OUTLOOK FOR THE U.S. MARKETS
As
we see it, 1997 will be a frustrating year for U.S. stocks. Inflation will
remain in check, and everyone will keep buying, anticipating another 1995
or 1996.
But a sharp market correction will scare the pants off of the public.
And at the end of the year, the market will end slightly higher than current
levels.
The Bill factor
Betting against the collective power of Greenspan, Clinton, and
Rubin is like playing Quarters with a bunch of inebriated college kids:
You'll end up with a splitting headache.
In early 1996, Taipan was bullish, betting that low interest rates
would keep U.S. stocks running higher. And it wouldn't matter if rates bottomed
out, because there is a time lag before rates have an lasting impact on
the market (usually, bonds top out nine months before stocks).
More importantly, 1996 was an election year. It was safe to assume
that Washington would do everything in its power to keep the market floating.
Over the long run, however, manipulating the markets for political reasons
always backfires. But that doesn't mean you can't make money by playing
their game.
As soon as the Fed cut rates last January, the bond market tanked.
It was a classic case of "buying the rumor and selling the fact."
Underlining the power of 401K cash to keep propping up equity prices, the
market ignored the surge of bond yields above 7%, as well as a bubble in
commodity prices that took the CRB index to the highest level in eight years.
Reality caught up with the market in July. The Dow corrected by
10%. But the whole affair lasted a matter of weeks, and the index quickly
made a run at new highs, breaking our projected target of 6,000.
At over 18 times estimated 1996 earnings, the market is pricey.
I don't believe that U.S. companies can generate the earnings growth necessary
to sustain that valuation. In other words, U.S. stocks are fundamentally
overvalued. The S&P can still go higher. But it will crash back down
even more quickly than it goes up.
Taipan's 1997 Forecast:
Taipan projects 13% earnings growth in 1997. Applying a 17 multiple
to those earnings, you get a target of 800 for the S&P. Expect the Dow
to rise to just over 6900 - a 6% gain from current levels.
Super-tech bargains
The best U.S. opportunities will arise in the OTC technology sector.
The U.S. is still the world leader in technology. Cutting-edge research
is opening up entirely new commercial opportunities for high-tech companies.
And I expect the global semiconductor market to recover, reviving Silicon
Valley.
That doesn't mean you should jump on the bandwagon and buy Netscape.
Avoid overpriced favorites like the plague.
The biggest - and safest - gains will come from small caps that
have fallen out of favor - and unknown startups that are about to turn profitable.
Taipan's resident Web guru, William Sanders, and technology editor Brian
Hicks are keeping their "cyber-ears" to the ground for profitable
opportunities. And our analysis research team is combing through stacks
of classified research reports to find an undiscovered gem before the mass
media jump on it.
Pray to the Megatrend
There's really only one word you need to remember when forecasting
the market. Liquidity. It's what sends markets through the roof - or down
the drain. You can measure liquidity by looking at money supply expansion,
the level of interest rates, and the flow of new cash in the market.
Think of it as supply and demand. When there's too much money chasing
too few stocks, stocks go up.
U.S. stocks are in a long-term mega-bull market that will keep
going higher for the next decade. But over the next twelve months, excess
liquidity will flow to undervalued emerging markets.
The biggest factor that will let U.S. equity prices rebound from
20% or even 40% corrections is the omnipresent reach of the mutual fund
industry.
The real McCoy
While current U.S. valuation levels are too high, they're not outrageously
high. An example of a real equity bubble is Bangladesh. It's one of the
poorest countries in Asia. But its market's trading at 90 times earnings.
At the 1996 peak, the index was up 600%. The worst-performing stock was
up 65%!
That's what happens when you have a population of 10 million chasing
a dozen stocks. When the opening bell rang in the morning, crowds would
gather in front of the exchange. As the market went higher, the crowd kept
growing, until a permanent festival of thousands of investors danced to
stock quotes from open until close. When the market dropped 20%, the crowd
stormed the exchange and attacked brokers. Police had to use tear gas to
dispel the rioters.
I don't know how high the U.S. markets will go - or how outrageous
valuations will get before a real bear market begins. The mega-top will
probably occur right before the baby boomers start retiring - a decade from
now. But there's plenty of tricks that Washington can pull out of its hat
in the meantime ... (Congress, for one, is considering putting Social Security
into stocks ...)
But that won't stop short-term crashes from occurring. And if history
is any guide, one may be around the corner.
Escaping the liquidity trap
Even if the United States is the world's largest debtor, it currently
enjoys some of the lowest real rates in the world. Foreign investors keep
buying U.S. debt - now holding 33% of all U.S. treasury debt ever issued
and financing the entire 1995 current account deficit.
Thanks to foreign cash, rates are artificially depressed. Uncompetitive
yields keep money flowing into stocks - making debt easier to finance. Consumers
have taken advantage of low rates by racking up record amounts of debt.
The media keep reporting about record levels of personal bankruptcies and
installment debt defaults. But imagine what would happen if rates went up
to 8% or higher.
And that's exactly what would happen if foreign investors stopped
buying U.S. treasury debt. Since consumer spending fuels two-thirds of economic
growth, this would almost certainly trigger a recession.
If the dollar collapsed, foreign investors would drop U.S. treasuries.
Since the dollar is currently strong, that doesn't seem like a near-term
possibility.
But the U.S. trade deficit is ballooning again. When the U.S. imports
more than it exports, the world is flooded with dollars. That tends to drive
down the value of the dollar. And the easiest way to make exports more competitive
is currency devaluation. It's no secret that American companies are begging
the White House to knock down the dollar.
Taipan's 1997 Forecast:
If the dollar falls 10% against the yen, look for a 15% to 20%
correction in the stock market. Treat any deep crash in the coming months
as a buying opportunity, with a 6900 target for 1997.
Outlook for inflation
Pundits keep arguing that a tight labor market will cause "wage
inflation." Here's what I think about that: Strong employment reports
will keep knocking down the Dow for a day or two, but the "wage inflation"
argument is fundamentally flawed. Productivity continues to grow faster
than inflation, so the economy can absorb higher labor prices.
More importantly, global wage deflation will continue to depress
the wages of unskilled labor. If you can hire workers for US$0.50 per day
in Indonesia, why would you hire anyone in North America? Europe is totally
missing the boat with its restrictive labor laws - and is paying the price
with anemic growth and high unemployment.
The gap between wages in developed and emerging economies will
continue to contract. U.S. wages can be expected to deflate, not inflate.
Any tiny spike in hourly wages will look like the golden age for labor in
a matter of years.
Agricultural commodities and base metals have tanked after the
speculative run-up in early 1995. But oil is still strong. The possibility
of an oil shock to the U.S. economy cannot be discounted. Bull markets have
a strange way of going higher. Nothing seems to be able to derail the bull
market in crude oil and natural gas.
Supplies are tight and demand is growing - a recipe for higher
prices. Over the short term, oil is choppy and hard to forecast. But a run
to US$30 on the March futures contract may be in the cards. That could spell
trouble for bonds.
Taipan's 1997 Forecast:
Taipan forecasts GDP growth around 2.0%.
Interest rates will spike as high as 7.5% in early 1997, but will
end the year at 6.5% or lower. The Consumer Price Index (CPI) will gain
3.5%, but the core inflation rate will remain under 3.0. Equity and bond
markets won't make impressive year-on-year gains. The money will be made
by buying during corrections.
Inflation may underperform our expectations if Congress changes
the way the CPI is calculated. The government will find it easier to balance
its books, which may support the bond market, but less cash will flow into
the pension system (since actuarial calculations use CPI to figure out if
pensions are overfunded). While the net effect of the change is impossible
to predict, one thing is certain: magically lowering inflation won't help
win back the confidence of foreign investors.