How a top market analyst regards Wall Street for next year
For the past nine years, Robert J. Farrell, chief market analyst at Merrill Lynch, has held the No. 1 market-timing spot in Institutional Investors' annual All American Research Team poll. In a recent interview, Mr. Farrell predicted continuation of the bull market and outlined his reasons for seeking high-quality equities.
What is your economic outlook and how does that influence your stock market forecast?
I don't generally try to forecast the stock market based on what the economy is doing, because it's very difficult to use a lagging indicator, which is the economy, to predict a leading indicator.
The economy is important if we had total foresight of what the economy was going to do. You would know the trend in earnings, and that would determine how the stock market would do. But I tend to be a contrarian, and I'm more interested in the consensus economic opinion. And the consensus has not had a great record in the past maybe eight years.
I think the investment problem now is whether the economy will continue to improve as it has in September or whether it will disappoint again. If it disappoints again, I think you might find the economic consensus will give up on the recovery coming in 1986 and start predicting a recession. If that happens, that's probably initially negative for the stock market.
But I still think the odds are -- as our economic forecast for 1986 says -- that we're going to see moderate recovery, at a slow but expanding pace. And yet, I can see the potential for more sell-off in the market if the expectations of recovery are not met. But I don't think the Fed [Federal Reserve Board of Governors] will stand by and just allow that to happen without taking dramatic action [that is, lower interest rates]. And I can see a buying opportunity coming out of that disappointment later thi s year or the early part of next year.
You don't look at the economy so much as economists' expectations and how that influences the market?
The one question to always ask is, ``What is it that is already discounted in the market?'' Now the past year, the economy has been weaker than expected and most earnings estimates by analysts have been lowered in subsequent periods rather than raised. So they keep overestimating the earnings because they are anticipating the economy is going to get better. Now we've been going through a year of that kind of dissapointment.
If the economy just gets a little better in 1986, we're going to have some better earnings. So there is a positive that can come out of this slow growth economy. So, I don't ignore the economic forecast, I just don't use it to try to make a stock market determination.
OK, what is it, then, that you are looking at now?
I look at the stock market on the longer-range basis and ask what is the basic theme. In the '70s, the theme was accelerating inflation. Now as long as you can recognize the theme, then all the setbacks become opportunities to buy the things that work on the theme.
So in the late '70s you wanted to buy hard assets: real estate and energy stocks. And you wanted to buy companies growing rapidly, faster than the inflation rate. You wanted to avoid bonds, slow-growing stocks, and utilities.
It's been the opposite since about 1980. We've had a disinflation environment. The assets that are working are the financial assets rather than the hard assets. And bonds are doing well in a bull market. Utilities have been in a bull market. Essentially we have a very positive background that has not gone to an extreme, that is, disinflation biased.
So we are not yet at the end of this disinflaton theme and this bull market?
I think we have a lot of money on the sidelines. Look at any market cycle over a long period, it goes from undervaluation to overvaluation. This market, by traditional measures, is not overvalued. P/e's [price/earnings ratios] are still modest compared with levels in the past. Book value-to-market value is still low compared with past peak periods. It's also a question of going from under-ownership of stock to over-ownership of stocks.
One of the least popular investments for the public today is equities. What we've found over time is that the unpopular investments are the ones that turn out best. Looking at it from a percentage of ownership, the average individual in 1968 had 45 percent of his financial assets in equities. In 1974 he had less than 20 percent. And today, he has only 23 percent.
He has a lot of liquid money. There's over a trillion dollars in CDs, money market funds, and savings accounts. That money is now moving to recapture lost income. You don't get the high yields today that you got three years ago in a liquid, low-risk money market fund or CD.
So mutual fund sales in income-type funds are at a record level. The first half of this year was equal to last year. And last year was a record. That is the first step in the public's recognition of the attractiveness of financial assets. I think it will go to equities as well.
What might derail the stock market advance?
The problem may be a cyclical problem. The stock market has a four-year cycle that has existed all through the post-World War II period. Every four years the market has had a significant low or setback which was a major buying point.
The last one was 1982. The one before that was 1978, and so on. It's somewhat tied into the presidential election cycle. It sounds very mechanical, but of course, it would suggest that 1986 would be the next point. We've gone up in the last three years, 36 months, by 70 percent. The average cycle in the past six cycles has been a gain of 60 percent in 34 months. So we've kind of fulfilled the expectations we've had in the past.
And we have an element of complacency in terms of the psychology of the investor. The market is dominated by the institutional investor today, and he's pretty fully invested.
When the professional investor is pretty confident and complacent, he doesn't carry much cash. Complacent periods haven't been the launching point for big rises in the market. The big rises have occurred usually in periods of high worry, high anxiety, times of crisis. I think the period ahead, therefore, is going to be a corrective period.
You expect a near-term dip in the market? How much of a dip?
Well, the plus is that at this point in a typical four-year cycle, we have a strong economy and interest rates going up, and a negative yield spread. We don't have that here. We've had declining rates and the Fed easing. That's a plus that says maybe it won't be a decline of 20 percent or more that we've had in a typical four-year cycle. Maybe just a 10 or 15 percent correction.
What investment strategy would you recommend at this juncture?
Hold on to some buying power at this point. We want to be cautious, looking for a good opportunity to accumulate equities for another big move upward, starting in the early or middle part of '86. Or if the market holds up here longer, maybe it won't start until later in '86. But I think the important thing is to view any setback that occurs in the next six to nine months as an opportunity to increase the percentage of your assets in equities. And I would stress the highest-quality equities. I think the
market is going to grow more selective.
I also think there is going to be a year where equities become very popular and you get a 500-point move in the Dow. I don't know if it's 1987 or '88, but it's sometime before the end of this decade. The important thing is to be invested ahead of time. The problem is that when there is a down market, you just see all kinds of negatives to discourage you.
Which stocks would you want to be invested in, come 1986?
The high-quality stocks, particularly where you should see some benefit from an improving economy next year. The cyclical-growth electrical equipment and computer companies are where I'd want to put my money. Some of the financial stocks and the insurance stocks will continue to do well. There'll be an attractive opportunity in the big technology stocks. I think the leaning is going to be toward the industrial technology companies that have productivity-improving products -- as opposed to the last cycl e, which leaned on consumer technology stocks -- the PCs, home computers, and video games.
I also think some of the down-and-out areas -- companies hurt by the strong dollar, those with big international operations -- will fare better: paper and forest product companies, chemical companies, and machinery companies.
Why would you choose stocks over bonds, which offer such attractive yields at this point?
Our approach has been half bonds, half stocks. And I'm inclined to go to more cash. We're likely to shift by early next year to 60 percent stocks and 40 percent bonds. That would be on the assumption we still have another big stock move to come and it would probably outperform bonds during that period.
What is your outlook for the bond market?
I still think bonds are an asset that works. In fact, if bonds come back above 11 percent, I'd be more aggressive about buying them between now and the end of the year. Basically, bonds are going to have lower yields two or three years from now. When you've got a real rate of return as high as it is now, and let's say, you can get 11 percent on a high-quality government bond, you should think about it in terms of locking in that rate of return for 10 or 15 years.
That is competitive historically. The best 10-year period for stocks over the last 50 years was between 1948 and '58. The total return was 20 percent. The next best was between 17 and 18 percent. If you can lock in 11 or 12 percent on bonds with very little risk, that's a pretty good alternative.
Do you expect the disinflation theme to last through the decade, and what does one look for to signal its passing?
I think its going to last. Maybe disinflation is the wrong word. Its a balance between deflationary effects in one part of the economy and continued inflationary effects in another. On balance, it slows the growth rates of the world economy. I think we will continue to absorb the problem areas, shocks, and the best quality companies will survive, do well, and get a premium.
The thing to watch is the markets themselves. The commodity markets are probably going to give you as good a clue as anything as to when inflation picks up again. The trend in the dollar has a bearing as well.
The dollar peaked this year, and I think its going to continue in a downtrending mode. That can help strengthen world economies.
The bond market also bears watching. If inflation is going to come back, then bonds will weaken and short rates will go up a lot. Our expectation is that we may have some increase in rates as the economy gets better, but essentially the long term trend is still down.
But if we are going to have to change [our theme] it will be the rates and trends in commodities that will tell us when.
Would you care to dispense any closing advice?
The most important thing to remember, the best slogan on the stock market, is: ``Get rich slowly.'' People who rush in to buy only when it's hot, or on a story they hear at a cocktail party, are going to be disappointed.