Long view puts markets in perspective

Wednesday, July 27, 2005 at 12:00am

Last week, the Dow Jones Industrial Average closed at 10,651.18, the S&P 500 Index at 1,233.68 and the Nasdaq Composite at 2,179.74.

Our longer-term view is that the U.S. equity market has been supported by low interest rates, particularly out along the yield curve, and reasonably strong earnings. Nonetheless, there are some headwinds - rising short-term interest rates and higher oil prices - and the equity market has not been able to decisively break above the levels we saw in March.

The optimistic case for stocks is that they are cheap relative to bonds and could break out to the upside when there is some relief from the Federal Reserve Board and/or oil. In our minds, the gap between real bond yields and earnings yields is at the low end of the range, implying that the equity risk premium has increased.

We tried to make the point all along that market forecasts have to be put in the context of a low-return world going forward. To put that in perspective, we think that there were three very powerful supports for the secular bull market in stocks that we enjoyed in the 1980s and 1990s.

The most important was the sharp decline in inflation, and therefore interest rates, which created a record bull market in bonds and a re-rating in stocks. In addition, the corporate sector shifted from being pretty inefficient with low profitability in the early 1980s to being highly efficient and much more profitable by the end of the period. Finally, stocks were certainly an unloved asset class in 1982 following the 1966 to 1982 sideways/bear market. The S&P 500 was trading less than seven times forward earnings at that time and equities were small parts of portfolios. Unfortunately, we think that these three supports have been pretty fully exploited.

Meanwhile, profit margins are at their highest level of the post-World War II period and, in our opinion, are more likely to fall than to rise. In addition, equity valuations are unlikely to rise significantly from current levels and investors are unlikely to substantially increase their equity holdings as a percentage of portfolios, which puts us in this muddle-through sort of period.

More broadly, we think the economic and financial environment has settled into an unusual state of a stable disequilibrium. We have housing prices high in many parts of the world, record financial imbalances (for example, the U.S. deficits) and massive leverage. All of these things create the potential for huge instability.

And yet, everything is pretty calm. Stock prices are holding near their highs, bond yields are reasonably low and currencies are reasonably stable. We believe the main reason for this is the plentiful supply of global capital and liquidity that has been able to flow to the savings deficient United States and, by keeping interest rates down, has supported the economy, partly by fostering the housing boom.

In many ways the global economy, in our opinion, is still in a post-bubble phase with companies being reasonably cautious about expanding. And given the relatively benign outlook for the economy, we think it makes sense, with some caution, to take on more risk in portfolios. Two key developments in our minds for that to be rewarded would be a more significant drop in oil prices and/or indications that the Fed is finished raising rates.

Bob Doll is president and chief investment officer of Merrill Lynch Investment Managers. For more information on MLIM, e-mail mlim_feedback@ml.com.

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