Stock and bond lockstep could be ending. Big increase in corporate profits should continue boosting equities
Comfortably slouched in a well-padded chair, gazing into his Quotron machine as if it were a crystal ball, Burton Siegel declares, ``The stock and bond markets have come to a parting of the ways.'' Bonds are basically taking a southward fork, while stocks will trek north, according to Mr. Siegel, Drexel Burnham Lambert's chief investment officer.
On the face of it, such a claim defies common logic. For four years, the fixed income and equity markets moved virtually in tandem. And traditionally, one assumes that when rates go up (pushing bond prices down), investors soon migrate away from stocks and into the higher, ``safer'' bond yields.
Not this time, says Siegel. Like many of his counterparts on Wall Street, he believes corporate earnings are going to be so powerful as to propel stock prices higher. ``Compound annual earnings growth for the last six years [of the Standard & Poor's 500] has been a negative 0.2 percent. Now, the drought is over,'' says Siegel.
He cites first-quarter earnings coming in well ahead of consensus expectations. The trend has continued through May. Drexel forecasters predict a 17.4 percent jump in corporate profits of the S&P 500 this year and a 14.7 percent hike next year. That comes off less than a 1 percent gain in 1986. ``Our concern now is that we may be underestimating the rise,'' he stressed at a press briefing last week.
But the earnings explosion has a decidedly blue (chip) hue. First-quarter earnings revisions are more than twice as likely to be upward in the largest 200 companies (out of 2,000 Drexel follows), while disappointments or downward earnings revisions are more than twice as likely among the smallest firms.
The dollar's decline is pivotal to the Drexel forecast and this lopsided earnings picture. ``Those companies influenced by world trade, either exporters or domestic manufacturers faced with substantial foreign competition, are benefiting from the fall. For the most part, that means large multinational companies,'' Siegel reasons.
Drexel's shopping list is top-heavy with major consumer companies (Coca-Cola, Chrysler, General Mills), technology firms (Unysis, Avnet, General Electric) and health care concerns (Johnson & Johnson, SmithKline Beckman, Squibb).
And these companies could continue to reap currency-oriented rewards. The dollar is 40 percent off its high. Drexel economist Richard Hoey sees the dollar slipping another 10 percent. ``The primary trend in the dollar is down,'' he surmises. But first, there will be a pause.
Mr. Hoey expects the greenback to rest for six to nine months. Indeed, two reports served to bolster the dollar and bond markets last week. First, Japan reported its trade surplus shrank in May for the first time in two years. Then, the Commerce Department reported the US trade deficit eased to $13.32 billion in May.
A stabilized dollar will lure foreign investors back to US securities. Thus, traders will be treated to ``one last-chance'' rally in the bond market, says Hoey, before the dollar crumbles again, interest rates rise, and bonds return to a bear-market trend begun in April 1986.
Drexel analysts cite the 1963-69 bull market as precedent for stocks and bonds going their separate ways. Earnings soared while interest rates rose because demand for credit increased as the economy strengthened.
But some market mavens don't share Drexel's optimism for equities. Some question whether rates might be getting ahead of the economy and worry that an expansion will be choked off prematurely.
Louis Navellier of Insight Capital Management in Moraga, Calif., recently noted that this mid-course split between stocks and bonds isn't generally a long-lasting phenomenon. ``Historically, stocks tend to peak eight to nine months after the bond market starts declining because of rising rates. This peak is typically characterized by a `last gasp' rally led by technology and other non-interest sensitive issues.''
Mr. Navellier is ``extremely cautious'' now. He is not alone.
Investors Intelligence reports 37.6 percent of the investment advisers it tracks were bullish on stocks last week - a low for the year. Bears came in at 27.2 percent. And 35.2 percent expect a correction.
Of course, even if a majority of sages sour on the market, that doesn't mean they are right. In fact, in market technicians' logic, the negative sentiment has swung too far. ``We're very close to a buy signal based on these readings,'' says Michael Burke, editor of the Investors Intelligence, which is based in Larchmont, N.Y.
``The summer rally is already upon us,'' says Eugene Peroni, chief technical analyst at Janney Montgomery Scott. The Dow Jones industrial average caught a wave last week, rising 51.58 points to close at 2,377.73 on Friday.
But investors had better get in the water now, advises Mr. Peroni. ``This will peak sometime around the first week of July.'' He expects a high of 2,450 to 2,500. Then, the Dow will be in the doldrums until the fourth quarter, when it will sail to 2,700.
Like Drexel prognosticators, Peroni believes the earnings sun will shine mostly upon the larger companies. ``The performance of the broader market will pale by comparison.''
But it's not the 30 Dow industrials that he favors so much as second-tier blue chips. ``The earnings potential of the high-quality secondaries hasn't received as much recognition. They're more likely to outperform the Dow in a rally.''
He figures the airline, aluminum, retail, broadcast, and entertaiment groups will do well. Specifically, his picks included Aluminum Company of America (Alcoa), AFG Industries, Gerber Scientific, and Gulf & Western Industries.
Gulf & Western should get ``substantial sizzle'' from its Paramount subsidiary this summer, says Peroni. Paramount has released what appear to be two big box-office attractions: ``Beverly Hills Cop II'' and ``The Untouchables.''