It hasn’t been a bad year for Orange County’s cadre of publicly traded stocks, though it hasn’t been a great one either.
The Roth OC Tech index posted a solid 11.9% gain in the past 12 months, with the Roth OC 50 index close behind on a 9.6% rise. The OC 50 tracks companies with market values of $25 million to $1 billion.
The Roth Billion-Dollar Club of OC-based companies, with market values greater than $1 billion, is up a more modest 2.4% in the period.
OC’s market indexes are tracked by Newport Beach-based Roth Capital Partners LLC.
Nationally, indexes also are up in the past year, with the S & P; 500 index up 9.4%, the Dow Jones Industrial Average gaining 5.1% and the Nasdaq Composite index rising 2.9%.
While the market gains are decent, they pale compared to a year earlier. Last year at this time, the OC Tech index was coming off a 12-month gain of 135% while the Billion-Dollar Club was up 91% and the OC 50 rose 86%.
The markets in the past year have battled concerns about the war in Iraq, the coming election and a mixed economic rebound amid interest rate and oil price hikes.
While the OC Tech index led local gainers, their larger counterparts in the Billion-Dollar Club mostly have struggled on Wall Street in the past year. For instance, Irvine-based chipmaker Broadcom Corp., one of the biggest gainers at this time last year, is down 2.6% in the past 12 months. Lake Forest-based disk drive maker Western Digital Corp. is another decliner, off 34.5%, as is Irvine-based computer maker Gateway Inc. (down 12.7%) and Aliso Viejo storage device maker QLogic Corp. (off 39.3%).
The biggest gainers among OC’s largest companies include banks (Irvine-based Commercial Capital Bancorp, up 98%), homebuilders (Irvine-based Standard Pacific Corp., up 23%) and surfwear makers (Huntington Beach-based Quiksilver Inc., up 57%).
The biggest Billion-Dollar Club gainer: Santa Ana-based Advanced Medical Optics Inc., up 111%. The biggest loser: Santa Ana-based for-profit school operator Corinthian Colleges Inc., off 52%.
The uncertain environment could have an effect on another big OC name,Newport Beach bond manager Pacific Investment Management Co., or Pimco.
A Democrat or Republican election win could yield very different results for the bond market,the bread-and-butter for the mutual fund management company.
A widening budget deficit,pegged at more than $400 billion this year,could hit the price of bonds, which make up the bulk of Pimco’s mutual funds.
As the deficit rises, interest rates tend to increase, as investors demand a greater rate of return for buying more bonds. Prices of existing bonds fall in response to rising bond coupons, as they become less attractive to buyers. Despite the uncertainty, Pimco has seen overall assets rise to $392 billion following a dip last summer.
Stocks, on the other hand, are more likely to gain with a victory by President Bush, whose tax-cutting policies are seen as better for the economy than Sen. Kerry’s economic plan.
To help sort out what’s in store for the stock and bond markets, the Business Journal asked OC stockbrokers, investment bankers and money managers for their impressions of the markets.
Each was asked to answer several questions: What’s your take on the stock market?; What’s the impact of oil prices on the stock market?; How does the election factor into your outlook?; How will rising interest rates play out for the stock and bond markets?; and What’s your recommended asset allocation for clients?
Following is an edited version of their responses, plus excerpted commentary from Pimco Managing Director Paul McCulley’s latest Fed Focus report.
GORDON MCBEAN
Director of research
Roth Capital Partners
Newport Beach
What’s your take on the stock market?
After significant gains in 2003, we had expected to see stock prices level off this year as fundamentals caught up with stock prices.
We now feel that we are at the point where we should see improved returns in stocks over the next 12 months. With the S & P; trading at just over 17 times expected 2004 earnings, we are at a level that is well below the average price/earnings (P/E) ratio over the past 15 years.
We also feel that the quality of earnings today is greater than in previous periods due to all of the recently introduced accounting rules.
What’s the impact of oil prices on the stock market?
It never ceases to amaze me how little emphasis our nation puts on reducing its reliance on oil. With that being said, it still only accounts for about 3% of consumer spending. For businesses it looks like much of the increase in energy costs have been offset by productivity gains as price increases have been benign and profitability remained healthy.
When oil prices spiked in the early 1980s, consumption habits changed and new production came on line in the North Sea and in Alaska that eventually brought prices steadily lower until last year. We would expect to see similar behavior once again should oil prices continue their recent ascent.
Our current stock market expectations take into account the higher energy costs, so should we see a sharp drop in oil prices, we would expect even greater returns over the next 12 months.
How does the election factor into your outlook?
Our view is that the stock market would prefer no change in leadership in the near term, so Bush being re-elected would probably be best for returns in the near term.
If Kerry were elected, it may create some near-term jitters due to the uncertainty that any change brings, but using President Clinton’s election as a case-in-point, longer term it may not make any difference to stock returns.
How will rising interest rates play out for the stock and bond markets?
When there are broad expectations of rate hikes, then bonds become less attractive and equity allocations are increased. Rate hikes are normally a function of an improving economy, which also would mean good times for stocks.
AARON GUREWITZ
Managing director,
equity capital markets
Roth Capital
What’s your take on the stock market?
A look at the 52-week ranges of the major indexes as of early October shows that though the markets experienced their typical ups and downs, year-to-year numbers actually show gains, albeit modest in indexes such as the Nasdaq.
In early October last year, the Dow hovered around 9,500, reached a 52-week high of about 10,753 and, as of this writing on Oct. 7, was about 10,170.
The 52-week range for the N.Y. Composite index checks in between 5,779 and 6,798, and hovers near 6,670 at recent check.
Although these are not the blockbuster and unrealistic gains of the dot-com era, seasoned and long-term investors understand that we now are seeing signs of a sustained recovery in the equity markets. These are long-awaited improvements following a lengthy economic recession and shock resulting from the Sept. 11, 2001, terrorist attacks.
During the past few years, low mortgage rates reminiscent of the mid-1960s drove investors out of the equity markets into what was perceived as the relative safety of real estate.
Nevertheless, equities historically have outperformed real estate over the long term. The recent softness in equities may represent a significant buying opportunity, especially as rising interest rates make real estate a less attractive speculative investment.
What’s the impact of oil prices on the stock market?
Until recently, the Big Five oil producers,Chevron/Texaco, Total, BP, Royal Dutch/Shell and Exxon/Mobil,controlled 77 billion barrels of proven reserves and were spending an estimated $47 billion a year on exploration and production.
Industry analysts are saying that with the increase in oil prices, these producers will step up to the plate and invest more in extraction technologies that will allow them to reach the estimated 7.6 trillion barrels of oil remaining in the earth’s crust, according to Department of Energy statistics.
Drilling through 10,000 feet of water in the Gulf of Mexico and then through 20,000 feet of bedrock will become more commonplace as producers strive to satisfy the growing global demand for oil.
The ferocious appetite for oil from a rapidly industrializing China has driven the demand side of the equation. China, at 6.3 million barrels a day, is now the second largest consumer of oil, just behind the U.S.
Higher oil prices naturally will impact those companies dependent on shipping and distribution, as well as airline stocks. If there is good news, however, it may be found in the entrepreneurial, small cap sector, where technological innovations and alternative fuels are being researched.
How does the election factor into your outlook?
The markets traditionally are skeptical of any change in administrations. Investors already know President Bush and his economic policies as well as his approach to free market economics.
A Sen. Kerry victory could spark an initial sell-off as concerned investors digest the impact of a potential shift, both in domestic policy, such as promised tax increases, as well as in foreign policy. Kerry’s intention to roll back the dividend tax cut if elected could cause a rotation out of low-growth stocks with high dividend yields. Additionally, Kerry policy could negatively impact selected sectors such as insurance and healthcare.
Kerry also has campaigned to enact policy that would be punitive for anyone earning over $200,000 per year. This unfortunately also will encompass entrepreneurial and small business taxpayers who file under Subchapter S.
How will rising interest rates play out for the stock and bond markets?
Despite rising short-term interest rates, current rates are at historic lows. The Federal Reserve policy has begun to modestly increase rates, which tells us that Federal Reserve Chairman Alan Greenspan is confident that the economy is in recovery.
The rate increases will tend to ward off volatility and assure a more stable market. And stability bodes well for the equity markets.
VICTORIA COLLINS
Principal
The Keller Group Investment
Management Corp.
Irvine
What’s your take on the stock market?
Compared to bonds, U.S. stocks are trading at reasonable valuations, so they are still a good investment.
We are particularly attracted to large cap quality growth companies because they offer the best risk-versus-reward characteristics in today’s market.
Since we use a bottom-up fundamental approach to stock selection, we don’t recommend investing in stocks based on a sector strategy. That said, we do use approximate weightings of the S & P; industry sectors and one of the sectors we think has upside potential is healthcare.
We recommend inves-tors consider allocating a portion of their portfolios to international stocks. International stocks trade at better valuations and offer better growth pro-spects than U.S. stocks. If the U.S. economy slows down, international growth may continue to be driven by Asia.
What’s the impact of oil prices on the stock market?
High oil prices act like a tax on the economy, dampening global growth and hurting stock prices. But over time, oil imbalances have a way of working themselves out.
High oil prices encourage more oil and gas production, as well as exploration, which in turn puts downward pressure on prices. Slowing global growth also puts downward pressure on demand and prices.
In addition, high energy prices encourage more conservation and alternative energy development. So over time, we expect these free market forces to resolve energy imbalances.
How does the election factor into your outlook?
In our opinion, the market would prefer a Bush administration. Bush’s free market policies likely would relieve more and create less economic imbalances than a Kerry administration.
Chances of tax increases under Kerry would hurt the recovering economy. I think Greenspan has more potential impact on the markets than either Bush or Kerry.
How will rising interest rates play out for the stock and bond markets?
We believe most stock investors anticipate higher interest rates and have priced them into their valuation models. These higher interest rates likely will be driven by a growing economy producing higher corporate profits.
Thus, we believe the stock market can move higher in the face of higher interest rates.
Higher interest rates are bad for bonds. We recommend investors underweight long-term fixed rate bonds and hold more low duration and high yield fixed income securities.
How are you recommending clients allocate their portfolios?
Today our balanced accounts have 60% in equities and 40% in bonds.
In the stock portfolio, we are over-weighted U.S. large cap quality growth stocks and under-weighted U.S. small cap stocks. We have 20% of our stock portfolio in a diversified international portfolio.
In our bond portfolio, we are over-weighted low duration bonds and under-weighted long-term fixed rate bonds. To further diversify the bond portfolio away from long duration bonds, we hold a portion of the portfolio in high yield bonds and an internationally diversified bond fund that isn’t hedged.
MATTHEW HEALY
Senior regional investment manager, vp
Wells Fargo Private Asset
Management Group
Newport Beach
What’s your take on the stock market?
Clearly, the stock market measured by the most familiar indices such as the S & P; 500 and/or the Dow Jones Industrial Average would indicate the stock market has not performed all that well this year.
Rather than solely focus on these indices, investors should be looking at other parts of the equity market for diversification. There are areas of the market that have performed particularly well this year.
For example, value stocks have outperformed growth stocks in general. In fact, large cap value stocks are up year-to-date 6.6%, midcap value stocks are up 6.4% and small cap value stocks are up 10.6%. International stocks have performed well, too.
We believe stocks are positioned to outperform bonds during the next 12 months. We are emphasizing international over domestic stocks, value over growth and small cap over large cap.
Our greatest conviction is with the international overweight as the story around small cap and value is starting to look less compelling on a relative valuation basis. In terms of sectors, we are reducing our exposure to energy and adding to our consumer discretionary sector.
What’s the impact of oil prices on the stock market?
We believe investor pessimism is overdone, led by higher oil prices and terrorism concerns. In our view, there is currently a terrorism premium in bonds and a terrorism discount in stocks. We think that such concerns are likely to become less over time, diminishing their impact on the markets.
How does the election factor into your outlook?
We are less focused on the outcome of the election than the economic recovery.
How will rising interest rates play out for the stock and bond markets?
We think stock prices can rise as bond yields rise, much like what happened in the 1950s and the 1960s when stocks did very well despite bond yields trending higher from very low levels. The strength of the economy and earnings are likely to be a significant positive for stocks.
Moreover, bond yields and inflation are still very low and we believe they can rise from current levels without creating a significant hurdle to economic growth or the stock market.
How are you recommending clients allocate their portfolios?
For balanced accounts, we are recommending an asset allocation of 70% stocks and 30% bonds.
Within the bond allocation, we are recommending a “barbell strategy” where we are extending out on the yield curve with 50% of the fixed income allocation and the remaining 50% keeping relatively short in terms of maturities.
Within the equity allocation, we are recommending 62% large cap, 13% mid cap, 4% small cap and 21% international. Diversification in other asset classes also is recommended including real estate and alternative investments.
MICHAEL JOHNSTON
Managing director,investments
The Pacific Group at Smith Barney
Irvine
What’s your take on the stock market?
Though stocks may not be as attractively valued as they were in late 2002 and early 2003, we think that stocks still should be included in an asset allocation that also includes fixed income, cash and alternative investments.
Given the recent negative news and uncertainties in the marketplace (rising oil prices, slowing employment growth, increases in short-term interest rates, decelerating earnings growth, Iraq, terrorism and a very close election contest), we are surprised that the equity markets have held up so well.
Smith Barney’s equity strategist is cautious on the equity market through the end of 2004 but has a more constructive view for 2005. During the next few months, we believe the stock market could re-test the lows of August due to the deceleration of earnings growth.
Corporate profits have increased more than 20% in each of the past four quarters, which is very unusual and we think unlikely to continue. The stock market needs to lower its expectations for future earnings growth to a more normalized level, in our view. For cash on the sidelines, we are waiting for a better buying opportunity during the next few months. Smith Barney’s official 2004 year-end target on the S & P; 500 is 1,025 and the Dow is 9,750.
For 2005, our year-end target is 1,225 for the S & P; 500 and 11,700 for the Dow. These targets are based on our view that the Federal Reserve will complete the interest rate increases by the end of 2005, oil prices will drop from current levels, the election uncertainty will be eliminated, the market’s expectations of earnings growth will decline to a more realistic 6%, and GDP growth will be in the range of 3.7% in 2005.
Longer term, we believe that investors may need to expect lower returns from the stock market. With the S & P; 500 trading at a price/earnings ratio trading of 17.3 based on trailing 12-month earnings, future stock market appreciation likely will be more dependent upon corporate earnings growth than valuation increases.
We are over-weighting healthcare (healthcare equipment, managed care, pharmaceuticals, biotech), consumer staples (household and personal products, foods and staples retailing, and food, beverage and tobacco) and energy. We believe these defensive industry groups have less risk of being impacted by decelerating earnings expectations.
We are beginning to look at technology again, especially the smaller companies whose valuations have contracted relative to their larger peers. We’re expecting consolidation within the technology industry in the next year as larger companies buy attractively valued smaller companies.
What’s the impact of oil prices on the stock market?
Increases in oil prices today don’t negatively impact the rest of the economy as much as increases did in the past due to the economy being more service-based and less industrial-based, according to Smith Barney’s economists. These companies are better able to absorb oil price increases in the manufacturing of their goods and services without passing along the oil price increases to the consumer.
Higher oil prices might have a more muted effect on the prices of goods and services than has historically occurred. However, consumers could reduce spending, which would result in companies reducing hiring, capital spending and production.
With oil prices around $50 a barrel, we believe that a lot of speculation is built into prices.
Once the momentum subsides, oil prices are expected to drop to levels that more appropriately reflect a normal level of supply and demand for oil. Still, because of the longer-term projected imbalance between supply and demand for oil, consumers might need to become accustomed to higher oil prices than experienced during the past decade.
How does the election factor into your outlook?
It seems that the election is adding uncertainty to the equity market. The markets do not like uncertainty. We believe the markets will be choppy until the election is over.
With a Sen. Kerry win, our strategist thinks the stock market will focus on the potential increases to tax rates on capital gains and dividends. Tax increases are likely to be considered a negative for the stock market, especially for the dividend paying stocks that have performed well since the 2003 tax cut program was implemented.
Tax increases might benefit the bond market given that the increase in tax revenues could help reduce the federal deficit. However, unless the Democrats are able to take control of the House or the Senate, gridlock has the potential to prevent any meaningful changes to the tax code.
We would expect alternative energy stocks to perform better with Kerry as president given his vocal support for alternative energy sources. Also, we would expect pharmaceutical and managed care stocks to suffer given some of Kerry’s stated plans for healthcare reform.
Historically, the stock market has believed that a Republican White House is better for stocks; however, gridlock has tended to be the best environment for stocks.
Therefore, a win by President Bush doesn’t necessarily equate to a strong outlook for the stock market. In fact, industry groups that you would expect to perform well with a Bush re-election, such as defense, energy and healthcare, have been moving in tandem with re-election poll surveys.
We would expect dividend-paying stocks to continue to perform well with a Bush second term since the recent dividend and capital gain tax cuts likely would remain in place. These continued tax cuts also could benefit the financial industry that generates revenue from managing equity market assets.
How will rising interest rates play out for the stock and bond markets?
The common theory is that high interest rates are bad for the stock market as they raise the cost of capital.
However, one must determine the reason for the increase in rates to be able to predict how it will affect the stock market.
It could be a positive for the stock market if rates are rising because oil prices are dropping, consumers are spending more, and corporate profits are increasing.
On the other hand, the stock market likely would react negatively to increasing interest rates if oil prices continue to increase, consumer spending slows, corporate profits decrease, economic growth declines, the federal deficit continues to increase and interest rates increase due to foreign investors buying less U.S. bonds because of a declining dollar and greater perceived risk in financing the budget deficit.
Next year we expect the Federal Reserve to increase the Fed Funds rate to 3.25% as the economy overcomes some of the challenges that were mentioned previously.
How are you recommending clients allocate their portfolios?
We have our clients’ assets invested in four broad categories at this time.
We have raised some cash during the past few months in anticipation of a mild stock market downturn.
We are keeping the cash on the sidelines until early 2005.
For the fixed income allocation in our clients’ portfolios, we have significantly reduced the average duration of the bond portfolios given the expectation of higher interest rates. We also have invested into other income-generating strategies that have very little, if any, interest rate risk.
We are defensive with the equity allocation in our clients’ portfolios. Last year, we shifted more of the equities into dividend-paying stocks. Second, we have over-weighted international markets due to our longer-term views of a declining U.S. dollar and the lower valuations in those markets.
For the alternative investment allocation in our clients’ portfolios, we have exposure to various investment strategies that have low correlations to the equity and bond markets.
