THE SOVEREIGN ADVISOR Prepared by Sovereign Asset Management
Valuations Improving
(November 17, 2000) The market may climb a wall of worry but it hates uncertainty, and it hates slower earnings growth. The past several weeks has given us both, which has dropped the market down to valuation levels which are more palatable than what we have experienced over the past several years. The S&P 500, the bellwether index, is currently trading at a P/E of 26.31 versus last year's P/E of 34.03. A P/E of 26.31 on an historic basis is still high (historic level approximately 15), but investors have accepted high P/E's all along as long as inflation has remained tame.
Inflation is now creeping back into the system as energy prices remain high, the economy slows, service costs increase, and productivity growth slows. Although my indicators are showing that inflation will eventually work its way completely through the system and will show itself at the retail level, it will be slow in doing so.
As the P/E ratio on the S&P 500 has fallen by over 20% this past year (valuations have fallen faster than earnings have gained) the risk reward ratio has now moved more in favor of increasing ownership in stocks, at least on a short tern basis. What is currently missing is a catalyst to get stocks to move higher. The most powerful catalyst over any other, more than rising earnings, lower inflation, strong economic growth or demographics, is falling interest rates with increasing liquidity in the form of a growing money supply.
At this point it appears that the bond market rally which we have had this year is played out (i.e., interest rates have stopped falling), and money supply growth, which a year ago was growing at a rate of +18% annualized, has fallen to a growth rate of +3%. A growth rate of 3% is currently only sufficient to accommodate the growth in GDP which is estimated to be approximately 2% in the third quarter, but is not sufficient to also supply the necessary liquidity for another major bull move in stocks. Add to this the worldwide demand for dollars needed to purchase crude oil which over the past twenty-two months has gone from $10.35/bbl to the current price of $35.58/bbl and one can see there is not enough dollars to go around.
What we face now is a situation whereby on a fundamental basis stock valuations are beginning to look attractive but there is no catalyst in the form of falling interest rates and increasing liquidity to start another bull move. Where does this put both short and long-term investors? Short-term investors and traders should continue to play the trading ranges set forth in my last issue.
There will be ample opportunity to play both sides of the ranges as volatility will remain high. Long-term investors should begin to slowly and carefully incrementally increase their exposure on any dips to the bottom of these ranges. This should only be done knowing that the market may not begin another major bull move until liquidity improves; again, once interest rates fall and liquidity increases.
Indicators
Monetary Indicators
Neutral--With the Fed taking no action at their meeting, it appears that they continue to see conflicting signals about the economy and the markets. They do not want to lower interest rates because of low unemployment, a still overvalued tech sector, and the threat of inflation. They do not want to raise them because of higher energy prices and a slowing economy. No movement by the Fed is a slight positive for the market, but investors are now looking for lower rates as a catalyst to move the market higher. They may not occur until the first quarter of 2001.
Bond Indicators
Moderately Bearish--Once the election is over, the flight to quality in bonds will end weighing on that market. Market players and investors must now consider the effects of higher inflation in the form of rising energy prices and labor costs on the bearish side versus a slowing economy on the bullish side. At this point, my indicators are showing the bears have the edge.
Momentum Indicators
Moderately Bullish--The election fiasco has created so much daily volatility in the market that it is wrecking havoc on the traditional short-term momentum indicators. However, one solid positive is that the lows of October 18 have so far held. Ideally, we would like to see all three major indices moving in tandem as well as the broad market. If we could achieve this, it would be a major positive.
Technical Indicators
Moderately Bullish--After major sell-offs resulting from lowered earnings reports and from confusion over the election, the major indices are holding support levels set on October 18. Entry points for the major indices would be at these approximate levels: S&P 500--1320, Dow--10000, NASDAQ--2900.
Market Notes
Hopefully within the next week the election will be over and investors can remove that event from their list of concerns. Since we know it will eventually be over, any market downturn attributed to election uncertainty can be used as an opportunity to increase ones market exposure.
Trading Rules
12. Buy the news, sell the fact
If the market rumors are bullish, buy on the news; but when it turns to reality, then sell. Market players tend to build the news into the price.
Portfolio Strategy
The major indices have so far held the support levels on October 18 which is a solid positive for the overall market. Stock allocations should be increased as valuations have become more attractive and we are in a seasonally strong period for stocks.
Model Portfolio: Balanced portfolio is now 68% stocks; 10% bonds; and 22% cash. Equity portfolio is now 76% stocks and 24% cash.
November 17, 2000 Donald L. Sazdanoff Sovereign Asset Management 2628 Trotters Way, Columbus, Ohio 419-884-8309
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