negative, or negatively neutral, on the market. But I just can't get there from what I see, hear and smell."
Call McGregor an incredulous bull. "My hope for the year was to be up 10%, and I'm up 10%," he said recently. "We've certainly seen a much stronger start to '98 than I anticipated, but the underlying conditions warrant it. Whatever social theorists might think, the management of American companies today is so much more focused on helping shareholders. The fact that the market can withstand Asia's falling apart, Presidential rumors and the like suggests it will take something much more fearsome, and by definition unforecastable, to shake people up. I don't like today's lofty stock valuations -- but you've heard 150 portfolio managers say the same thing."
However worried the Big Money managers may be, most of them plan to stick to their current strategies. As a group, they plan to shave their collective exposure to stocks only slightly in coming months, reducing it from 73% to 70.6%. Similarly, they claim they'll merely tweak their allocation to bonds, lifting it to 18% over the coming 12 months, from today's 16.5%. And they'll raise just a smidgen more cash in the next six months, nudging their exposure to 12%. (Because some managers also hold real estate, commodities and other assets, the aforementioned allocations don't add up to 100%. In addition, some firms manage balanced accounts, a practice that automatically lowers the group's mean equity allocation.)
Have the managers, who fret about the public's complacency, themselves grown complacent in the face of the market's torrid advance? Not exactly. While the pros have left their clients' equity exposure unchanged over the past six months, they've cut their personal stock holdings to 75% of assets, from 79%. And they have 14% of their own money sitting in cash, up from 11% six months ago. (Although 53% of our correspondents view bonds favorably, compared with the 12% who think prospects for them are dim, the managers evidently aren't big bondholders for their own accounts.)
Big Money stockpickers still rail, as they did in November, against highflyers such as Coke, Microsoft, Gillette, General Electric and Dell Computer, all of which they rank among the market's most overvalued issues. But the managers gradually have grown more accepting of the dominance of these mega-stocks. Will the so-called New Nifty Fifty, a clutch of bluechip Goliaths, continue to lead the market over the next six to 12 months? Perhaps so. Last fall, when investors feared Asia's woes might imperil the growth prospects of U.S. multinationals, 80% of our crowd said "nay." In the intervening months, however, doomsday pundits have released their grip on the panic button, and the market's biggest stocks have proved their mettle. Consequently, they've earned the pros' respect.
Today 47% of Big Money managers think the New Nifties will continue to chart the market's course. That, by the way, is about the same percentage that look favorably on blue chips in general.
It's obvious that buying the biggest stocks in the capitalization-weighted S&P moves the index higher. But that's just what Coldstream's Gher is looking for. "In the year's second half, we expect economic growth to slow to 2%-3%," he says. "That favors high-quality, large-cap stocks such as Merck that can deliver dependable earnings. By definition, money flowing into these stocks will push the market up." (Merck, one of our managers' favorites, two weeks ago surprised its fans with lower-than-expected profits, and the stock tumbled sharply, to 119 7/16. But investors are nothing if not forgiving; Thursday the shares jumped 4 1/2, and now repose above 120.)
For the past two years, the Big Money poll has been conducted for Barron's by Beta Research, of Syosset, New York. The current endeavor drew responses from 230 portfolio managers, including many first-time participants. Some manage less than $25 million, while others handle billions for mutual funds, bank trust departments and private firms. The managers represent a cross-section of styles, from Graham-and-Dodd value investors to aggressive growth seekers. Our mix is also spiced by asset allocators, convertibles pros and hedge-fund managers; and some managers specialize further according to company size, favoring large-, medium- or small caps. On average, the managers have placed just over half of client assets in large-cap stocks, with mid-caps accounting for a further 25%, and small-caps 21%.
Our latest poll, mailed out in early April, caught much of Wall Street reveling in the market's 13.6% first-quarter gain. At the time, the Dow stood on the cusp of 8800, the S&P was at 1101 and the Nasdaq Composite at 1835. The prevailing ebullience rubbed off on our respondents, some of whom had performed none-too-shabbily themselves in the year's critical opening months. In particular, their once-grim view of Asia's likely fallout on the U.S. economy and markets had been tempered by the winter's encouraging events. "If the financial markets are a leading indicator, and they're the best, they are signaling that Asia is stabilizing," says Jim Kaplan, president of Boston-based J.L. Kaplan, which manages $600 million in assets.
Some 66% of Big Money panelists expect Asia's financial crisis to have a lingering impact on the U.S. stock market, with several seers citing Japan as the source of gravest concern. "On one level, I think most of Asia's economies are too small to bring down the U.S. economy," says Alan Hoffman, a senior portfolio manager at Value Line Asset Management in New York. "At the same time, Japan has much more of a direct stake in what happens in Thailand and Malaysia and Indonesia. The failure of Yamaichi Securities last year was pretty cataclysmic, and a few more prominent failures would be dangerous."
Yet a number of portfolio managers see the silver lining, not the cloud, and they expect the U.S. to reap numerous benefits from the erstwhile Asian Tigers' malaise. In the near term, at least, the crisis has helped put a lid on commodity prices, which has prevented the U.S. economy from overheating, and quite possibly kept the Fed from raising interest rates. In addition, turmoil overseas has made our market a safe haven for jittery investors everywhere. And Asia's fire sale has offered opportunities aplenty for intrepid American firms.
"Psychologically, the effect of the Asian crisis already is abating," says James Pappas, proprietor of James Pappas Investment Counsel, in Longboat Key, Florida. "Certain industries still might be afflicted, but others could enjoy a positive effect. American companies can go across the ocean and buy plant and equipment more cheaply."
As a group, the Big Money managers expect the Dow to end the month of June at 8905.77. Upon closer inspection, however, 54% of panelists envision the market finishing June at or above 9000, while 13% think the mighty Dow will be looking down from a perch of 9400 or higher.
Typically, the managers worry more about the distant future, and the latest survey is no exception. There is a lot more that could cripple the market over the next nine months than the next three, they reason. While an impressive 40% of our respondents call themselves "bullish," or even "very bullish," about stocks through year-end, only three in five members of that group are bulls about the current quarter.
A fourth of the panelists feel sufficiently worried to call themselves bears about the market's propects at year-end '98. Some of these are long-term bears, but most are neutral for the short term and plan to defect to the bear camp as the year progresses.
The managers look for the Dow to wrap up '98 at 8877, although they estimate the average will hit an interim high of around 9513 before settling back to that 8877 level.
Again, it's instructive to put the data under a microscope. The group's collective predictions are thrown off by 11 exceedingly dour souls who believe the Dow will slide to 7000, or lower, by the year's final bell. Conversely, 36 respondents, or almost 16% of the total, look for a close of 9500 or better.
And consider this: If the Dow does bow out at 9500, it will be up a handsome 20% on the year. But most of the gains will have come in the first quarter, suggesting a lot of running in place in the frustrating months ahead.
According to the average of our panelists' predictions, the S&P 500 will end '98 at 1128, just around the corner from the index's current level. The greatest proportion of responses, however, is clustered at 1150, followed by the 1200 level.
If our Big Money managers are right, the technology-freighted Nasdaq Composite will end the year down from last week's close, at 1848. Again, our respondents were not uniform in their views. In fact, one wild-eyed prognosticator sees the Nasdaq hitting a high of 2851 sometime this year. Don't bet your bottom dollar on that one.
Let the record show that the Big Money pros are high on technology shares, notwithstanding the sector's frequent booms and busts. Compaq and Cisco Systems are perennial favorites among our panelists, although Cappy McGarr can't resist pounding the table for Dell. Never mind that the shares, at 80, now fetch more than 33 times next year's earnings; "It's a great company, and management owns a huge amount of stock," he says. "Dell boasts 60% return on equity, versus Compaq's 20%, and the company's Asia business actually is up."
McGarr bought Intel, which tied for first place among the managers' picks, for 14-15 times earnings, but confesses he sold it when the P/E on the shares hit 20. "When a stock reaches its growth rate, we have to take a hard look at what will make it go up from here," he says. He's not the only one of our pros eyeballing Intel. In fact, some of them are looking to buy now that the shares have toppled to 80 from an earlier peak of 102.
Although most Big Money panelists are stockpickers, they're all too aware that they might be singing for their supper if the economic backdrop weren't so close to perfection. Right now the economy is neither overheating nor precipitously cooling; interest rates are near historic lows, and corporate profits still are growing, if at a somewhat slower clip than in the past two years. "When you get down to it, it's nirvana," marvels Ellis Smith, of San Diego's Messner & Smith Theme/Value Investment Management. "The planets are lined up. We never thought it could happen. And, like an aircraft carrier going 30 knots, it will take a bit to slow us down."
The managers, as a group, see no looming threats to the health of the U.S. economy, although they think economic growth will slip to between 2.6% and 3% over the course of the year. Nor, despite last week's market rumblings, do they expect the Fed to start jacking up interest rates. "I really think they were jawboning," Smith says of the central bank officials who recently hinted through the press that the Fed was leaning toward tightening. "Is the Fed going to make the same mistake as in the past, and try to take the punchbowl away? You're assuming they haven't gone to the library and read the history books, too."
That said, there still are pockets of disagreement across this fat and happy land. Jim Kaplan, of J.L. Kaplan Associates, for one, isn't quite ready to hang out the crepe for inflation. "We think rates and inflation are going higher," he opines. "Wage inflation, which is quite strong, is being masked by commodity price drops, including a drop in oil. And the dollar could face competition from the euro, which is likely to become a reserve currency once it's introduced."
Yet, rightly or wrongly, such worries aren't widespread. Okay, maybe this crowd is complacent: Poll participants see the unemployment rate inching up only slightly and inflation growth hovering around 1%, while bond yields remain virtually unchanged through the end of the year. They've got the gold price going nowhere, at around $315 an ounce, and they're looking for oil to sell at $16-$17 a barrel for the next eight months. That's not stopping the managers from being enthusiastic buyers of oil-services shares, which soared for two years only to make a recent reappearance closer to earth.
"If you think back 15 years to the last oil crisis, there was a lot of activity in the domestic energy sector," says Gher, of Coldstream. "Then the crisis ended, Houston went to hell, and rigs were left to rust in the desert. Well, that era's played itself out. Now there's a new secular play in oil, driven by the need to cultivate new productive resources."
Gher's prospecting has led him to Transocean Offshore, specialists in deepwater drilling. "The shallow water space has become fairly crowded, so you want to buy people who are good at finding oil where there aren't many others looking," he says. Last week Transocean moved up to 59 5/16, after posting first-quarter earnings that were nearly triple year-ago results, on an 18% rise in sales.
In some ways, the Big Money managers themselves are a bit like Transocean: As investors pile into the leaders of the Standard & Poor's 500, hoisting P/E ratios to once-unimagined heights, these pros have had to dig for value in the market's murkier precincts. Quips Stephen Bache, chief investment officer of Hamilton & Bache, in Glendale, California, "Nothing is cheap today. Some things are reasonable."
Ironically, an unprecedented level of takeover activity also has complicated matters, as Jim Kaplan explains. "We had 14 takeovers in our portfolio in the past 15 months," he says. "It's not that we target takeover candidates, but the factors that draw us to companies are the same as those an acquirer looks for. As the market climbs higher, the number of stocks that still attract us is smaller than the number we were forced to sell."
These days, Kaplan's got a big stake in Chase Industries, a Montpelier, Ohio, maker of brass rods that earned $2.36 a share last year, on revenues of about $500 million. At $32 a share, he notes, the stock is fetching less than 13 times estimated '98 earnings, and considerably less than one times sales.
Unlike little Chase, with 10 million shares outstanding, big-cap stocks with skimpy multiples usually have big problems. Take, for example, Philip Morris, whose chief role in the Dow seems to be making the much-put-upon Eastman Kodak feel better. The tobacco sector's litany of legal and legislative woes needs no recounting. Why, then, has Big Mo drawn more fans from the ranks of the Big Money crowd than any stock save Intel?
First and foremost, Philip Morris is changing hands at 37, only 12 times this year's estimated earnings. "Fundamentally, it's a compelling story," says money manager Paul Jackson. "We still think it's a $60 company. For all intents and purposes, the tobacco deal is dead, although you never know in Washington. Later this year, I think you will see a stock buyback, maybe a dividend increase. The company will say, 'Our shareholders have been more than patient while we tried our best to appease everyone. Now let's take care of them.' "
Because the managers follow so many different investment disciplines, it's rare to find unanimity about their favorite stocks. Far more often, they're in agreement about which stocks are most overvalued. Coke, as noted, again topped the rankings, with an astonishing 59 votes, followed by Microsoft, with 42, and Yahoo! (the exclamation point emphatically isn't silent) with 26. Gillette and Pfizer also took a lot of heat from this group; new-product hype, the portfolio managers say, has levitated both to unsustainable, if not unreasonable, levels.
The managers haven't had much luck panning Gillette before, although the shares, at 117, are down a few points from a high of 125. Still, the stock is changing hands at a more-than-generous 34 times estimated earnings. The company has high hopes for its new Mach3 razor, but the Big Money managers fret that Gillette could be ripe for a major haircut. "How much good news can you squeeze out of a $70 billion market capitalization?" ponders small-cap manager Warren Isabelle, of Boston's Ironwood Capital Management. "Let's say the new razor does $1 billion in sales, and the company's total sales are $10 billion. That means it's only going to contribute 10%. Like the Jack Nicholson movie, this is 'as good as it gets.' "
Can the same be said of Pfizer, whose Viagra impotence drug, though two weeks young, already has made the cover of Time? Some of our managers think so, each time they contemplate the company's P/E of 46. Notwithstanding Viagra's evident appeal, notes Donald Gher, Pfizer is selling for roughly the same price as Merck. Yet Merck, he wagers, will earn almost twice as much this year. "Either Merck is extremely undervalued or Pfizer is overvalued," he concludes. "When investors came out of energy stocks a few months ago, it was 'look out below.' Pfizer could end up like that."
As the Dow once more closes in on the record high it set in mid-April, skeptics are waiting for a fall. After all, this bull has run so far, so fast. But it will take more than high P/Es to drive the Big Money managers out of this market. As long as interest rates and inflation remain benign, and U.S. companies keep posting profits, our managers plan to stick around. And why not? They're expecting a most enjoyable ride.