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Investors May Have Become Too Optimistic
But Bulls Say Higher Stock Prices are Justified
By Dennis Trittin, Portfolio Manager
Russell Investment Group
Global Leaders in Multi-Manager Investing
September 30, 2003
This article has been provided by our parent company, and any references to rates or returns are based in $US and specifically relate to US markets.
If the stock market is right, we will see a strong economic recovery and higher corporate profits next year. But then, of course, this year's strong rally may have put the market ahead of itself.
A presumption of strong future growth is already built into many stock prices. Investors, who generally anticipate economic events that lie six months to a year ahead, foresee strong future earnings and so are pushing up stocks to those values in anticipation of such growth.
It remains to be seen, however, whether the growth in business and consumer spending will be sufficient to justify those predictions.
Indeed, if companies' forecasts in coming months fail to justify this optimism, we could see a drop in stock prices to compensate.
The optimism pervading the markets represents a dramatic change from just a year ago, when investors faced a wall of worry. Concern about what would happen in Iraq combined with few signs of economic growth left investors afraid to take risks. Bonds were king. Technology was one of the worst hit sectors. Few saw signs of any imminent improvement.
Suddenly, however, a few leading technology companies said in October last year that business was stabilizing and no longer deteriorating. Although they were careful not to talk about growth, but only stabilization, investors eagerly bought into the stocks and pushed up their prices.
Rally Stretches Toward a Year
The rally, which began in the fourth quarter of 2002, has continued into this year. The rise has been particularly evident in small company stocks, but stocks in many of the most popular technology companies have more than doubled.
The optimistic spirit has affected most sectors of the market, driving large and mid-cap stocks higher, too. The Russell 1000® Index, which measures the movement in the 1,000 largest US stocks, is ahead 17% year to date.
However, we have reached a point where investors are divided into two camps over the future direction of the market.
The bulls suggest that companies will indeed show the growth needed to justify today's prices. They say companies have lowered operating costs so much that profits are expanding as business improves. Replacement demand is kicking in, they add.
The bears, however, argue that stocks never became cheap enough in the downturn and now are selling way above the levels that are justified by their growth prospects. They suggest the market is wrong. Once investors realize all these companies are not going to show the dramatic improvement today's prices suggest, stocks will fall back once more, they say.
Worthy Optimism?
What is clear is that valuations and expectations are higher. Optimistic investors have raised the bar. It will no longer be good enough for managements to say that business is stable.
The crucial question is whether they have raised it too high or whether companies will be able to vault the new level with comparative ease. New information from publicly traded companies in the next few weeks will need to reflect continued optimism or we may encounter setbacks.
Copyright© Frank Russell Company 2003. All rights reserved. See Legal Information. Date of first use: October 16, 2003.
This is a publication of our parent, Frank Russell Company. It should not be construed as investment, legal, or tax advice. The contents are intended for general information purposes only, and you are urged to consult your own investment, legal, or tax advisor concerning your own situation and any specific investment questions you may have. For further information about these contents, please contact Russell Investments Canada Limited.
Russell Investment Group is a registered trade name of Frank Russell Company, a Washington USA corporation, which operates through subsidiaries worldwide. Frank Russell Company is a subsidiary of The Northwestern Mutual Life Insurance Company.
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