Smoke Signals
Industrial stocks, along with financials and healthcare, are the market's hot spots
In the very early stages of a bull market, investors tend to act a lot like teenagers: They're carefree and impetuous, and they take a lot of chances. That was certainly the case last year, as Wall Street took a "What, me worry?" attitude and bid up small, speculative, and even profitless stocks. "I don't think we're going to see that this year," says Christopher Orndorff, head of equities for Payden & Rygel. "This is going to be a more mature market."
Bull markets, like human beings, eventually grow up. They settle down and slow down. After a year in which the Nasdaq soared more than 50 percent, Mark Jordahl, chief investment officer for U.S. Bancorp Asset Management, thinks the market will see "upper single-digit to low double-digit returns." Smith Barney strategist Tobias Levkovich thinks the S&P 500 could even fall slightly in 2004, saying "a low-return environment for the next several years may be in the making."
That's in part because as bull markets age, investors start to worry more. They demand not only the potential for future growth but consistent earnings and current revenue growth. That shift in attitude, should it come to pass, could put the spotlight this year on a couple of sectors that were somewhat overlooked in 2003: financial services and healthcare. The latter should see 15 percent earnings growth in 2004, up from 10 percent last year. And as the economy improves, financial services firms like Citigroup may well see double-digit revenue growth.
Changing gears. Meanwhile, as the economy downshifts from the torrid growth of the third and fourth quarters, investors are likely to switch in 2004 from "early stage" cyclical sectors like technology, retail, housing, and autos to more "mature stage" sectors, in anticipation of a pickup in business spending and production. The recent uptick in manufacturing, for instance, could spark more interest in the stocks of basic materials companies, like DuPont, and energy firms like ChevronTexaco or ConocoPhillips.
This shift will also benefit the big blue-chip stocks like Microsoft at the expense of small unproven companies that tend to do best at the very earliest stages of a recovery. Though the Russell 2000 index of small-cap stocks trounced the megacap Dow Jones industrial average last year, their fortunes reversed last month. Over the past four weeks, the Dow gained more than 7 percent while the Russell rose only 4 percent.
If the dollar continues to weaken and global economies recover further, that would strengthen the case for large-cap dominance. A falling dollar means greater profits for U.S. companies that generate business and profits overseas, such as General Electric and Coca-Cola. If investors start to think about dividends again--as market strategists say they should given last year's reduction of taxes on this income stream--that too would benefit large stocks, since their dividend yields are on average 70 percent bigger than small stocks. "When you move into an environment where stock appreciation isn't 20 percent or more, but perhaps half of that or less, dividends become a larger percentage of one's total returns," says Harvey Hirschhorn, head of asset allocation and strategy for Columbia Management Group.
By historic standards, this bull market is already middle-aged. Though investors were spoiled by extraordinarily long bull markets in the 1980s and '90s, bulls have typically lived an average of only 36 months. But while this bull run may be nearly half over, it's by no means headed for the pasture just yet.
For one thing, there's plenty of economic wind at its back. The recovery that propelled stocks in the second half of 2003 shows no signs of letting up, as economists now forecast a jump of 4 percent or more in gross domestic product this year. What's more, the world could be in store for the first synchronized global recovery in about a quarter of a century, says John Caldwell, chief investment strategist for McDonald Financial Group. A recent survey of fund managers by Merrill Lynch found expectations for GDP growth in the G-7 industrialized economies of 4.5 percent in 2004, up from 3.5 percent as was previously estimated.
Risky business. Of course, there are risks. Though the Federal Reserve has made it clear that it does not intend to raise short-term interest rates anytime soon, that could change if policymakers start to see inflation risks or the decline of the dollar on foreign exchange markets accelerates alarmingly. Already, there are fears that corporate earnings, while still rising, will grow at a slower rate in 2004. "As the recovery ages and the profits increase at a slower rate, equity prices lose momentum, sometimes leading to a plateau or a correction," says Sung Won Sohn, chief economic officer of Wells Fargo Banks.
Take technology stocks. In 2003, the stocks of tech companies in the S&P 500 soared nearly 47 percent, based in part on the 87 percent jump in tech earnings last year. This year, the pace of tech earnings growth is expected to slow to 33 percent.
But not all sectors are slowing down. The basic materials sector, for instance, is expected to enjoy earnings growth of 49 percent in 2004, up from 11 percent last year, according to Thomson First Call. This sector is benefiting from two concurrent trends: the rise in global production as well as the substantial jump in prices for raw materials. Prices on raw materials like scrap steel and copper soared more than 18 percent over the past year. Though some worry this sector is overpriced--materials stocks soared 35 percent last year and now trade at an average price-earnings ratio of 22 times 2004 projected earnings--many believe there's still some room to run. "In an environment of a weakening [dollar], strong demand from China, and good supply-side restraint, all of which underpin the strength in commodity prices, we are still overweight the sector," notes Abhijit Chakrabortti, global equity strategist for J.P. Morgan Chase & Co.
Banc of America strategist Joseph Quinlan likes big-cap stocks in this sector, including DuPont, a chemical giant that also offers a fat 3 percent dividend yield. He also likes aluminum giant Alcoa. Donald Ross, chief investment officer for National City Investment Management, favors Freeport-McMoRan Copper & Gold. Though this stock soared 154 percent last year, it still trades below its industry peers.
Another attractive sector is energy, argues James Stack, editor of the InvesTech Market Analyst newsletter. Given the low valuations of natural gas companies, Stack picks firms like EnCana, a Calgary-based natural gas exploration company whose shares trade at just eight times earnings.
A strong economy and an accommodative Fed should benefit the financial services industry. This is particularly true for big banks, which stand to gain from both an increase in commercial loan demand and a decrease in loan defaults. Payden & Rygel's Orndorff favors big, diversified banks like Citigroup, which trades at a modest P/E ratio of less than 17 and sports a 2.2 percent dividend yield. Still, there are pitfalls in this sector. Keep away from banks with big mortgage portfolios, as rates are on the rise and refinancing activity is shrinking.
Finally, there's healthcare. Though the sector rose 13 percent in 2003, healthcare stocks were among the laggards of last year's bull run. Concerns about the dearth of new drugs hit big pharmaceutical stocks such as Merck hard. But with merger and acquisition activity expected to pick up this year, even Big Pharma is getting another look.
Stack favors companies that are trading at reasonable prices based on their cash flows, such as Pfizer and Bristol-Myers Squibb. For his part, Orndorff likes beaten-down Johnson & Johnson. As one of the few Dow components that lost ground in 2003, J&J now trades at below-market multiples. But Orndorff thinks the company can post earnings growth of 15 percent next year. "This could be a real opportunity," he says.
That's what investors hope to say about 2004 when all is said and done.
This story appears in the January 19, 2004 print edition of U.S. News & World Report.