In our last commentary (September 14th), we wanted to alleviate investors’ fears of a substantial and long lasting (post 9-11) decline by focusing attention on prospective trading levels for the S&P 500 in 2002. We forecasted an average price of 1058 but stated that “levels as high as 1300 might be observed”. Since the writing of that commentary, anticipated inflation has declined, which is good, but so have earning per share expectations, which is not so good. What we have witnessed over the quarter has been a bounce-back by the depressed sectors and a modest performance by the “less-damaged” sectors.

Now that the market has recovered half of the decline since June 30th and the S&P 500 is trading above our previous target, we need to revisit the fundamentals. Based on our lower earnings estimate of $49.25 for 2002 and lower inflation assumptions of 2.2%, our target average for 2002 is now 1186. However, as was the case in other years following bear markets (1991, and to a lesser extent 1983), actual price-earning multiples are often above what would normally be expected. At this juncture, we believe that a fair value for the S&P 500 might be 1350 during the second half, 17.0% above current levels. There have been a number of positive developments that lead us to this conclusion:

At this juncture, we’re still in the “U-turn” camp, rather than a “V” or “super-V” as some have proffered. The primary reason for this outlook is that a recovery from the technology bubble will take time: there is still a “financing gap” that has created an over-leveraging of corporate balance sheets. During the 1991 recession, debt as a percentage of corporate net worth was about 51%, and peaked at 54% a year later. It subsequently dropped to the mid-40s. As recently as the end of last year, it was at 54% and today stands at 59%. This ratio will probably trend lower over the next few years and is something to monitor. More importantly, however, corporations have spent excessively, and this has strained their balance sheets.

Corporations typically utilize more money to expand than what they generate internally from operating cash-flows. However, there are periods when they spent well beyond what is considered prudent: 1968-1970, 1972-1974, 1978-1981, and 1998-2001. By the end of 2000, the gap between capital spending and internally generated funds had become exceedingly large (See Chart 1). The ratio of capital spending to internally generated funds (the financing gap ratio), which appears in the lower section of the chart, is the best way to measure the magnitude of the gap. In order to make up the difference between spending and cash-flow, corporations can issue debt, i.e. bonds or short term paper. In Chart 2, one can see the relationship between debt growth and the financing gap ratio. As the financing gap rose in 1998, double-digit debt growth was needed to fill the void. By the end of last year’s the third quarter, however, the growth of debt outstanding had slowed to 6%. Furthermore, our analysis of corporate interest expense levels suggests that debt-servicing for the Value Line Industrial composite of 1700 companies is manageable and nowhere near the dangerous levels of the mid-1980’s (See Chart 3). Moreover, the decline in interest rates over the past year will greatly aid next year’s income statements and help to shore up balance sheets.

As corporate America restructures its debt to take advantage of lower interest rates and rids itself of unwanted divisions, capital spending will remain on the “back-burner”. We believe capital spending momentum will reverse itself once the financing gap reaches .90% (See Chart 4). This could occur by the third quarter of 2002 and will provide the fuel for technology spending to grow again, albeit at a lesser rate than in the previous cycle. And then when you build it, they will come. 

CHART 3

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CHART 4

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