Sailing In Choppy SeasWestwood has updated and extended our economic outlook through year-end 2003. We continue to believe that the fundamentals are in place for an improving economy and a rebound in corporate profits in 2003.
Before we outline the details of our view, it is instructive to review the expectations that are currently being discounted in the marketplace.
The market’s recent volatility is due in large part to increased investor anxiety that we may be in for a prolonged period of sluggish economic growth. The biggest concern is that a “double-dip” recession will be brought on by a significant slowdown in consumer activity. The level of consumer spending has remained high since 9/11. Some economic prognosticators speculate that this level is unsustainable and that consumers will soon rein in spending, further slowing economic growth. The market is also burdened with very low expectations for business investment and, correspondingly, low growth in corporate profits. The dollar is expected to fall sharply against foreign currencies. Finally, the market is focused on the prospect of deflation. Deflation is a rare economic phenomenon that has dramatic implications for corporate profit margins. If companies are forced to sell their wares at declining price points, profits are squeezed and equity valuations will suffer. These are the doubts that are currently being priced into the market.
In contrast to the market’s view, Westwood’s outlook is far less pessimistic. First and foremost, we do not see a double-dip recession. Rather, we see a sustainable economic recovery, albeit modest and unevenly paced. Economic growth will continue to be led by consumer activity, though spending will become more cautious. Consumer spending will be sustained by mortgage refinancings and low interest rates. However, sluggish job growth and modest wage increases will act to restrain expenditures and increase savings rates modestly. On the business side, we see strong productivity gains. Aggregate inventories and corresponding inventory/sales ratios are at historically low levels while interest rates are at extremely low levels. Inventory replenishment, along with productivity gains and low borrowing costs will work together to stimulate capital expenditures and support a recovery in corporate profits. We are less concerned about deflation as our economy is service based and the services sector continues to exhibit pricing power.
The slide below illustrates our operative economic scenario for 2003. Economic growth, as measured by Real Gross Domestic Product (GDP), continues at a modest pace of 2.5% while inflation, measured by the Consumer Price Index (CPI) remains tame at 2%.
In forecasting aggregate operating profits for the S&P 500, we apply a bottom up analysis to the stocks represented in the index. Once we have determined the earnings expectations for the component companies in the index, we assume the index were a stock and forecast a ‘per share amount’. Our 2003 operating earnings forecast is $55 per share. This is 10% higher than our 2002 outlook of $50 per share. The aggregate dividend of the S&P 500 should be about $19 per share, representing a dividend yield on current prices of 2.3%. A low interest rate and low inflation environment supports a higher price/earnings multiple. We are forecasting an 18x multiple for next year. Based on this outlook we are anticipating an expected return above 20% through 2003 for the S&P 500. Because the S&P 500 is a market capitalization weighted index, we also apply the earnings to the index assuming all companies are equally weighted and arrive at an expected return of nearly 30%. This indicates that some of the smaller companies in the index are more undervalued than the larger companies. Under our operative 2003 economic scenario, we are also assuming a rise in the level of short-term interest rates and a flattening of the yield curve. We are forecasting that shorter rates, i.e. the T-Bill, 5-Year and 10-Year, will rise while long rates, as measured by the 30-Year Treasury, will fall slightly by year-end 2003.
Given this modest growth environment, we felt it would be helpful to explain how we arrive at our forecast of significant growth in corporate profits. Productivity is the key to the realization of 10% growth in earnings next year. GDP, defined as the total value of all goods and services produced by an economy, is a function of productivity and hours worked. Whether GDP expands or contracts depends in large part on changes (D) in productivity and changes in hours worked, as shown in the formula below. We believe productivity will continue to expand at its current rate of 4%, which implies a slight decline in hours worked given our forecast of a 2.5% increase in GDP next year. With little pressure on firms to raise wages, hourly earnings are expected to rise only modestly next year, which, combined with strong gains in productivity, implies that unit labor costs will be negative (second equation). Historically, negative unit labor costs have been accompanied by a sharp increase in corporate profits. The reason for this relationship is that negative unit labor costs produce an expansion in profit margins. Expanding margins, combined with an increase in volumes sold, should be sufficient to produce a significant increase in corporate profitability (third equation).
While the short-term wanderings of the markets are anyone’s guess in this uncertain environment, our view of the sustainable strength in the economy and a rising level of corporate profits should be comforting to long-term investors.
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