April 3, 1998
The U.S. economy celebrated another milestone as the Dow Jones Industrial average broke through the 9000 point mark for the first time in history. But news was not so encouraging for the world's second largest economy, Japan. Phil Ponce talks with two investments strategists about why the U.S. economy is apparently soaring while Japan's continues to flounder.
PHIL PONCE: For the world's largest economy, the United States, the way of the Dow is up. It went up past 9,000 today for the first time in history before closing about 20 points lower. How much higher will the Dow go? Are there signs a correction might be in the offing? For analysis we turn to Gail Dudack, chief investment strategist at UBS Securities, an investment bank in New York, and Joseph Battipaglia, chief investment strategist at Gruntal & Company, a New York brokerage firm. And welcome both.
A RealAudio version of this segment is available.
February 3, 1998:
Exploring the impact of Asia's economic crisis on the U.S.
January 19, 1998:
An examination of the IMF's bailout plan for Asia.
January 16, 1998:
Treasury Sec. Rubin discusses Asia's economic crisis.
December 31, 1997:
An economic year in review.
December 25, 1997:
A look at the job market around the country.
December 16, 1998:
A new economic paradigm: growth with no inflation.
October 28, 1997:
The stock market gains 337 points after a 517 loss the day before.
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The bulls and the bears.
Mr. Battipaglia, speaking from the bulls perspective, why is this happening?
JOSEPH BATTIPAGLIA: Good evening. The reason it's happening is threefold. First, we've conquered inflation, so expectations about the future are quite bright. We've gone from thinking about 4 percent inflation to talking about 2 percent or less as the ongoing inflation rate, very powerful financial asset or financial asset performance. And secondly, we've had a globalization going on since the end Communism, the adoption of mercantile activity, economic commerce as the way of the world, and that has benefitted the United States, or has gone through a dramatic restructuring to be a leader in the world. And what that leads to is a third element of this, an explosion in corporate profits. In the last five years alone profits have expanded by 60 percent. All of these factors coming together have led us to a dramatic bull market, making 9,000 just another milestone on our way to 10 and beyond.
PHIL PONCE: Ms. Dudack, he's painting a near perfect picture. Is that how the bears see it?
GAIL DUDACK: Well, I think there's--what Joe said is actually true. What I disagree with is that this is some kind of new era or new paradigm because I think that the 90's are very much like the 1960's. In the 1960's, though, we had a nine-year economic expansion with lower inflation than we have right now, lower interest rates than we have currently, better productivity than we have, a higher savings rate than we have today, lower debt as a percent of GDP. In fact, we had a better environment than we have today but today we have stocks trading at record multiples. The S&P is trading at over 23 times trailing operating earnings. We've never seen that kind of valuation before, and even in the 60's we never got above 22, and that was when earnings were falling in a recession. The other thing about profit margins--and I think it's true--we've had a wonderful expansion in profit margins--they're now at 1966 peaks, and I think they have peaked. That's the key problem here. So I don't think companies will be able to gain productivities, and earnings may slow down pretty dramatically in the next couple of years.
PHIL PONCE: So is the earnings portion, Ms. Dudack, the portion of this equation that concerns you the most?
GAIL DUDACK: Well, I think it's going to end up being the underlying problem for the stock market in the long run. There are other things too I think that are somewhat of a problem, which is that a lot of people are banking on demographics as the reason to buy stocks because baby boomers have to save, and they have no place to go but to equities. There's two problems with that. And I've been a part of that belief that there's two things. One is that savings rate is very low today. It was recently at a 58-year low, so the demographics aren't working. The other thing is that the savings that the public has found they've put primarily into equities, and so the average investor now has over 50 percent of their financial assets in equities so that their need to continue to force the money into stocks is certainly diminished. And their cash ratios are actually quite low.
The stock market: high participation or overvalued?
PHIL PONCE: Mr. Battipaglia, along the lines of participation, participation in the stock market is also high, in addition to the level of the Dow Jones, yes?
JOSEPH BATTIPAGLIA: Well, it is, and it should be, because investment flows will go where the returns are the best. We've found that throughout this century. And in this period of time the best place to be is the U.S. stock market, so it goes hand in hand. I would say that the most interesting development with all of this is that we have a situation like the 60's, except that we will not have the 70's on the tail end of this, as opposed to being topped out in the competitive field by the Japanese, as went through the 70's, as opposed to having the Vietnam War to deal with, and thirdly, having not one but two oil shocks during the 70's, we actually have a world that is more like the U.S. model in many respects, rudimentary democracies, the expansion of commercial activity, the opening of borders to trade. So I would argue that we are still in a transition of a positive nature, where inflation stays very low, where savings starts to build rather dramatically, helped along by a rising stock market, U.S. competitiveness means global profitability for American companies, which when added to the domestic profitability continues what has been enforced through the 90's. And if wages continue to rise, I view that as a very positive element because it helps the consumer with the savings rate, lowering the debt balances, and also to keep the consumption going. So we have a scenario of ongoing improvement without some sort of cliff that we're going to go off of any time soon. There is the difference between the 1960's.
PHIL PONCE: So, Mr. Battipaglia, how much longer do you think this ascendancy will continue?
JOSEPH BATTIPAGLIA: As long as these conditions remain in force, the bull market will continue to rise with no particular cap in sight. And if we have our sights set on 2 percent or less inflation for goods and services and that we continue to open up economic activity on a global basis, and the United States still exhibits the ability to be a technological leader, we will see 10,000 fairly soon and well beyond that, and, indeed, our path may cross with the Japanese. Their Nikkei Index has been rolling backwards. Their economic model does not work. The ascendancy here is rather obvious.
PHIL PONCE: Ms. Dudack, 10,000 pretty soon?
GAIL DUDACK: The market seems almost destined to go there like a magnet because the market, I think, is driven more by psychology than fundamentals, and I'm the last one to underestimate psychology, but kind of following up on what Joe said, one of my biggest concerns is related to Japan, and not just the Japanese economy, which is a problem down the road, but also that the U.S. stock market does have many similarities to the Japanese market or the 80's, where the market disconnected from fundamentals went to 44 times earnings on the belief that the economy in Japan would continue as it was forever. It turned out that the Japanese market was way overvalued and then it crashed about 40/50 percent. So I think that you can disconnect from fundamentals for the short-term but not in the long run. And I think that investors should really, you know, take a hard look at valuations right now.
The crisis in Japan.
PHIL PONCE: Speaking of Japan, yesterday the chairman of Sony made a fairly strong statement. This is the Sony chairman Norio Ohga, who said, "The Japanese economy is currently facing its most difficult time ever. I am concerned that if Japan falls into a deflationary spiral, it would affect the Asian economies. In that case, not even the U.S. economy would be able to maintain its healthy state." Mr. Battipaglia, does that statement concern you?
JOSEPH BATTIPAGLIA: Well, I want to go back to Gail's statement, which concerns me, and that is that we have a construct similar to Japan. I'd like to point out that their economy is closed, so the price for goods and services in that country are out of kilter with the rest of the world. Secondly, they chose not to have open competition for business. So, in effect, their model fumbled in an economically competitive environment. As to the prime minister's remarks, I would say that, indeed, the Japanese will work harder to import more of the goods that they do buy from the U.S. because that helps their economic engine, which is an export engine. So in order for them to be in global markets, they need to continue to import the goods from the U.S. that they use. However, they don't import a tremendous amount of other goods from the U.S. for the consumer side of things. So they will rely on their export engine to help their economy along. They do have to make fundamental changes in the consumer part of their society to regulate their financial institutions to make up for the lost ground. So, in effect, a deflation in Japan will only bring their prices into where they should be on a global basis, and I don't believe it goes beyond the borders of Japan.
PHIL PONCE: So you don't think Japan's troubles would affect the U.S. market that much. Ms. Dudack, do you agree with that?
GAIL DUDACK: Not really. It's hard to say that the second largest economy in the world won't impact other economies in the world, even the U.S., although I think the U.S. is probably less immune, but I think that it does point out one key thing, that if the 90's are like the 60's, like I think they are, it's true, as Joe said, that it's not going to be--the stock market won't be broken down by inflation because the baby boomers created the inflation partially of the 70's but it could be deflation. It could be that the real risk out there is deflation, and so many of the things that this generation is looking at to end a bull market cycle won't materialize, i.e., inflation or higher interest rates may not be the catalyst for the end of the bull market cycle. It may be a lack of earnings, and that's the source of my concern.
PHIL PONCE: Staying with Japan just for a second, explain in lay terms how the economic troubles in Japan could conceivably hurt an American investor.
GAIL DUDACK: Well, I think we saw in October with the Asian currency crisis how interlinked most stock markets and economies are. And the biggest risk right now to what happened in Asia is to Japan, and, more precisely to the Japanese banking system. The Japanese banking system has really a series of problems, going back to the fact when their economy was doing very well, they over-invested in real estate throughout the world, and that was a source of one problem. They invested in throughout Asia, and they now have some very bad loans in Asia, and they're also very linked to the stock market. Banks in Japan can hold capital in stocks, and their stock market this week is falling. If it falls below 15 percent, that all puts pressure on the banking system in Japan. Clearly, if you have a weak or a crumbling financial system that's bad for the economy, and it could create a credit crunch that could then circle around the world. So it's going to be, I think, a situation that deserves some monitoring going forward.
A bit of investment advice.
PHIL PONCE: Mr. Battipaglia, what kinds of advice are you giving to your clients--to stay where they are, enjoy the ride so to speak?
JOSEPH BATTIPAGLIA: Well, understand how we got here and that we have a reason to be here. Be watchful for the return of at any time of inflationary tendencies. Be watchful for recession in the major industrialized countries, particularly Europe and the United States. I leave Japan out of this. And there are opportunities in the market because it has been very rationale. Companies that don't meet their earnings expectations are taken out and literally shot. There are industrial sectors that have under-performed. There are companies that are in transition. There are still great opportunities in the bull market, so that I see more investment coming, and I also see new investors who have money to invest moving away from fixed income vehicles and money funds to take advantage of what equities, opportunities are presented to them. So as long as the mix of fundamentals does not change, there is an opportunity to get the 11 percent or so per annum performance out of equities that have been the historical norm not just for a five-year period of time but for a sixty-year period of time.
PHIL PONCE: And, Ms. Dudack, what advice are you giving to your clients?
GAIL DUDACK: I think it's very important for people to take a look at what they have in terms of their assets. And I think stocks are 20 percent overvalued, and if the stock market were to have a 20 percent/25 percent correction, would they still feel as comfortable with their asset mix they have today? If they do, fine, because I do think that on the long run the U.S. economy is in very good shape--but I do think that there will be a lot of volatility in the next 12 months.
PHIL PONCE: Well, thank you both very much. That's where we'll have to leave it.