Capital Markets Commentary
By Jim Baird
Universal Advisor , 2005 Issue No. 2
Through the first six months of 2005, stocks drifted generally lower. The S&P 500 Index is down 0.8% during that time, despite valuation multiples that appear increasingly attractive. Mid cap stocks remain the relative bright spot in the domestic markets with their year-to-date return of 3.9%. After falling precipitously in the first quarter, small cap stocks rebounded robustly in May; through June, however, the Russell 2000 Index remained in negative territory with a year-to-date loss of 1.3%. International stocks, which held up better than U.S. stocks earlier in the year, did not participate in the recent rally and remain down 1.2% through the first six months of 2005.
Preliminary estimates of first quarter Gross Domestic Product growth precipitated discussion of a so-called “soft patch” in the economy, but recent revisions of those estimates have resulted in stronger than previously reported annualized growth of 3.8% for the quarter, in line with that during the fourth quarter of 2004. For all the concern expressed about a weakening economy, the current rate of growth exceeds the average annual growth rate over the long term. Even during the ’90s, the average annual rate of growth was only 3.1%. From 1980 through 2004, that average was fractionally lower still at 3.0%. The bottom line is that for all of the hand-wringing and concern about inflation, employment, and the twin trade and federal deficits, the economy appears to be growing at a reasonable pace. This is not to suggest that these other considerations should be ignored, but investors should be cautious not to fixate on a handful of uncertainties and lose sight of the big picture.
Sooner or later, investors will likely fit the pieces together and demonstrate improved confidence in the equity market which, in time, should generate demand and ultimately stronger performance. In he interim, equity valuations will likely persist in their retrenchment of levels well below their peak in 2000, with contracting valuation ratios increasingly blurring the lines between traditional value and growth stocks.
Value has unquestionably ruled the day since 2000, just as growth easily trumped value during the late ’90s. Five years after the end of the technology bubble, however, there is growing evidence of the relative attractiveness of growth stocks. Price/Earnings (P/E) ratios among large cap growth stocks haven’t been this low since 1996. Cash flow ratios are less than half their levels at the 2000 peak, while prices relative to book value have fallen more than 65%. Increasingly, traditional value managers are selectively adding technology and other growth companies to their portfolios based on their underlying fundamentals and the perception that their favorability will improve as investors embrace these same stocks that erased the paper fortunes of many overly aggressive speculators just a few years ago. Smaller growth companies, which have generally traded at a premium relative to value, also appear to be well-positioned to fare favorably relative to value stocks currently trading at comparable P/Es.
The inflection point of change between style or market cap dominance is only clear in hindsight and influenced not only by quantitative factors but by aggregate investor sentiment. We expect that value stocks will be harder pressed to continue to eclipse the performance of increasingly attractive growth stocks, especially among large blue chip issues. With P/Es at their current levels, even seasoned value managers are finding it easier to see the merit in growth stocks. Investors who have maintained a value bias in their large cap portfolios would be well-advised to consider taking a balanced stance and reintroduce growth to their large cap portfolios.
