December 1, 2001

What's Next

Members of IA's Market Strategy Committee share th

Each month, Investment Advisor's Asset Allocation page tells you how our Market Strategy Committee of prominent economists and money managers thinks you should allocate your clients' assets. This year, for the first time, we asked board members to forecast the path of the economy, stocks, and bonds for the coming 12 months. Among those taking part in our survey, there was a clear consensus that a substantial recovery from the current recession is in the cards for 2002. The bulls won 5-1: Only notorious bear Gary Shilling predicted that stocks would end 2002 lower than where they began.

On average, the committee sees the Dow Jones Industrials rising 12% by the end of 2002 and the S&P 500 up by the same amount (see table at right). The beleaguered Nasdaq composite won't rocket back over 4,000, the experts feel, but will still close 2002 with an 11.5% gain. And the U.S. economy? By next year's end, a recovery will be firmly in place with gross domestic product growth of 3.27% for all of 2002.

Presumably, this expansion will be fueled in part by a continued aggressive monetary policy. The committee felt that the Fed funds rate would fall even further than its current low levels to end the year at 2.13%. And the panel felt that the yield on 10-year Treasuries would fall in sympathy to 3.57% by the end of next year.

While they conceded that part of their rosy outlook is due in part to the financial optimism inherent in economists and money managers, panel members also pointed to other reasons to believe in an upward trend. People in the market "have a default setting that is positive by nature, at least in part due to our faith in the American financial system," says analyst John Manley of Salomon Smith Barney. "That said, there are some real reasons that this will not be a prolonged recession."

Manley, as well as nearly all the other panelists, sees good news in today's historically low interest rates, the absence of any inflation, lower energy prices, and Washington's aggressive posture toward fiscal policy, including this year's tax bill and the economic stimulus package in the works on Capitol Hill. Not even the military buildup in the wake of the Sept. 11 terrorist attacks fazes our forecasters. "You have to take into consideration that even though defense spending is ramping up right now, it will be nothing like levels during the Cold War," says Lincoln Anderson, research director for LPL Financial. "Eliminating the Cold War drag has been, and will be, big for the economy going forward."

Predictably, defensive sectors (health care, consumer staples, and utilities) will do poorly next year, while technology and consumer cyclicals will show the greatest appreci

Why Arnie is smiling

Arnold Kaufman of Standard & Poor's has gone back in time to back up his argument that the stressed-out stock market is not only poised for a good 2002, but a sustained bull run into the near future.

He says that there have only been three times since the end of World War II that the S&P 500 has declined by 10% or more for two years in a row: 1940-41, 1973-74, and 2000-01. Following the 1940-41 decline, there were double-digit gains for the next four years: up 12.4% in 1942; 19.5% in 1943; 13.8% in 1944; and 30.7% in 1945. After 1973 and '74, the S&P 500 was up 31.6% in 1975 and 19.2% in 1976.

Most relevant, perhaps, are the figures from the 1940s. The attack on Pearl Harbor occurred in December 1941, but much doubt surrounded the market the year before as hostilities raged in Europe. Kaufman notes that the compound growth rate of the S&P 500 for the 5-, 10-, and 25-year periods following 1940-41 and 1973-74 was a minimum of 9.3% and a maximum of 13.0%. "And all of these figures are before dividends," he says. "This is especially important because back in the 1940s, and even the 1970s to some extent, a large portion of the real return of the market was constituted in dividend payments. This is all capital appreciation."

ation, according to our panel. "There wasn't an inherent problem in the nature of technology and telecommunications," says Manley. "Rather it was just an overbuild. A lot of that will clear up next year." Only Shilling disagrees. He believes that such conservative plays as utilities, regional banks, and apartment REITs (real estate investment trusts) will continue to post the solid returns they have delivered over the last two years.

As the record-shattering economic boom of the past decade disappears into history, some committee members have been doing some thinking about what will be the motor of the new century. This is not just navel-gazing: The automobile, the computer, the airplane, and the telephone formed the technological foundation of America's 20th Century economy. A.G. Edwards Chief Economist Gary Thayer observes that these innovations played a major role in producing the oft-quoted historical returns that the markets have yielded since the 1920s. Advisors are betting on similar returns when constructing asset allocation models for the future. But, Thayer asks, if such revolutionary economic stimuli are not present in the 21st Century, will American business continue to generate the same returns in the future as in the past? "I think about this a lot," says Thayer. "We're always trying to figure out if it's appropriate to change our strategic view."

Despite such doubts, our panelists hailed technological innovations and the enormous gains in productivity seen over the last five years as a major reason for their continued faith in stocks and American business. On the day that the Labor Department reported that the third quarter rise in worker productivity was a surprisingly large 2.7%, Manley said, "Yes, there is no Great Depression to recover from and there is no World War II to place America in a prominent position. But productivity continues to rise, and as long as that is the case, profits will grow."

Indeed, from 1973 to 1995, productivity averaged lackluster gains of just above 1% per year. But since 1995, increases have more than doubled on the heels of the information technology revolution. Federal Reserve Board Chairman Alan Greenspan has said he believes that recent gains in productivity will continue for the future. "The pace of innovation is so fast and its ability to deliver cost savings and new products so great, that I see things accelerating for some time," says Anderson.

Along with technology, most panelists believe that the continuing pace of globalization and the spread of democratic free-market principles across the globe will continue to fuel corporate profits. "The opening of markets, continued deregulation, and globalization are enormous stimuli for the American economy," says Thayer. "Just imagine if only a tenth of the people in China, Latin America, and Africa bought Intel chips and Ford cars. Globalization is something to look forward to in the coming decades." Adds Manley: "People want better [lives] for themselves and their families, and the infrastructure to recognize those dreams is only now materializing in some places across the globe."

These concepts come with a word of caution: Shilling believes price/earnings ratios are out of whack. "Stocks are widely overpriced," he said a month ago. Also, Shilling is still looking for the oft-noted "capitulation" on the part of investors which he euphemistically refers to as "the puke point." "I haven't seen investors saying, 'Get me out of stocks at any price,' and traditionally, that is what signals the end of a bull market."

The events of September 11th may be cause for caution, the panelists say. By many people's thinking, the attacks will represent only a blip on the screen in the face of the steamroller-like progression of the American economy. Yet Thayer thinks about the arguments he has heard to the contrary. "If we respond to this terrorist threat with isolationism and by erecting barriers to protect our own businesses, things will change for the worse." At the very least, advisors--even those loath to change their historically based asset allocation strategies in the smallest manner--should give these visions of the future some thought and careful consideration.

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