What’s Next?

The time when investors should worry most about their investments is when their friends, market pundits, and the maid are most vocal about how great the market is. (Think March 2000 at the height of the Internet bubble). And the time when investors have the greatest opportunity is when these same people are negative about the market, and insist, �it�s not yet time to go back in.� (Think March 2003 before the postwar market rally). At no time has this pattern been truer and more evident than over these last 3 years.

A �healthy� market requires that not everyone agree. And fortunately, that�s what we seem to have now. There are about as many positive outlooks as there are negative. The September 2 issue of the Wall Street Journal reported that Thomas McManus, who forecasts the stock market for Banc of America Securities, is feeling upbeat going into the last stretch of the year. He says stocks could rise another 5%-10% before the year ends. But Richard Bernstein of Merrill Lynch sees a chilly autumn, saying stocks are so overpriced that they could fall as much as 14% during the next year. These views are typical of what we read about. (We also note that both of these experienced analysts rightly saw stocks as overpriced during the bubble, which gives them some credibility.)

What has many analysts concerned is that we are in the most worrisome period of the year: September and October. September is the month when stocks have historically done their worst. This period is known as the �confession� period, when companies who have not met their quarterly earnings targets issue warnings and cause stock prices to go down. October is the month that has seen the most crashes. But October has seen significant rallies as well, sometimes marking the beginning of the �Santa Claus Rally.�

The rally this year has been dizzying. And some say it�s been too fast, with stock prices outpacing earnings growth by a wide margin. (Stock prices are ultimately a function of a company�s earnings.) The S&P now trades at about 19 times earnings, compared with its average of around 13. And the NASDAQ index has jumped 61% since its low, while earnings are up only 7%-15%. This would indicate to us that much of the good news is already priced into stocks, and gains from this point will likely be much slower.

Real earnings growth has been in the 7%-8% range, and we would expect to see this sort of total return in stocks in a healthy economic climate.

And lately, we have seen data that has indicated a stronger economic recovery than was forecast. The revised estimate of second quarter GDP was 3.1%, up from 2.4%, and the Chicago purchasing managers� index for August was 58.9, up sharply from the consensus forecast of 54, and up from 55.9 in July. (Above 50 indicates expansion activity.) Consumer and business spending is up, and disposable income, helped by tax cuts, posted its biggest gain in over a year. Improvements in employment and job growth, which have been the weak links in the recovery thus far, should be the final confirmation of a recovery.

So what�s the most likely near-term scenario? We see an uncomfortable October followed by additional small gains (2%-3%) to the end of the year. Gains for the full year in the growth stock portion of our clients portfolios could be quite impressive, perhaps close to 20%.