One of the key reasons for the stock market’s lethargy over the past several months has been investor concern over the pace of future growth. The greater than expected rise in earnings and economic growth was a significant factor in the market’s robust rally in 2003. However, as investors begin to factor in higher interest rates, rising inflation, and the unsustainability of the rapid growth seen over the past 12 months, they have seriously begun to question the source of future market gains.
We contend that the broad stock market will remain largely within its current trading range over the next 12 months. The larger sectors of the market, such as financial services and consumer discretionary, will be hard pressed to move higher in the face of rising interest rates. And as the larger sectors go, so goes the broad market. Historically, a low nominal return market has been favorable for active managers. In other words, we are now in the midst of a “stock picker’s market.”
We have discussed at length our belief in the continued growth prospects for stocks in the energy and industrial segments of the economy. Stocks in these sectors will likely continue to be the leaders over the near term. However, there are two additional ways to profit from the current slower growth, low nominal return environment, namely dividend paying stocks and stocks leveraged to the growth of foreign economies.
Last year’s dividend tax cut was initially ignored by investors, whose singular focus in 2003 was in acquiring as much risk as possible. However, in 2004 the tide has turned. In fact, through mid-July, dividend-paying stocks in the S&P 500 have gained 4% year-to-date, while non-dividend paying stocks have lost 5%. A decline in investor risk tolerance, as well as the acknowledgement that a “bird in the hand” is a valuable commodity in a slowing growth environment, has been the catalyst for this rotation into dividend paying stocks. U.S. corporations are seeing the light as well. The recent announcement by Microsoft Corp. that it planned to double its regular dividend and issue a $3 special dividend (which equates to $32 billion – the largest dividend payment in the history of the S&P 500) is evidence that corporate managers are acknowledging the dearth of high growth investment opportunities as well as the growing investor preference for a quick return on their capital. The 4% increase in the company’s stock price immediately following the announcement is proof of investor approval. We believe there are many opportunities for additional gains via the employment of this strategy as the historically strong cash flow realized by U.S. corporations over the past 2 years has brought paying & increasing dividends back into style.
In addition to dividend payers, we see value in companies with leverage to foreign markets. It’s no secret that certain emerging economies are experiencing rapid growth. Despite efforts by its government to cool things down, China’s GDP will still expand at an 8% -10% rate over the next 12 months. The growth of emerging economies such as China and India is having a trickle down effect on the rest of the world. Even Japan has announced that it sees its GDP growing at a solid 3.5% in 2004. Such growth presents an outstanding opportunity for global firms to increase their overseas revenues. In addition to consumer-oriented companies that will benefit from the “westernization” of the developing world, industrial firms stand to reap huge benefits from the build-out of the infrastructure needed to support the growth in these nations. In fact, this “global industrial revolution” is a phenomenon that could last for several years. Major companies such as Eaton Corp., United Technologies, Ingersoll-Rand Co., Honeywell International and General Electric have recently issued strong second half outlooks while remarking that they are seeing one of the strongest global industrial economies in years and believe we are just at the beginning of the cycle. We’ve heard a lot about the expansion of the U.S. trade deficit, which is a direct result of a decline in U.S. exports. Note that roughly 2/3 of the U.S. decline in exports over the past several years has come from a steep reduction in orders for capital goods and industrial supplies. However, we are now seeing a significant pickup in global industrial orders. For investors looking for a segment of the global economy where there is “pent-up demand” this is the place.
Despite all the angst and hand wringing, there are ways to make money in stocks in a slower growth, rising rate environment. You just have to know where to look.
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