Last summer I made a couple of forecasts. One called for a “W” type bottom sometime over the following twelve months. After 9-11 I predicted that the S&P 500 should trade in the area of 1058 near the middle of 2002. This was based on estimated earnings of $52.90 and anticipated inflation of 2.5%. In early January of this year I reduced my earnings expectations (to $49.25) and the market’s inflation expectations were lowered as well. Our mid-2002 target for the S&P, then trading at 1155, was moved upward to 1186. Certainly not an exciting performance prospect, but also not a reason to sell out the portfolio!

With a nascent economic recovery and an accommodative Fed, the stock market should be in a reasonable recovery mode. But it isn’t! Many of the ten sectors that make up the S&P 500 are trading below their 200-day moving average . . . a sign that a long-term upswing in price has yet to occur. This applies to the healthcare, industrial, technology, utility and financial sub-indexes. These sectors, when combined, make up 67% of the market weighting of the S&P 500. So what gives?

The economy seems to be on the right track. Inventory liquidations have slowed to almost zero, and consumer demand remains healthy. One the other hand, corporate spending remains a “no-show". The trend during the first quarter was a negative 5.7% annualized change from last year’s final period. And now comes the news that durable goods orders for March were lower than February! While business investment spending may have hit bottom, it shows few signs of rebounding. By our analysis, it shouldn’t bounce back until next summer, at the earliest. (See our report “If You Build It Will They Come?” of January 2, 2002). The bottom line is that the top line will remain sluggish for a few more quarters, giving the bad news bears plenty of opportunity to run stocks into the ground.

Based on extant labor productivity and modestly rising demand, earnings should start to show their metal. The market consensus for 2002 S&P 500 earnings is $50 per share. (We’re actually estimating earnings slightly higher than that, so we’ll stick with the more conservative estimate.) We believe the appropriate multiple for the S&P 500 is 23 times earnings, thereby producing a target of 1150. But many well-meaning bears would object to a multiple that high. In 1996, the forward earnings multiple of the S&P 500 was 16.2, close to its long-term average. Since earnings are “out” (due to accounting changes) and cash flow is “in” (rightly so), we’ll use that convention to determine value. Cash flow is computed by adding depreciation and amortization (non-cash charges) back to net income. (Recall that there is no longer amortization of goodwill for unimpaired assets). Furthermore, we prefer to use the more inclusive concept of Enterprise Value. Enterprise Value includes net debt per share as well as price per share and thus it adjusts for leverage.

The decline in the cash flow yield of 27% over the intervening six years can be explained by a 16.4% decline in bond yields, and a 12.1% increase in sustainable growth. Changes to either of these metrics over the coming years will impact valuations. (To view more detailed information on valuation methodology, see our “Valuation Primer”). For example, if bond yields increase to 6% and ROE declines back to its old norm of 13%, cash flow yields would need to increase approximately 30% and EV/cash flow ratios would decline by 23%. This would act to dampen the positive impact from rising earnings. So the real question for investors is not the returns from this year, but from the next three years. And the key for investment managers is to find stocks and sectors that will not get trapped in this valuation pressure cooker.

The increased role of short selling in determining prices, a technique used by hedge funds, appears to be leading us into an increasingly volatile valuation environment, where prices swing wildly one month, only to reverse course for the next. It’s a traders dream and an investor’s nightmare. Moreover, the Enron affair has changed how brokerage analysts recommend stocks, i.e., clearer sale recommendations. It will be a field day for brokers who will be more than happy to increase turnover of their client’s portfolios. For those of us who are long-term investors and have assets committed to large capitalization stocks, there’s nowhere to hide!